(With thanks to Barbara Klementz for this post.)

Why hire through a PEO?

When companies start expanding internationally, it is often important to “put boots on the ground” as quickly and cost-effectively as possible.  The traditional approach of establishing a local entity and employing employees through the local entity may not always work due to the cost and time involved in setting up and maintaining the local entity and local payroll, as well as the complexity of establishing and administering supplementary benefits.

Aside from engaging local national individuals as consultants, another alternative is to contract with a third-party entity employer that in turn hires the individuals as its direct employees while the individuals provide the desired services to the company.  The most popular form of third-party entity employer is the Professional Employer Organization (PEO).  In the US, a traditional PEO is the employer of record for payroll purposes and group benefits only.  Outside of the US, however, a PEO is essentially an entity that acts as the legal employer of the individual the company wishes to hire, enters into an employment relationship with the individual directly and administers payroll, local benefits, etc.  The PEO can even sponsor work permits and visas for the individual.  Under this model, there is no direct contractual relationship between the company and the individual.

Both the consultant and PEO approaches can enable companies to engage individuals quickly, without the hassle of setting up an entity as well as establishing all of the other processes needed to engage local service providers.  But each approach also carries its own risks and, in the case of PEOs, upfront costs, that should be carefully analyzed, depending on the country.[1]  And, of course, granting equity awards to consultants or PEO employees also entails certain issues that need to be vetted.[2]

Can equity awards be granted to PEO employees?

The first thing to consider when granting equity awards to PEO employees is whether the company’s equity plan permits such a grant.  For companies incorporated in the U.S., the eligibility provisions typically are driven by Rule 701 (for privately-held companies) and the Form S-8 requirements (for publicly-held companies), which seek to exempt from (in the case of Rule 701) or comply with (in the case of Form S-8) the securities registration requirements.

Both sets of rules allow the grant of equity awards to service providers, which includes employees and consultants of the issuer or any subsidiary of the issuer.  Therefore, most plans will provide that individuals eligible for awards under the plan must be either an employee or consultant of the issuer or a subsidiary of the issuer (or another service provider, such as a non-employee director).  On its face, this may not allow grants to PEO employees, given that these individuals technically are not traditional employees or consultants of the issuer nor of any of its subsidiaries.

However, based on my experience, most companies take the position that PEO employees can be classified as either common law employees, “de facto” employees or consultants under an equity plan.  A characterization as a common law or “de facto” employee seems appropriate, provided the PEO employee provides services on an exclusive basis that benefit the issuer (or a subsidiary of the issuer) and that are traditionally performed by an employee, and where the compensation received by PEO employees for the services performed is the primary source of the individual’s income.  But each plan will need to be reviewed carefully to make sure it does not contain any overly restrictive provisions which could jeopardize this conclusion.[3]

Regulatory issues for PEO employee grants

The next thing to consider when granting equity awards to PEO employees are the local law implications. From a securities/regulatory perspective, if PEO employees are classified as “non-employees,” it could be problematic to grant equity awards in several countries because various securities law exemptions may no longer be available.  In other words, many securities law exemptions are predicated on an issuer granting equity awards to employees or other service providers.  Thus, if PEO employees are classified as non-employees, these securities law exemptions may be lost and companies would need to rely on other exemptions (to the extent available, such as small-offering exemptions).

To a lesser extent, other regulatory restrictions may also prevent an issuer to grant to non-employees.  As an example, in China, the requirements under Circular 7 require companies to seek approval from the State Registration of Foreign Exchange (SAFE) prior to offering a plan to individuals in China.  Based on our experience, SAFE would not approve awards granted to employees of an entity that is not part of the company group.

Tax issues for PEO employee grants

From a tax perspective, the implications will generally differ depending on whether PEO employees have to be classified as employees or consultants. For example, if equity awards are granted to a consultant in a particular country, there will generally be no withholding/reporting obligations for the company since contractors are typically considered “self-employed”  and the receipt of equity awards would be deemed additional income for services rendered.  Furthermore, the timing of the taxable event itself could be different in certain non-US jurisdictions depending on whether the PEO employees are classified as employees or consultants. For example, in Canada and the UK, consultants generally are taxed at grant of equity awards.

On the other hand, if PEO employees are classified as employees, the PEO may have tax withholding/reporting obligations (depending on the country) and the company will be required to (i) communicate the taxable amount and taxable event to the PEO as well as certain other information regarding the equity awards, and/or (ii) transfer funds to the PEO so that tax can properly be remitted (assuming tax withholding obligations are satisfied by selling/net settling shares at the taxable event, rather than through payroll).   It should not be assumed that a PEO is familiar with the tax obligations for equity awards, so advance planning will be advisable.

Practically, since companies otherwise generally will treat PEO employees as “real” employees and tax on salary is treated accordingly, it may be most pragmatic to be consistent and to also treat them as employees for purposes of the tax treatment of their equity awards.

Separately, however, even if PEO employees are classified as employees, certain tax-qualified regimes may not be available for such grants.  For example, in the UK, it is not possible to grant tax-qualified options under the so-called Enterprise Management Incentive scheme to individuals who are not actual employees of the issuer or a subsidiary of the issuer.  Similarly, in France, it is not possible grant tax-qualified options or RSUs to individuals who are not employed by a local entity of the issuer in France.

Conclusion

Although hiring individuals through a PEO may be a very good approach for companies to quickly and cost-effectively put boots on the ground in many countries, companies will need to consider certain special issues when granting equity awards to such employees.  Often, companies will not even alert their advisors to the fact that the grant recipients are, in fact, employees of a PEO because they are otherwise treated as “real” employees of the company.  However, as noted, the considerations can be different and companies are well-advised to check if such grants are problematic in applicable countries.

Barbara thanks colleagues Susan Eandi and Sinead Kelly for their assistance with this blog post.