Unlike most other provisions of the tax code, the employee retention credit (ERC) has reached mainstream consciousness. Robocalls and television ads promise up to $26,000 per employee for businesses that were affected by COVID-19. Perhaps you are an employer who claimed an ERC refund based on one of these ads or after consulting with a tax professional. Whether you anticipated it or not, you are now in the IRS's sights.
The IRS took the extraordinary step on September 14 of announcing in IR-2023-169 an immediate moratorium on processing new ERC claims, in order ''to protect against fraud and revenue loss.'' In March, in IR-2023-49, the IRS designated abusive ERC claims on its ''Dirty Dozen'' list of tax scams. The situation has even drawn the attention of Commissioner Danny Werfel, who explained that ''[w]hile the credit has provided a financial lifeline to millions of businesses, there are promoters misleading people and businesses into thinking they can claim these credits.'' To target dubious claims, the IRS has referred thousands of ERC claims for audit. (IR-2023-169.)
Maybe you were careful and made your claim only after consulting with a reputable adviser. This might mean that you will ultimately get the refund, but it may not save you from an audit—the IRS cannot readily separate questionable ERC claims from those based on professional advice. As it often does, the IRS is taking a one-size-fits-all approach and has further slowed down processing of ERC claims received prior to the moratorium start date so that it can engage in ''detailed compliance reviews.'' (IR-2023-169.) I have worked with eligible employers who have been waiting more than two years to receive their employee tention credit refunds—funds that were intended to be a lifeline to help businesses through the pandemic but have been delayed while the IRS struggles to ascertain eligibility.
With the IRS aggressively targeting fraud and underlying rules that are fact-bound and ambiguous, the conditions are ripe for a glut of contentious disputes. Because the rules for eligibility are unclear, the IRS may end up disallowing arguably meritorious claims. Even when the IRS has paid out a taxpayer's ERC claim, the taxpayer is not necessarily in the clear. The IRS can sue taxpayers to recover what it later deems to be an erroneous refund.
ERC claimants will need to ready themselves for the reality that audit is likely and that they might be facing a difficult and fact-intensive dispute with an incredulous and aggressive IRS. It is therefore worth reviewing the relevant law and grounds that the IRS may cite for disallowing ERC refund claims.
Fact-Intensive Eligibility Questions
The purpose of the ERC was broad; Congress enacted the ERC to support businesses hit hard during the pandemic. The IRS explained in IR-2022-183 that ''[t]he ERC is a refundable tax credit designed for businesses who continued paying employees while shutdown due to the COVID-19 pandemic or had significant declines in gross receipts from March 13, 2020'' to September 30, 2021. Like with all such broadly beneficial credits, the devil is in the details.
There are two main paths by which an employer is eligible for the ERC.
- The employer's business operations were fully or partially suspended during the calendar quarter due to orders from a governmental authority due to COVID-19 (the ''Partial Suspension Test'').
- The employer had gross receipts in that quarter that were less than 80% of the gross receipts for the corresponding calendar quarter in 2019 (the ''Gross Receipts Test'').
While the Gross Receipts Test appears to be an objective, bright-line test, it is nevertheless the subject of some disputes. The IRS has raised issues with employers about what revenue is included in gross receipts and whether the employers used correct method to determine if there was a 20% decline. And in selecting ERC claims for audit, the IRS is often unable to distinguish between Gross Receipts Test and Partial Suspension Test claims. An employer with a claim based on the Gross Receipts Test should ensure that it has documentation that demonstrates the requisite 20% decline.
That said, most of the eligibility disputes involve employers whose claims ride on meeting the Partial Suspension Test. This is because the statutory language makes it so non-obvious as to who qualifies. Most businesses were adversely impacted by COVID19-related government action, but does that mean they are all eligible for the ERC?
How Much Is a Nominal Portion?
Eligibility under the Partial Suspension Test hinges on a facts-and-circumstances analysis of how one or more COVID-19 governmental orders affected the taxpayer's operations. If some of your business's operations were suspended due to COVID-19, the difficult question is whether the suspension was material enough to qualify as a partial suspension.
There at least is a safe harbor under IRS guidance, but that safe harbor requires parsing some facts about operations during the suspension. According to Q/A-11 of Notice 2021-20, that safe harbor kicks in when:
''either (i) the gross receipts from that portion of the business operations is not less than 10 percent of the total gross receipts . . ., or (ii) the hours of service performed by employees in that portion of the business is not less than 10 percent of the total number of hours of service performed by all employees in the employer's business. . . .''
This safe harbor raises a host of questions. What constitutes a portion of a business? How does this safe harbor work with the aggregation rules (described below)? Does this safe harbor apply at the trade or business level or the employer level? How does this safe harbor apply where multiple factors or governmental orders affected the employer's business (possibly in different ways)? These are hard and fact-specific questions; eligibility for the credit could hinge on the answers to any one of them.
Identifying Specific Governmental Orders
Another common threshold issue in applying the Partial Suspension Test is identifying the relevant COVID-19 governmental order. In the same Notice at Q/A-20, the IRS explained that qualifying governmental orders must be mandatory in nature and not recommendations, such as those issued by the CDC or DHS for social distancing. To qualify, the governmental order must be in effect and cause a suspension of operations for the entire period during which the employer paid the wages that undergird the employer's ERC claim, as explained at Q/A-22. It is unclear whether the indirect impacts of governmental orders can qualify, such as where the relevant the order discouraged, but did not strictly prohibit, in-person activities.
Employers can at least argue that Congress intended the ERC to provide broad relief. With the Taxpayer Certainty and Disaster Tax Relief Act of 2020, Congress expanded the ERC's availability for 2021 by increasing the threshold for an eligible small employer from businesses with 100 full-time employees to businesses with 500 full-time employees. That law also raised the maximum amount of the credit from $5,000 per employee per year to $7,000 per quarter.
While the ERC offered a greater incentive in 2021, the other requirements remained the same, including that the employer experience a partial suspension of operations due to a COVID-19 governmental order. At the same time, COVID-19 governmental restrictions decreased after 2020, making it harder to qualify under the Partial Suspension Test in 2021. As governmental orders waned, it may be difficult for a business to identify governmental orders that were in effect through the end of the third quarter of 2021.
The ERC was intended to benefit small businesses affected by COVID-19. Accordingly, the aggregation rules treat businesses under common ownership as a single employer so that large business conglomerates split into many distinct entities do not qualify as small employers. These aggregation rules also apply in determining whether the employer experienced a partial suspension. In other words, in analyzing whether more than a nominal portion of the business experienced a partial suspension, the employer must look at the business of the entire aggregated group and not a discrete subpart. Id. at Q/A-7.
Then there is one further unexpected wrinkle—it is unclear whether the aggregation rules require an employer to include foreign entities. The statutory aggregation rules in §3134(d) of the Internal Revenue Code and §2301(c)(2)(A) of the Coronavirus Aid, Relief, and Economic Security (CARES) Act require employers to aggregate ''[a]ll persons treated as a single employer under subsection (a) or (b) of section 52.'' In turn, Treas. Reg. §1.52-1 does not expressly exclude foreign entities—but see §30B(f)(4)(B), §59A(e)(3), and §199A(g)(3)(D)(ii)(II), which state that determinations under §52(a) shall be made without regard to §1563(b), which excludes foreign corporations, suggesting that foreign corporations would otherwise be excluded from an affiliated group under §52(a).
If an employer must aggregate its foreign entities with its domestic entities, does the employer then need to consider whether there was a partial suspension of its non-U.S. operations because of foreign COVID-19 governmental orders? If it does, then such a foreign aggregation rule would arguably contradict IRS guidance in Notice 2021-20, wherein Q/A-10 defines an ''order from an appropriate governmental authority'' as any order from federal, state, or local government. There is not yet any IRS guidance about how to treat foreign entities for the aggregation rules.
The IRS Guidance Is Susceptible to Challenge
Aside from the statute, most of the details on ERC eligibility come from IRS Notices. And because the statutory language is fairly brief and open to various interpretations, it may be possible for employers to challenge the validity of rules announced through IRS guidance.
Suppose that the IRS argues that employers must aggregate foreign entities, but following Notice 2021- 20, it also maintains that foreign governmental orders do not qualify to cause a partial suspension. The ERC statute (I.R.C. §3134(c)(2)(A) and CARES Act §2301(c)(2)(A)) does not exclude foreign governmental orders from the phrase ''orders from an appropriate governmental authority.'' To the extent IRS guidance is inconsistent with the statute, it is subject to challenge under the Chevron deference standard.
To view the full article, click here.
Originally published by Bloomberg Industry Group, Inc.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.