The Employee Retention Tax Credit (ERTC) is a refundable tax credit of up to $26,000 per employee for businesses affected by the COVID-19 pandemic. It is a powerful tool for business owners, but the ERTC has become abused to the extent that the Internal Revenue Service has warned taxpayers to “think twice before filing a claim for the credits” due to misleading claims by tax promoters in exaggerating eligibility criteria.1 It describes the practices of many tax promoters promising ERTC refunds as “deeply troubling and a major concern for the IRS.”2 Those tax promoters have created a network — described as a “vast sales army” by the Wall Street Journal — to cold call potential claimants and promote their consulting tax services.3
Employers who have already made ERTC claims should review eligibility and substantiation requirements to ensure the claim is valid. Employers still considering claims should know the IRS has placed a moratorium on processing new claims through at least the end of 2023 so it can implement more detailed compliance reviews.4
As described in Internal Revenue Code §3134, the ERTC provides a credit for eligible employers who pay qualified wages to some or all employees between March 12, 2020, and Oct. 1, 2021, with “recovery startup businesses” eligible for a credit in the fourth quarter of 2021. The ERTC was first implemented by the federal CARES Act in March 2020 and has been subsequently amended by the Consolidated Appropriations Act of 2021, the American Rescue Plan Act, and the Infrastructure Investment and Jobs Act. The ERTC compensates businesses that kept employees during the COVID-19 pandemic despite being subject to reduced gross receipts or orders forcing it to shutdown.
An employer is eligible for a credit for a calendar quarter if it was carrying on a trade or business in that quarter and satisfies one of three conditions: there was a governmental order suspending the employer’s trade or business, a “substantial decline” in the employer’s gross receipts, or the employer qualifies as a recovery startup business.5
GOVERNMENTAL ORDER TEST
For calendar quarters in 2020 through the third quarter of 2021, employers are eligible for the ERTC due to orders from an appropriate governmental authority limiting commerce, travel, or group meetings (for commercial, social, religious, or other purposes) because of COVID-19.6 Governmental orders include:
- An order from a city’s mayor stating that all non-essential businesses must close for a certain period;
- A state emergency proclamation directing residents to shelter in place for a specific period other than those employed by an essential business who may travel to and work at their workplace;
- A local order imposing a curfew that impacts the operating hours of a trade or business for a specified period; and
- A local health department order mandating workplace closure for cleaning and disinfecting.7
Relying on this requires an employer to establish that it is subject to a governmental order in effect, the order must be applicable to the particular employer (it cannot be an order applicable to customers),8 the order must be issued by a governmental entity with jurisdiction over the employer’s operations,9 and the order must also be mandatory — statements by government officials or mere declarations of emergency do not suffice.10
Additionally, the employer seeking the ERTC must demonstrate the applicable order has “more than a nominal impact” on its operations either due to suspending them or requiring modifications to them.11 A suspension may either be a full suspension of operations or a partial suspension if, under the facts and circumstances, “more than a nominal portion” of the business is suspended by the order.12
For purposes of the ERTC, “more than a nominal portion” is determined if either the gross receipts from that portion of the business operations is at least 10% of the total gross receipts (calculated using gross receipts of the same calendar quarter in 2019) or the hours of service performed by employees in that portion of the business is at least 10% of the total number of hours of service performed by all employees in the employer’s business (both determined using the number of hours of service performed by employees in the same calendar quarter in 2019).13
A business may also qualify for the ERTC if its operations are modified due to a governmental order with “more than a nominal effect.”14 A governmental order that resulted in a reduction of an employer’s ability to provide goods or services in the normal course of business of not less than 10% is deemed to have more than a nominal effect on business operations.15 Examples of these modifications include limiting occupancy to provide for social distancing, requiring services to be performed on an appointment basis (for businesses that previously offered walk-in service), or changing the format of service (for example, restrictions on buffet or self-serve restaurants, but not prepackaged or carry-out.)
The mere fact that employers must make modifications to business operations due to a governmental order does not result in a partial suspension unless the modification has more than a nominal effect on business operations. Whether a modification required by a governmental order has more than a nominal effect is based on facts and circumstances.
The IRS requires businesses to consider these factors in determining if an employer can continue to operate at a level comparable to its operations prior to the governmental order:
- Telework capabilities: The employer must consider whether it has adequate support for operations to continue via work from another location.
- Portability of work: The employer must consider the amount of portable work — work that can be performed from a remote location — within its trade or business operations.
- Need for presence in a physical workspace: The employer must evaluate the role its physical workspace plays in its trade or business. If the critical workspace to trade or business operations that tasks central to the operations cannot be performed remotely, this factor alone indicates that the employer is not able to continue comparable operations. Employers with workspace that is critical include laboratories or manufacturers with special equipment or materials that cannot be accessed or operated remotely.
- Transitioning to telework operations: If an employer can conduct comparable operations via telework but did not previously allow for or allowed for only minimal telework, some adjustment period is expected and, generally, operations are not considered partially suspended during that period. However, if an employer incurs a significant delay (beyond two weeks, for example) in moving operations to a comparable telework setting, the employer’s trade or business operations may be deemed subject to partial suspension during that transition.16
In almost all cases, an employer that had to close its workplace but continued operations comparable to its operations prior to the closure, including by requiring its employees to telework, generally are not eligible for the ERTC under the governmental order test.17
GROSS RECEIPTS TEST
For the tax year 2020, employers are eligible for the ERTC in any quarter in which their gross receipts were less than 50% of those in the same quarter in 2019. Employers remain eligible for the ERTC until the quarter following the first quarter in which gross receipts are greater than 80% for the same quarter in 2019.18
For the tax year 2021, employers are eligible for the ERTC in any quarter in which gross receipts are less than 80% of those in the same quarter in 2019. Employers will remain eligible for each successive quarter in which gross receipts have declined 20% or more compared to the same quarter(s) in 2019 through the third quarter of 2021. In addition, in 2021, employers can look back to the immediately preceding quarter and if they meet the 20% decline in gross receipts in that previous quarter, they are automatically eligible for the current quarter.19
RECOVERY STARTUP BUSINESSES
For the third and fourth quarters of 2021, recovery startup businesses are also eligible to claim up to $50,000 per quarter providing it began carrying on a trade or business after Feb. 15, 2020, and its average annual gross receipts for the three-year tax period ending with the tax year that precedes the calendar quarter for which the ERTC is determined does not exceed $1 million as determined under rules similar to those under Code §448(c)(3).20
The definition of qualified wages depends on whether an employer is a large or small employer. In either case, “wages” refer to wages and compensation as defined in Code §§3121(a) and 3231(e). Credit can only be taken on wages not forgiven or expected to be forgiven under the Paycheck Protection Program.21
The size of an employer for ERTC purposes is based on the average number of full-time employees (within the meaning of the shared responsibility health coverage rules for large employers under the Affordable Care Act as described in Code §4980H) in 2019. For purposes of the 2020 ERTC, a large employer has more than 100 full-time employees. For the 2021 ERTC, it is more than 500 full-time employees.
For eligible large employers, qualified wages only include those paid by the eligible employer with respect to when an employee was not providing services due to suspension of the employer’s trade or business under the governmental order test or where the employer has experienced a decline in gross receipts under the gross receipts test.22
For the 2020 ERTC, a small employer has 100 or fewer full-time employees. For the 2021 ERTC, it is 500 or fewer full-time employees.
Eligible small employers can treat all wages (other than those for which the employer claims a credit for qualified sick leave or family leave wages) as qualified wages during any period in the calendar quarter when eligible under either the governmental order or gross receipts tests.
IMPROPER POSITIONS ADVOCATED BY PROMOTERS
Promoters have been filing claims based on unjustified positions that generally do not merit claiming the ERTC.23 Speaking at the IRS nationwide tax forum in July, Commissioner Danny Werfel warned that “[t]he further we get from the pandemic, we believe the percentage of legitimate claims coming in is declining, [but] we continue to see more and more questionable claims coming in following the onslaught of misleading marketing from promoters pushing businesses to apply.”24
This is especially true for governmental order claims since they are more subjective than gross receipts claims. Examples of unjustified claims from promoters include:
- Suggested guidance and recommendations from federal bodies such as the Centers for Disease Control and Prevention that do not qualify as suspension orders and are not mandatory.
- Claims based on cost increases to successfully maintain pre-pandemic levels of operations, which is not a factor in IRS guidance.
- Claims based on shutdown orders not applicable to the employer such as shutdown orders applicable to the employer’s customers.25 This sometimes includes the employer’s inability to visit customers in person. Again, if an employer could plausibly continue to serve customers via telephone, e-mail, or teleconference, it likely is not able to claim the ERTC.26
- Claims based upon an employer’s voluntary shutdown. Many critical or essential business operations were exempted from most state and local governmental orders, but some employers chose to close offices or branches during the height of the pandemic. IRS guidance makes clear that unless businesses were ordered to do so, closing or diminishing an operation alone will not justify a claim.27
- Claims based on modifications to operations that do not rise to the level of a partial suspension because they did not have a “more than nominal effect” on the business and did not result in a reduction in an employer’s ability to provide goods or services in the normal course of business by 10% or more.
- Claims based upon supply chain issues. The IRS in July stated that “[a] supply chain issue, by itself, does not qualify you for the [ERTC].”28 The IRS provided a narrow exception if an employer’s supplier was fully or partially suspended — applied only when the employer absolutely could not operate without the supplier’s product and the supplier was fully or partially suspended themselves.29
In addition to having the supplier’s governmental order, an employer would need to show that the order caused the supplier to suspend operations, the employer could not obtain the supplier’s goods or materials elsewhere at any cost, and it caused a full or partial suspension of business operations.
Many promoters have filed claims that do not comply with IRS substantiation requirements provided in Notice 2021-20 and in its FAQs. These include:
- Copies of specific governmental orders relied upon for the claim.
- Documentation of the decline in gross receipts.
- Documentation demonstrating the qualified wages and amounts including any qualified health plan expenses.
- Whether any employees who received wages under the claim are related to owners of the employer.
- The relationship of the employer to other businesses or entities and how required aggregation affects the claim.30
- Any completed 7200 forms submitted to the IRS.
- Any completed federal employment and income tax returns to claim the ERTC.
The IRS warns specifically to not “accept a generic document about a government order from a third party. If they say you qualify for [the ERTC] based on a government order, ask for a copy of the government order [and] review it carefully to make sure it applied to your business or organization.”31 Many promoters, in the author’s experience, have produced short documents no longer than a couple pages with simple conclusory statements claiming the company experienced a “more than nominal effect” or had been suspended for “more than a nominal portion” without any documentation or analysis as to why. Lastly, many promoters fail to limit ERTC claims to the specific periods in which the orders applied and instead claim the entire quarter or the entire year in which it applied.
The IRS has made the above a part of its standard information document requests for ERTC audits.
Interest and penalties can be assessed on an erroneously claimed ERTC. IRS code provides for different penalty provisions, a full discussion of which is beyond the scope of this article. Potential penalties include, but are not limited to, penalties for inaccuracy, erroneous claims for refunds, fraud, or evasion of employment taxes.32 Taxpayers bear the burden of substantiating reasonable cause to avoid penalties and must exercise ordinary business care and prudence in reporting proper tax liability. All tax returns are signed under penalties of perjury.
Taxpayers may demonstrate reasonable cause and absence of willful neglect to avoid penalties. Factors that may be considered in making this determination include whether the taxpayer made attempts to report proper tax liability, the complexity of the issue, and the taxpayer’s overall patterns and compliance history.33
STATUTE OF LIMITATIONS
A three-year statute of limitations applies to ERTC claims under IRS Code §6051 and FICA taxes assessable on Form 941 where the ERTC is claimed. A special five-year statute of limitations applies to ERTC claims for the third quarter of 2021.34 The IRS could bring a suit related to an ERTC claim pursuant to tax court deficiency procedures under Code §6212. Additionally, the IRS could also file suit for an erroneous refund claim under Code §7405. Generally, a deficiency proceeding must be initiated within the three-year statute of limitations under Code §6501, but an IRS claim for an erroneous refund may be brought within two years of the date of the refund or even five years of the date of the refund if there is fraud or a mistake of fact in making the refund claim.35
Simply because the IRS pays an employer’s claim for an ERTC does not mean the IRS agrees that the employer is entitled to the credit. The credit is not claimed on an application reviewed and approved by the IRS; it is claimed by amending Form 941 indicating the employer is claiming it. Only when the relevant statute of limitations has expired and the IRS ability to bring a civil suit becomes time-barred can employers feel comfortable knowing claims will not be challenged by the government.
AGGRESSIVE MARKETING WARNING SIGNS
The IRS has identified the following warning signs to look for in connection with aggressive ERTC marketing:36
Unsolicited calls or advertisements mentioning an easy application process. In reality, there is no application process. An employer claims the credit but bears the burden of proof that it was justified upon an IRS audit.
Statements that the promoter can determine ERTC eligibility within minutes. Generally, an actual interview should take place to understand how the business operated before and during the pandemic.
Claims from the promoter that the employer qualifies for a credit before discussing the specific situation. The ERTC is complex and requires careful review.
Lack of written information that offers a comprehensive explanation to an IRS examiner regarding which provisions in a governmental order applied to the operations and how the provisions caused the business to be suspended.
Wildly aggressive suggestions urging employers to submit claims; this author has seen claims such as there is “nothing to lose“ and employers must act “before funds run out.“ Improperly claiming and receiving the credit may amount to tax fraud with substantial penalties and interest due. Additionally, there is no “set amount of funds“ for ERTC claims. Employers have until April 15, 2024, to file a 941-X return to claim the ERTC for any quarter in 2020 and until April 15, 2025, to file a claim for any quarter in 2021.
Contingent fees based on the amount of a refund the number of employees covered, which are forbidden by §10.27 of Circular 230 governing practice before the IRS.
MORATORIUM ON NEW CLAIMS
In September, the IRS announced an immediate moratorium on processing new ERTC claims through the end of 2023, reflecting the IRS’s increased concern regarding “honest small business owners being scammed by unscrupulous actors.”37 The IRS also announced that it is developing initiatives to help businesses victimized by aggressive promoters including repayment programs for those who received improper ERTC payments and a special withdrawal option for businesses that filed an ERTC claim that has not been processed.38 The IRS is also “continuing to assess options on how to deal with businesses that [paid an ERTC tax promoter] contingency fee … out of its [ERTC] payment.”39
Employers who have claimed the ERTC but have concerns about the justification of their claim should consult a tax professional to examine its sufficiency. To the extent that employers take advantage of the ERTC settlement program, they may be able to avoid interest and penalties as well as the expense of an audit. Alternatively, a thorough review could reveal that the claim is justified based on the facts and analysis and will provide an enhancement to the taxpayer’s demonstration of ordinary business care and prudence in making an appropriate claim.