How the IRS’s New ERC Rhetoric Changes the Landscape for Business Owners and Tax Lawyers

Executive Summary:

• The government’s messaging has shifted from bemoaning the “low take-up of a very broad, very generous credit” to reframing the Employee Retention Credit (ERC) in terms of widespread abuse and narrower application.
• The new tone significantly impacts the ERC landscape, increasing overall uncertainty and positioning some employers for IRS audits, administrative appeals, and litigation.
• IRS guidance/internal inconsistencies are fueling concerns that Administrative Law requirements have been violated.
• Tax lawyers are bracing for years of ERC scrutiny and preparing to challenge the IRS on behalf of their clients in audits, administrative appeals, and even in the federal District Courts.

Since the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) Section 2301 was passed in March of 2020, the Employee Retention Credit (ERC) has gone from relative obscurity to evolving into a refundable payroll tax credit that continues to achieve its intended purpose for hundreds of thousands of eligible employers that experienced either significant declines in gross receipts or were restricted due to COVID-19-governmental orders. During this transformative period, however, employers and tax practitioners have noticed a remarkable shift in the Internal Revenue Service’s (IRS) messaging regarding the ERC. Once heralded by the Department of Treasury as “a broad based refundable tax credit designed to encourage employers to keep employees on their payroll,”¹ and even prompting an Office of Tax Analysis study “regarding the low take-up of a very broad, very generous credit,”² the IRS now presents the ERC in a much less favorable light.

For better or for worse, the IRS’s new tone is significantly impacting the ERC landscape, prompting questions and concerns, and, in some cases, positioning employers for IRS audits, administrative appeals, and litigation.

A New Tone

The original “broad based program" messaging from the Department of the Treasury seemed aligned with Congressional intent. As amended by the Consolidated Appropriations Act of 2021, the CARES Act required the IRS to work in tandem with the SBA, to provide information regarding ERC availability—especially aimed at employers that reported employing 500 or fewer employees on the most recently filed quarterly employment tax return.³ The Act required the IRS and SBA to:

• Provide employers of not more than 500 employees the requirements for eligibility to claim the ERC
• Provide all employers with educational materials about the ERC, including specific materials aimed at employers of not more than 500 employees⁴

We have not seen evidence that the IRS ever ran this public awareness campaign, and so perhaps we should all be asking: If Congress didn’t intend a broad application, then why would Congress require notification to all of these taxpayers? Moreover, it is logical to presume that the lack of this mandated public awareness campaign explains, in part, the low take-up rate.

By the fall of 2022, however, the Department of Treasury’s rhetoric transitioned from bemoaning the “low take-up of a very broad, very generous credit” to reframing the ERC in terms of abuse and narrower application. Around that time, the IRS initiated a campaign of cautions and warnings about promoters and penalties. A good example is found in the language contained in the following excerpts from IR-2022-183, issued on October 19, 2022:

WASHINGTON — The Internal Revenue Service today warned employers to be wary of third parties who are advising them to claim the Employee Retention Credit (ERC) when they may not qualify. Some third parties are taking improper positions related to taxpayer eligibility for and computation of the credit.

These third parties often charge large upfront fees or a fee that is contingent on the amount of the refund and may not inform taxpayers that wage deductions claimed on the business' federal income tax return must be reduced by the amount of the credit.

[ . . . ]

Businesses are encouraged to be cautious of advertised schemes and direct solicitations promising tax savings that are too good to be true. Taxpayers are always responsible for the information reported on their tax returns. Improperly claiming the ERC could result in taxpayers being required to repay the credit along with penalties and interest.⁵

Thereafter, the overall IRS sentiment appeared to grow increasingly less sympathetic to the businesses that were impacted by COVID-19. In early 2023, the IRS featured the ERC at the top of the 2023 “Dirty Dozen” List.⁶ The summer of 2023 also saw implementation of anti-fraud procedures, ERC-specific auditor training and intensified compliance work. Moreover, IRS Counsel prepared targeted memoranda about areas perceived to attract abuse or mistakes and ultimately drive improper claims; these include eligibility related to supply chain disruptions and governmental order analysis for guidance issued by the likes of the Occupational Health and Safety Administration (OSHA). All of this eventually culminated in a September 14, 2023, information release that a processing moratorium on newly filed claims was immediately in place until the end of the calendar year. 

As its basis for the moratorium, the IRS cited “growing concerns inside the tax agency, from tax professionals as well as media reports that a substantial share of new claims from the aging program are ineligible.”⁷ [Emphasis added]. Moreover, the IRS stated that:

The IRS believes many of the applications currently filed are likely ineligible, and tax professionals note anecdotally that they are seeing instances where 95 percent or more of claims coming in recent months are ineligible as promoters continue to aggressively push people to apply regardless of the rules.⁸ [Emphasis added]

But it is worth noting that the very definition of “anecdotal” generally implies the absence of scientific observation, research, and even facts.⁹ It is difficult to understand why the IRS would base the implementation of something so consequential as a processing moratorium on anecdotal accounts. For many hurried readers, the IRS’s usage of “95 percent” in this context may appear at first glance as a statistic with objective and measurable value. Instead, as an anecdotal account, the number should be viewed with an appropriate amount of skepticism.

Importantly, when specifically asked about whether claims may still be filed during the moratorium, the IRS continues to answer in the affirmative. As recently as November 2, 2023, in a webinar hosted by the IRS this question was raised and answered by the IRS as follows:

Q: Can we still file the ERC claim during the moratorium period? If not, when can we file? 

‍A: So that and I’m seeing that question come up a lot. And I’m glad that then we got asked. So absolutely, yes, you can submit a claim for ERC during this moratorium. Remember, that the moratorium for any claims are received on or after September 14th, is simply that the IRS is not yet going to process those returns. Right? That’s because we’re urging all the businesses to carefully review to ensure that all the ERC guidelines are met. If you’re 100% confident you know that this is a legitimate and good ERC claim. Please, we then, yes, you should be filing it.¹⁰

IRS Guidance and Inconsistencies Raise Specter of APA

Besides tone and rhetoric, the IRS's guidance and messaging also continue to evolve.  The statutory language of the CARES Act giving rise to the ERC states that businesses can qualify if, among other requirements, they were:

fully or partially suspended during the calendar quarter due to orders from an appropriate governmental authority limiting commerce, travel, or group meetings (for commercial, social, religious, or other purposes) due to the coronavirus disease 2019 (COVID-19).¹¹

The IRS subsequently issued guidance, most notably Notice 2021-20, discussing standards by which the IRS will deem business operations to be partially suspended if it meets the "more than nominal portion test" or can show the business experienced a "more than nominal effect" on operations due to COVID-19 related government mandates.¹²  Yet, the IRS Commissioner was very recently quoted in a Wall Street Journal article citing another standard with an unknown origin discussing certain restrictions that "don’t translate into a serious impact on a business to qualify for the credit.”¹³  [Emphasis added].

Arguably, this could be read as the Commissioner issuing a new, more stringent standard – “serious impact” – than what was promulgated in earlier IRS guidance.  Although the Commissioner almost certainly cannot create a new standard through simple off-the-cuff remarks, it highlights what appears to be the IRS’s difficulty with communicating clearly and consistently about the ERC.  

And this naturally prompts the next line of inquiry: what level of authority do these kinds of Notices generally possess?  Some tax practitioners believe that these Notices, including Notice 2021-20, are enforceable and have the full effect of law, but that belief warrants careful consideration.¹⁴  Recent cases discussing the Administrative Procedure Act (APA), including Mayo Foundation for Medical Education and Research v. United States, 562 U.S. 44 (2011), state that the IRS must comply with the APA to create rules and regulations that have the force and effect of law.¹⁵  When creating new rules and regulations, agencies are typically required to publish the proposed rule or regulation in the Federal Register and then have a period for notice and comments to allow for public input. The ERC-related Notices did not comply with these APA requirements to become rules or regulations; however, courts may nevertheless give these Notices at least some deference.  The courts may also bind the IRS to tax positions that were taken in reasonable reliance on these Notices. 

Formal challenges to these Notices are arriving.  The pattern of unclear and inconsistent IRS communications about the topic does not aid its argument that its positions deserve deference from the courts.  Additionally, taxpayers deserve clear and binding rules and regulations so that they can rest assured they are taking all proper steps to receive their refunds in conformance with the law. 

Tax Lawyers Are Going on Defense

Perhaps the takeaway here is that the IRS appears committed to continuing to target the ERC for many years, even well beyond the last day to claim the credit (April 15, 2025). Of course, some taxpayers will see their refund claims process and receive the amounts claimed, but for those who don’t, tax lawyers (particularly tax controversy attorneys) are generally best equipped to competently navigate an ERC dispute with the IRS. At the moment, many tax professionals are projecting that disputes may present as follows:

1. Pre-refund Examination. The IRS may initiate a pre-refund examination of an ERC refund claim.  In this case, the IRS may issue an Information Document Request (IDR), requiring the taxpayer to produce documentation to show why they are eligible for the credit during a particular period. Requested documentation may include substantiation of a revenue decline, copies of governmental orders creating a partial suspension of operations, full-time employee count data, and information on related businesses for purposes of a controlled group or affiliated service group analysis.  As part of this process, Revenue Agents may also attempt to interview business owners and operators.  Remember, it is the taxpayer’s burden to demonstrate they are eligible for the refund.  
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   If the IRS examiner does not agree with the taxpayer’s position, the taxpayer is afforded the right to a managerial conference.  If the taxpayer is unsuccessful at convincing the Revenue Agent’s manager of its eligibility for the ERC, then the taxpayer is given a notice disallowing the claim.  This notice gives rise to administrative appeal rights and allows the taxpayer to work with an Appeals Officer.  The Appeals Officer must not have had prior involvement with the case.  The Independent Office of Appeals may be permitted to settle claims based on the “hazards of litigation,” but if resolution is not reached, the taxpayer has jurisdiction to sue for a refund in a U.S. District Court or the Court of Federal Claims.
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2. ‍Post-refund Examination. The IRS may pay the claimed refunds, but later audit the taxpayer.  Many of the processes described above are would be similar, and the IRS initiates this audit by issuing an IDR. The taxpayer responds to that request, providing documentation to show they are eligible for the credit and the computations were correctly performed. 
   
   Ultimately, if a taxpayer-friendly resolution is not reached, then the IRS attempts to claw back the refund. In this scenario, the taxpayer is assessed interest and, potentially, penalties.  In order to challenge the claim, the taxpayer would be required to sue for a refund in a U.S. District Court or the Court of Federal Claims. There are no cases, either currently docketed or decided, that relate to the IRS's attempt to impose penalties on an erroneously refunded ERC, or to assess the erroneously refunded credit and any associated penalties. It is, therefore, too early to tell if the taxpayer would be required to full-pay the assessment prior to instituting a refund suit. Because of regulations promulgated by the Department of Treasury, the overpayment of ERC funds is deemed an underpayment of FICA taxes. This characterization could implicate the divisible tax doctrine. If a court agrees with this characterization, a taxpayer may only be required to pay one employee's share of an ERC claim in order to establish jurisdiction to bring a refund suit.¹⁶ Once the statute of limitations has expired, the IRS may also attempt to use its erroneous refund suit jurisdiction to recoup ERC funds.¹⁷
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3. ‍IRS failure to act. Finally, the IRS may simply choose not to process the ERC claim. A statutory mandate does not appear to exist to suggest that the IRS has a duty to process a refund claim/amended tax return. In this instance, the taxpayer would be afforded the opportunity, after six months of IRS inaction, to file an action in a U.S. District Court or the Court of Federal Claims to compel the government to issue a refund. The suit for refund must be initiated within two years of initially filing the claim with the IRS.¹⁸

Conclusion

The IRS has left much to be desired in terms of its handling of ERC refund claims. Taxpayers should prepare now for potential audits, administrative appeals, and, in some cases, litigation.  Taxpayers would be wise to have qualified tax professionals filing ERC claims and/or handling any ERC disputes.  Taxpayers who are proactive and prepared up front are far more likely to shoulder fewer burdens and experience less stress if a dispute arises. If you need assistance contact our team at (410) 497-5947 or schedule a confidential consultation.