Citing rampant ‘scams,’ IRS imposes ERC moratorium

The IRS moved on Sept. 14 to stem what it called a “flood” of improper claims of the employee retention credit (ERC), by placing an immediate moratorium on the processing of claims until at least Dec. 31, 2023 (News Release IR-2023-169).

The Service had been clear previously that it would scrutinize ERC claims, but in the news release announcing the moratorium, it disclosed that it was working with the Justice Department to bring criminal cases against hundreds of taxpayers and had begun thousands of ERC audits. As of July 31, 2023, the IRS Criminal Investigation Division had discovered over $8 billion of fraud stemming from the ERC and other pandemic-related provisions, of which it has opened investigations on over $2.8 billion in claims. Fifteen of these cases had already resulted in criminal charges, the Service said in the release. The IRS stated that the moratorium is needed to “protect taxpayers from scams” by promoters using “aggressive marketing” and “predatory tactics” against businesses.

The IRS said it will permit a special withdrawal option for businesses, allowing them to remove their claim from processing and provided the procedures for eligible taxpayers to withdraw a claim in a fact sheet issued in October (FS-2023-24). Withdrawal, however, does not eliminate the possibility that the IRS will still pursue criminal prosecution with the Justice Department against taxpayers that willfully filed fraudulent claims or conspired to do so. The IRS later emphasized this point as it provided further details on withdrawing a claim (News Release IR-2023-193).

The IRS will continue to receive ERC claims during the moratorium but will not process them for the remainder of the calendar year. The Service will also continue to process previously submitted claims, but with extra scrutiny and generally with a goal of completing them within 180 days — twice as long as previously, it said.

The IRS also has provided specific guidance on situations it believes are causing incorrect ERC claims. The Service issued News Release IR-2023-170 concurrently with IR-2023-169 to highlight red flags for employers who have claimed or intend to claim the ERC.

The credit applies to any eligible employer carrying on a trade or business that is “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)” (Sec. 3134(c)(2)(A)(ii)(I)) (the suspension test). Appropriate governmental authority includes an order, proclamation, or decree from the federal government or any state or local government (Notice 2021-20 (Q&A 10)). Alternatively, an employer may be eligible if its gross receipts for a qualifying quarter in 2020 are less than 50% of those in the same quarter of 2019, or less than 80%, for qualifying quarters in 2021 (Sec. 3134(c)(2)(A)(ii)(II)) (the significant-decline- in-gross-receipts test).

If an employer qualifies for the credit, it may be eligible for a refundable employment tax credit equal to 70% of the qualified wages with respect to each of its employees for a calendar quarter (Sec. 3134(a)). The ERC is limited to wages paid after March 12, 2020, and before Oct. 1, 2021, or Jan. 1, 2022, in the case of an eligible employer that is a recovery start-up business.

In announcing the moratorium, the IRS stated it “is seeing repeated instances of people improperly citing supply chain issues as a basis for an ERC claim when a business with those issues will very rarely meet the eligibility criteria.” The IRS earlier issued a Generic Legal Advice Memorandum (GLAM) to clarify these issues (AM 2023-005 (June 30, 2023)).

A “narrow, limited exception” to the general requirement of a full or partial suspension of business due to orders from an appropriate governmental authority was provided in Notice 2021-20 for employers that had to fully or partially suspend their business operations because their supplier was unable to “make deliveries of critical goods or materials due to a governmental order that causes the supplier to suspend its operations,” the GLAM noted. This exception provides that an employer may be “considered to have a full or partial suspension of operations due to a governmental order if, under the facts and circumstances, the business suppliers are unable to make critical goods or materials due to a governmental order that causes the supplier to suspend its operations” (Notice 2021-20 (Q&A 12)). As a result, based on the situation’s facts and circumstances, an employer may be able to “step into the shoes” of the supplier in determining if the suspension test is met.

However, the GLAM states that a supply chain disruption by itself does not “rise to the level of a full or partial suspension primarily because no governmental order applies to the employer’s operations.” Furthermore, the exception will not apply if the goods or materials disrupted did not impact the employer’s operations or the employer could have obtained the critical goods and materials from an alternate source.

In the GLAM, the IRS described five scenarios, only one of which supports a determination that an employer is an eligible employer due to a supply chain disruption under the suspension test (and that one for only part of the disruption period).

Scenario 1: Employer A was never subject to a governmental order limiting commerce, travel, or group meetings. During 2020 and 2021, Employer A experienced “several delays in receiving critical goods and materials” from its supplier. However, during this period, Employer A had a surplus of these critical goods on hand. At no time did Employer A cease its business operations. After inquiring about the delays, the supplier vaguely confirmed that the delay was due to COVID-19. Employer A assumed that the delay was due to COVID-19. No governmental order, though, was supplied to Employer A by the supplier, nor could Employer A find such an order through its own research.

Employer A did not meet the definition of an eligible employer under the suspension test because it could not demonstrate that the supplier fully or partially suspended its operations due to a governmental order. Also, even if Employer A could have verified such a governmental order or received a copy of it from the supplier, it continued to operate its own business, including having a surplus of critical goods on hand. Therefore, at no time was Employer A subject to a full or partial suspension of operations.

Scenario 2: As in Scenario 1, Employer B was not subject to any governmental orders limiting its business activities. However, certain critical goods and materials were stuck at port. Employer B assumed that the bottleneck was a result of COVID-19. Certain media outlets stated that the bottleneck was COVID-19-related, while other media sources said the delay was due to an increase in consumer spending and aging infrastructure. The supplier mentioned to Employer B that other critical goods not stuck at port would be delayed due to a truck driver shortage. Employer B saw social media posts stating that the truck driver shortage was due to truckers being out sick with COVID-19. At no time did Employer B find a governmental order verifying that COVID-19 was the reason for the disruption.

Since Employer B could not demonstrate that a governmental order was the reason for the supplier’s operation being suspended, even though COVID-19 might have been the reason for the port delays and trucker shortage, Employer B did not meet the definition of an eligible employer under the suspension test. Also, Employer B’s reliance on media outlets and social media posts that the bottleneck and truck driver shortage were COVID-19-related does not provide the appropriate substantiation that a governmental order was in place.

Scenario 3: Both Employer C and its supplier were in a jurisdiction that was subject to a governmental order suspending business operations for the duration of April 2020. The order was lifted in May 2020. For the remainder of 2020 and 2021, Employer C experienced a delay in receiving critical goods and materials from its supplier, which provided no explanation for the delay. It was Employer C’s assumption that the delay related to the government’s initial order in April 2020.

In this situation, Employer C is an eligible employer for the second calendar quarter of 2020 since its business operations were fully or partially suspended due to a governmental order. Therefore, any wages that were paid in April 2020, when business operations were suspended due to the order, may be considered qualified wages in calculating the ERC. For any subsequent calendar quarter, Employer C was not an eligible employer under the suspension test since it cannot demonstrate that the governmental order extended to this period. A prior governmental order, once lifted, does not continue to be a governmental order in any subsequent calendar quarter.

Scenario 4: Employer D was not subject to any governmental order limiting or suspending its business activities. During 2020 and 2021, Employer D could not obtain critical resources from its supplier. To meet its demand, Employer D had to purchase its critical goods and materials from an alternate supplier, which cost 35% more than it had been paying its original supplier. Even though its business was not as profitable as prior to the pandemic, it was still able to carry on its trade or business.

At no time during 2020 and 2021 was Employer D restricted in operating its trade or business, and incurring higher costs from an alternate source does not rise to the level of a full or partial suspension of business operations. Therefore, Employer D did not meet the definition of an eligible employer under the suspension test.

Scenario 5: Employer E operated a large retail business that offered a diversified product line. Employer E at no time in 2021 was shut down due to a governmental order. It was also still able to operate as a retail business during this period. However, due to supply chain disruptions, it was unable to stock a limited number of products while raising prices on other products that were in limited supply.

Since Employer E cannot demonstrate that a governmental order was in place causing any of its suppliers to suspend operations, it does not qualify as an eligible employer. At all times during 2021, Employer E was able to operate its business, even though some of its products were unavailable.

Looking at the above scenarios, a few conclusions can be reached. First, for an employer to qualify under the suspension test, the supply chain disruption must be the result of a governmental order that fully or partially suspends the supplier’s business operations during a calendar quarter. The employer must also substantiate its eligibility for the credit. Assumptions, media reports, or social media dialogue do not rise to the level of substantiation that the supplier suspended its operations due to a governmental order.

If the disruption does not affect the employer’s business operations, or an alternate supplier can be found, the employer also does not qualify as an eligible employer. Also, an increase in the employer’s cost of goods sold does not rise to the level of a supply chain disruption, according to the GLAM, if it does not result in a full or partial suspension of operations.

As can be seen in the five scenarios above, the only employer that potentially qualified for the ERC is in Scenario 3, where both the employer and supplier’s business operations were fully or partially suspended due to a governmental order. The scenarios show that the exception that applies in Notice 2021-20 (Q&A 12) for an employer to qualify as an eligible employer under the suspension test due to a supply chain disruption is a “narrow” exception that applies in only very limited circumstances.

■ News Releases IR-2023-169 and IR-2023-170; Notice 2021-20; AM 2023-005

— Thomas Godwin, CPA, CGMA, Ph.D., and John McKinley, CPA, CGMA, J.D., LL.M., are both professors of the practice in accounting and taxation in the SC Johnson College of Business at Cornell University in Ithaca, N.Y. To comment on this column, contact Paul Bonner, the JofA’s tax editor.