PEO clients may not see their ERC refunds

Part 2

Who is entitled to the ERC refund paid to a PEO? The answer might surprise you. (Apologies for the clickbait intro; it won't happen again. Probably.) This is the second issue I look at concerning the treatment of ERC refunds in the context of PEOs. If you missed the first part, it provides additional context for the treatment of ERC in the realm of PEOs.

Photo by Erik Mclean on Unsplash

Diamondback and the case of the missing refund

In Diamondback DTNM LLC v. ShiftPixy, Inc., the client company, or taxpayer, is Diamondback DTNM, a group of restaurants. The alleged (more on this in a bit) PEO is ShiftPixy. According to the complaint, ShiftPixy offered to file an ERC claim for the company. Diamondback ultimately agreed, and ShiftPixy filed the refund claims received in June 2023. The refund claims totaled approximately $ 1.5 M. Acting as the Third Party Payer, ShiftPixy filed the claims using its own FEIN and received them directly. And this is when the fight started.

Once ShiftPixy received the refunds, it used them to pay its tax liability and did not issue them to Diamondback or pay any amount to the company. As a result, Diamondback brought a suit against ShiftPixy in District Court, alleging breach of contract, breach of fiduciary duty, and negligence. It also sued the CEO and the controlling shareholder, but those claims were ultimately dismissed.

The District Court recently ruled on a motion to dismiss, providing a partial win to both parties.

Is ShiftPixy a PEO?

Throughout its defense, ShiftPixy has argued that it is not a PEO but merely a Third-Party Payer. In support of this, the provider points to the lack of self-identification as a PEO in any of the agreements with Diamondback, but does acknowledge that it was a co-employer. The Court has not ruled on this issue; being a Third-Party Payer was sufficient for the motion at issue, so we don't have an answer, but we do have some clues to go by.

While the client agreement did not explicitly use the term Professional Employer Organization, or PEO, it did describe the relationship as a co-employer. A co-employer is not a relationship officially recognized by the IRS, but it effectively describes many PEOs. Under this arrangement, employees are considered the common-law employees of the client company, while the TPP is the administrative employer. In other words, the client is the employer for the purpose of controlling the work, training, and functionality, while the TPP handles the pay, taxes, and other compliance issues. Many of these functions were outlined in the customer agreement as ShiftPixy's responsibility.

Ultimately, this may not matter. ShiftPixy is a Third-Party Payer and admits to being a co-employer. They fulfilled many of the roles and responsibilities of a PEO, whether either party was under that impression. But if ShiftPixy is a PEO, Diamondback may be absolved of certain employment tax liabilities.

Breach of Contract

As a quick note, from the IRS’s perspective, ShiftPixy can take any refund claim filed by the PEO and use it to offset the PEO's tax liability, including refund claims filed on behalf of its clients. Any dispute between the PEO and its clients is a civil, contractual matter, not the IRS's problem. As a result, the IRS is not a party to this suit and will not get involved. So we wind up in District Court, with Diamondback suing ShiftPixy for breach of contract, negligence, and breach of fiduciary duty.

On the breach of contract claim, ShiftPixy claimed that the contract never considered ERC because ERC did not exist at the time that the contract was entered into. The agreement didn't reference tax credits at all. But the Court found the contract language ambiguous regarding ShiftPixy's actual obligations related to payroll taxes - it specified that ShiftPix would “withhold, report, and remit, federal, state, and local payroll taxes, including unemployment insurance contributions, " without limitations.” The last part gave the Court pause since the ERC impacts this amount, so it looked outside of the contract to the communications between Diamondback and the PEO. This included emails in which ShiftPixy promised the client that it would file for the ERC and that it had all the necessary documentation.

Additionally, as Diamondbacks PEO or just TPP, ShiftPixy had to file the refund claim related to the ERC on behalf of Diamondback. So while the contract was not definitive, ShiftPixy did have an obligation of its own making. This claim survived the motion to dismiss and will continue for now.

Negligence and Fiduciary Duty

The court dismissed the negligence claim. The Court found that the negligence claim was preempted by the contract between the parties, which will determine how damages are determined. Diamondback tried to argue that ShiftPixy had an independent duty related to professional services but failed to specify the elements needed to give rise to this claim.

ShiftPixy again pointed to the lack of such a duty in the contract for the fiduciary duty clause. The contract would have stated it and specified the responsibilities if it had such a duty. DiamondBack argued that when ShiftPixy stepped into the role as the administrative employer, and used its own FEIN to pay the taxes, claimed the ERC on behalf of DiamondBack, and received the refund, it accepted the responsibilities of having a fiduciary duty to DiamondBack. The Court found that such a duty could have arisen during the relationship between the parties and denied the motion to dismiss.

Why does this matter?

When companies enter into an agreement with PEOs, they hand over a lot of administrative burden and control. ShiftPixy's situation may be an outlier, using the full refund to offset its tax liability and still having to file for bankruptcy, but in other instances, PEOs may take the refund for different purposes, or take the interest on the refund. With the slow processing and ongoing moratorium, older claims accrue significant interest.

Taxpayers in these situations do not have administrative remedies before the IRS. They must treat it as a civil matter, arguing breach of contract and fiduciary duty in the District Court, much like DiamondBack does now. As this case progresses, it will provide a roadmap for how other companies can be successful in disputes with their PEO.

Wrap-up

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The content of this article is for informational purposes only and should not be taken as tax, legal, benefits, financial, or HR advice. I am a lawyer, but receiving this newsletter does not mean I am your lawyer. Since rules and regulations change over time and can vary by location, consult a lawyer or HR expert for specific guidance.