Q: More small companies are using professional employer organizations (PEOs) that lease employees to small businesses. Under IRS regulations, does having the PEO as the employer of record preclude the small business from issuing incentive stock options to its leased employees?

— S.K., Atlanta

A: The short answer is yes. "Incentive stock options can only be issued to employees," says Kirk Maldonado, an attorney who specializes in employee benefits and executive compensation at the Los Angeles law firm of Riordan McKinzie. "They cannot be issued to leased employees." Under the Internal Revenue Code, the rules that govern certain employee benefits, including Section 401(k) retirement plans, treat leased employees the same as regular employees, says Maldonado. That isn't the case with incentive stock options. If you want to give stock options to your leased employees, Maldonado says, you can give them nonqualified stock options (NSOs), which can be issued to anyone the company chooses. (For a more detailed explanation of stock options, see the Nov. 25, 1999, Smart Answers column, "The Options Option: How Private Companies Can Use Stock as an Incentive".)

Your question is part of a larger and very thorny issue — the difference between employees and contingent workers (another term for leased employees). According to the American Staffing Association (www.staffingtoday.net), staffing companies send out 2.9 million people each day to jobs around the U.S.; the companies claim to have created 1 million new jobs over the last five years; and 80% of temporary employees work full time, the same percentage as the rest of the work force.

Increasingly, these workers are professionals hired for specific projects or individuals working full time for PEOs — not temps filling in for someone on vacation. Under a PEO contract, a business places most or all of its work force onto the payroll of a staffing firm, which assumes responsibility for paychecks, benefits, and other human-resource functions.

When employee leasing is done right, the staffing agency becomes a human-resources partner for an entrepreneur. Under these scenarios (contract details vary widely), a small business recruits, screens, and hires its own workers, then puts them on the staffing agency's payroll. The agency "leases" the workers back to the company for a fee. In some leasing arrangements, both the staffing agency and the client are considered joint employers. In others, the client company remains the sole employer. The purpose of the arrangement is to transfer responsibility for administering payroll and benefits from the client to the staffing firm — not to let employers avoid payroll taxes or other obligations that come with having employees.

"The IRS considers that the client company continues to be the employer of these individuals, since they hire, they fire, they discipline, they determine rates of pay, and pay them," says Phyllis Hogue, an attorney specializing in employment law for the law firm of Trenam Kemker, in Tampa, Fla. "The PEO then becomes solely a human resources partner with the client company. If these arrangements work right, small-business owners can get their employees better health insurance and better retirement plans, because the staffing agency can offer a more attractive product to a small employer who may be faced with exorbitant costs."

Before you sign up for employee leasing, investigate the staffing agency to make sure it is reputable, financially stable, and that its leasing plans don't violate IRS or EEOC (Equal Employment Opportunity Commission) guidelines, Hogue says. As recent employee lawsuits and IRS administrative actions have revealed, there have been situations where permanent, full-time employees were treated as contract workers and denied benefits or employers weren't paying employment taxes on full-time employees.

The next Smart Answers column will talk about creating leasing arrangements that don't illegally blur the line between full-time employees and contract workers.