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Co-employment is a confusing concept for many because of the shared responsibilities and blurring of lines regarding who the actual employer is. 

To make matters worse, varying labor laws and differences between similar arrangements (like EORs and outsourcing) add to the complexity.

Use this guide to help you get crystal clear on what co-employment is, as well as benefits and risks (and how to avoid them).

What Is Co-Employment?

Co-employment is a relationship in which two or more organizations share the responsibilities of an employee’s employment. 

The most common form of co-employment occurs when a company partners with a third-party organization, such as a professional employer organization (PEO).

In this setup, the responsibilities and liabilities associated with the employment relationship are split between the two entities with PEO handling HR admin functions like payroll processing or benefits administration.

Hiring independent contractors is not a form of co-employment because they are self-employed and operate independently from the company hiring them.

However, there are risks involved, particularly if the company exerts too much control over the contractor's work (e.g., setting strict hours, dictating methods) or misclassifies them.

How Does Co-Employment Work?

In a co-employment agreement, the responsibilities are normally split as such:

Client Company: Retains control over the day-to-day activities of the employee such as assigning projects and performance management.

PEO: Services vary per provider, but in general the PEO will take on more admin-y HR responsibilities, such as payroll, benefits administration, tax compliance, and sometimes recruitment, but they can also be used as consultants to assist HR teams in more strategic projects.

How Is The Co-Employment Agreement Defined?

A co-employment agreement is a comprehensive service contract that clearly defines the shared responsibilities and obligations between a company and its co-employment partner.

It ensures that both parties understand their roles and provides a legal framework for managing employees effectively. Here’s a breakdown of key areas this agreement typically covers:

Employment law compliance

This section outlines how both parties will adhere to labor laws at the local, state, and federal levels. It addresses fair treatment of employees, proper classification (to avoid employee misclassification issues), and workplace safety requirements.

The agreement specifies the PEO’s role in managing compliance matters, while also clarifying the client company’s involvement in ensuring compliance within daily operations.

Payroll, taxes, and benefits

The agreement details how employee payroll, tax withholdings, and benefits (such as health insurance, retirement plans, and paid leave) will be managed.

It specifies to what extent the co-employer will handle the administration of payroll and tax filings, ensuring compliance with tax laws.

The document also outlines how benefits are offered, administered, and communicated to employees.

Obligations and responsibilities

This part of the contract clearly defines the relationship between the client company and the co-employment partner.

It outlines who is responsible for what aspects of employment, such as recruiting, hiring, termination, performance management, HR policies, and employee relations. 

The agreement also explains how day-to-day supervision is managed by the client company, while the PEO provides HR administrative support.

Risk management and liability

The agreement addresses liability issues, specifying which party is responsible for employment-related risks like workplace accidents, wrongful termination claims, or benefits disputes.

It also includes details on insurance coverage, such as workers' compensation and professional liability insurance, to protect both parties in the event of a claim.

Dispute resolution

This section establishes procedures for addressing and resolving workplace grievances or conflicts.

It typically includes rules for dispute resolution methods, such as mediation or arbitration, and clarifies how disputes between the client company, the co-employment partner, and employees will be managed to prevent escalation to legal actions.

Termination of agreement

The contract outlines conditions under which either party can terminate the co-employment relationship, including the required notice period, transition of employee records, and settlement of any outstanding obligations.

Confidentiality and data protection

Since the co-employer handles sensitive employee information, this section addresses how confidential information will be protected and the measures in place to ensure data privacy and security.

The co-employment agreement serves as a foundational document that governs the working relationship, ensuring that both the client company and the co-employment partner operate in a compliant, transparent, and efficient manner.

What’s The Difference Between Co-Employment And Outsourcing?

The difference between co-employment and outsourcing primarily lies in the level of control, responsibility, and involvement in managing employees and business operations. 

Here’s a breakdown of the key distinctions between the two:

1. Control over work and employees

In a co-employment arrangement, the client company retains full control over the day-to-day work and performance of the employees. 

The partner organization handles HR functions like payroll, benefits, and compliance, but the client company directs the employees’ work and oversees their activities.

When a company outsources a task or function, the responsibility of managing that function lies with the external vendor or service provider. 

The outsourced company typically has control over the operations and processes used to deliver the outsourced service, including managing its own employees. The client company has minimal control over how the work is done.

2. Responsibilities

In a co-employment agreement, the employer and the co-employer share responsibilities

The client company handles business operations and supervision, while the PEO manages HR tasks like hiring, compliance, tax filings, and benefits.

In outsourcing, the external vendor assumes full responsibility for the specific business function

The client company is not involved in managing the vendor’s employees and only receives the end product or service.

3. Liability

In a co-employment scenario, both the client company and the co-employer share liability for employment-related issues.

The co-employer is responsible for legal compliance with employment laws, but the client company may still bear liability in specific cases (e.g., wrongful termination).

When outsourcing, the liability generally rests with the outsourcing vendor. Since the vendor is responsible for the function, it assumes legal and operational risks, as well as employee-related issues for its staff.

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Examples

Co-employment example

A small tech startup, "TechNova," decides to enter a new market and needs to hire employees quickly. Since they lack an in-house HR team to manage payroll, benefits, and compliance with local labor laws, they partner with a PEO.

They sign a co-employment agreement where TechNova manages the employees’ daily work, while the PEO handles HR functions like payroll, benefits administration, and tax filings. This arrangement allows TechNova to focus on its core business without the burden of complex HR tasks.

Outsourcing example

A mid-sized manufacturing company, "BuildPro," needs to handle payroll processing and employee benefits more efficiently but lacks the expertise in-house. 

They decide to outsource these HR tasks to an external payroll and benefits provider.

The outsourcing company takes over the entire payroll process, including calculating wages, managing tax withholdings, and administering employee benefits.

BuildPro provides necessary employee data, but the outsourcing provider manages all payroll operations, compliance, and benefits administration, freeing BuildPro from handling these complex HR tasks internally.

Summary

To summarize this section:

  • Co-Employment is a shared responsibility arrangement, primarily around HR functions, where the company retains direct management of the employees.
  • Outsourcing transfers control and responsibility for an entire function or task to a third-party provider, who manages its own employees and operations independently of the client company.

Co-employment is more about partnering in HR management, while outsourcing is about contracting out a function or task.

What Are The Advantages Of Co-Employment?

Organizations choose to enter co-employment agreements for the following reasons:

Compliance expertise

One of the main advantages of entering a co-employment agreement is the vendor’s compliance expertise.

Employment laws, tax regulations, and labor compliance can be complex and vary across jurisdictions.

A PEO typically has dedicated legal and HR teams that stay updated on changing employment laws and ensure that the company is compliant with local, state, and federal regulations.

Reduced administrative burden

No one’s a fan of admin. Entering a co-employment agreement takes admin-heavy and finicky HR tasks like payroll processing, employee benefits administration, tax filings, and workers’ compensation management off the organization's plates.

This is particularly beneficial for small or growing businesses because it removes the need for an in-house HR infrastructure.

Competitive benefit plans

PEOs pool employees from multiple client companies, allowing them to negotiate better group rates for health insurance, retirement plans, and other benefits. 

The economies of scale make it possible for smaller businesses to offer employee benefits that are on par with larger companies.

What Are The Risks Of Co-Employment?

But, as with most things in business, co-employment does come with some risks.

Differences in co-employment laws

Employment laws and regulations around co-employment differ from one country, state, or region to another. Some jurisdictions have more stringent regulations regarding the roles and responsibilities of each party in a co-employment relationship.

So, if a company expands into new regions without fully understanding the specific co-employment laws, it may face legal challenges. 

For instance, in some areas, the client company may be held more accountable for employment issues than in others. Failing to grasp these nuances can lead to unintended legal consequences and fines.

Regulatory compliance

Even though a PEO manages compliance in areas like payroll, taxes, and labor laws, the client company is still responsible for ensuring that the co-employer follows all regulations.

If the co-employer fails to stay compliant with local labor laws, both the client company and the PEO could be held liable for violations. 

This could include wage and hour violations, safety regulations, or improper handling of employee benefits. 

Relying too heavily on the co-employer without maintaining oversight can expose the company to fines and legal actions.

Contractual clarity

The terms of the shared relationship, including who is responsible for specific duties, must be clearly outlined in a contract.

If the co-employment contract is vague or doesn’t clearly specify the division of responsibilities, disputes can arise regarding who is accountable for issues such as employee management, benefits administration, or legal compliance. 

This lack of clarity can lead to costly misunderstandings, legal disputes, and gaps in employee management.

A poor employee experience

In a co-employment arrangement, employees might receive communication or support from both the client company and the PEO. This could create confusion if roles are not clearly defined.

For example, if employees feel that the process is disjointed, or they don’t know who to approach for HR-related matters, it can lead to frustration, confusion, and dissatisfaction.

A poor employee experience can negatively impact morale, engagement, and retention, especially if employees don’t feel supported or if there’s confusion about their benefits or payroll.

Communication gaps

In co-employment, clear and consistent communication between the client company, the PEO, and the employees is essential. Miscommunication or lack of proper information-sharing can cause operational issues.

Without effective communication, there can be delays in processing payroll, confusion about policies or benefits, or even failures in legal compliance. 

Poor communication could also lead to frustration among employees and internal teams, which can impact overall business operations and employee satisfaction.

Financial risks

Engaging a PEO typically involves regular service fees, which can be significant depending on the scope of services. Moreover, any mismanagement of payroll, benefits, or taxes by the co-employer can have financial consequences for the client company.

If the PEO mismanages payroll, tax filings, or benefits payments, the client company could be liable for back taxes, penalties, or fines. 

Additionally, financial instability or bankruptcy of the co-employer could lead to disruptions in payroll or benefits administration, leaving the client company to manage these tasks unexpectedly.

Employee misclassification

Employee misclassification occurs when an employee is incorrectly classified as an independent contractor or a different type of worker (e.g., exempt vs. non-exempt). 

In a co-employment situation, if the PEO or the client company misclassified employees, both parties could be held liable. 

This can lead to costly fines, lawsuits, and retroactive payments for things like unpaid overtime or benefits. Misclassification can also result in tax compliance issues, as different tax rules apply to contractors and employees.

7 Ways To Reduce Co-Employment Risk

1. Work with a reputable PEO

Seems basic, but partnering with a reputable PEO is the number one way to reduce co-employment risk.

Before entering into a co-employment agreement, it’s necessary to thoroughly research and vet any vendor or agency you plan to partner with. Some things to consider:

  • Accreditation: Check if the PEO is accredited by the Employer Services Assurance Corporation (ESAC) or certified by the IRS.
  • Industry experience: Look for a PEO with experience in your specific industry or business size.
  • Service offerings: Ensure the PEO provides the specific services you need, such as payroll, benefits, compliance, HR support, and risk management.
  • Compliance expertise: Verify their knowledge of local, state, and federal employment laws, especially in regions where you operate.
  • Costs and fees: Understand the PEO’s services costs and pricing model, including any hidden fees, setup costs, or per-employee charges.
  • Client support: Check for dedicated support, availability of account managers, and response times.
  • Reputation: Look for client reviews, testimonials, and case studies to gauge their reputation and reliability.

You can use our shortlist of the best PEO companies to help get you started.

2. Comprehensive contracts

The contract between you and the PEO should be win-win and reasonable. Some things to look out for here:

Detail service offerings

List all services provided by the PEO, such as payroll processing, benefits administration, tax filings, employee training, and regulatory compliance support.

Ensure the contract includes any add-on services and the conditions under which they can be accessed.

Outline compliance and liability

Clearly state the PEO's responsibilities for compliance with local, state, and federal employment laws. Define which party will assume liability in case of non-compliance or legal disputes related to HR functions.

Transparent pricing structure

Specify the fee structure, including all costs (e.g., monthly fees, per-employee charges) and any potential hidden costs. Include terms for how pricing adjustments will be handled if services change or the company grows.

Set performance metrics and service level agreements (SLAs)

Include performance metrics, such as payroll accuracy, response times for HR support, and compliance assistance. Define consequences if the PEO fails to meet the agreed-upon SLAs, including potential fee reductions or contract termination.

Include a dispute resolution process

Outline the process for resolving disputes between your company, the PEO, or employees, including steps for mediation, arbitration, or legal action. Specify which party will cover legal fees in the event of a dispute.

Address confidentiality and data security

Include clauses for protecting sensitive employee information and company data. Ensure that the PEO complies with data privacy regulations (e.g., GDPR, CCPA) and uses secure systems for data management.

Define termination and exit clauses

Clearly state the conditions under which either party can terminate the agreement, including notice periods and potential penalties. Outline the process for transitioning HR responsibilities back to your company or to a new provider, including data handover and benefit management.

Clarify risk management and insurance

Ensure the PEO has adequate insurance coverage, including general liability, professional liability, and workers' compensation insurance.

Include clauses stating how risk management responsibilities will be divided, particularly in cases of workplace accidents or claims.

Include indemnification clauses

Clearly specify situations where the PEO will indemnify your company, such as errors in payroll processing, tax filing mistakes, non-compliance with employment laws, or employee-related disputes.

Include reciprocal indemnification for situations where your company’s actions (e.g., negligence in managing daily employee tasks) result in legal issues, ensuring a balanced risk-sharing approach.

State the process for handling indemnification claims, including notification requirements, time frames, and how legal costs will be managed.

Legal counsel

It’s recommended that you have the contract reviewed by legal counsel experienced in employment law to identify potential risks and ensure that your interests are protected.

3. Properly classify workers

Ensure that workers are accurately classified based on their roles and responsibilities by reviewing the legal criteria for employee vs. contractor, focusing on factors like control over work, payment methods, and independence.

If unsure, consult with legal or HR experts (such as the PEO) to ensure classifications comply with federal, state, and local regulations.

4. Do not treat contractors like employees

Independent contractors should not be given the same treatment as regular employees. This means they should not receive company benefits, be subject to strict work schedules, or be closely managed in their day-to-day tasks.

Co-employment agreements often involve strict definitions around who is considered an employee versus a contractor. 

Blurring this line can create complications in the shared employer arrangement, potentially forcing the PEO/EOR to reclassify contractors, thereby increasing compliance risks.

5. Check for insurance

Make sure your company has the right liability insurance in place and confirm that the PEO also carries adequate insurance coverage.

Consider adding Employment Practices Liability Insurance (EPLI) to protect against claims such as wrongful termination, discrimination, or harassment.

While most PEOs typically have sufficient coverage, it’s important to verify this, not just for liability insurance but also for health insurance.

6. Regular communication

It’s good practice to set up structured communication protocols between your company and the vendor, including specific points of contact for handling HR queries, benefits issues, or compliance concerns.

Clear communication helps prevent mismanagement, reduces errors, and ensures that employee concerns are addressed efficiently, minimizing potential disputes and fostering a positive employee experience.

7. Document everything

Proper documentation is crucial if any disputes or legal issues occur, so it’s important to maintain clear and thorough records of all interactions and decisions related to contractors and employees.

For changes in wages or roles, ensure that your agency has a user-friendly system with a straightforward approval workflow and appropriate permission settings.

What Are The Different Laws That Impact The Co-Employment Relationship?

US co-employment laws

Co-employment relationships in the U.S. are influenced by federal laws such as the Fair Labor Standards Act (FLSA), Family and Medical Leave Act (FMLA), and Equal Employment Opportunity (EEO) laws, which govern wages, overtime, leave, and anti-discrimination policies.

Other key laws include the Affordable Care Act (ACA) for health benefits, Occupational Safety and Health Administration (OSHA) regulations for workplace safety, and state-specific labor laws that vary by region and may impose additional compliance requirements.

Co-employment laws abroad

Co-employment laws differ widely across countries, often encompassing local labor laws, tax regulations, mandatory benefits, and employee protections. 

For example, European Union (EU) countries have strict rules around worker protections, benefits, and data privacy (GDPR), while other countries like Japan or Brazil have unique requirements around employment contracts, social security contributions, and labor standards, all of which must be navigated carefully in a co-employment arrangement.

What Is Not Co-Employment?

Just to be clear, here are some situations where a company does not share employer responsibilities with another entity:

Traditional outsourcing

The company contracts a third-party vendor to handle a function (e.g., customer support, IT services) where the vendor fully manages its employees without any shared responsibility or direct control by the client company.

Independent contractors

When a company hires independent contractors, they are self-employed and not under the company’s direct control or management, meaning the company does not take on employer responsibilities like payroll taxes, benefits, or compliance.

Employee leasing

Employee leasing is when a company "leases" its workers through a staffing or leasing agency.

The leasing agency hires the employees and places them in the client company’s workplace, handling payroll, benefits, and administrative tasks. The client company, however, manages the daily work and supervises the leased employees.

This arrangement is similar to co-employment, as the leasing agency and client share employer responsibilities, but the employees are officially employed by the leasing agency.

Are EORs Co-Employers Too?

No, EOR (employers of record) services are not co-employers. An EOR becomes the legal employer of the worker, taking on full responsibility for payroll, taxes, benefits, and compliance with labor laws, while the client company manages the day-to-day tasks and supervision of the worker.

EOR benefits vs PEOs are reduced liability and they are generally considered a more flexible option suited to hiring international talent and global HRM.

For more information, check out our article on the difference between PEO and EOR.

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Finn Bartram

Finn is an editor at People Managing People. He's passionate about growing organizations where people are empowered to continuously improve and genuinely enjoy coming to work. If not at his desk, you can find him playing sports or enjoying the great outdoors.