The employee retention tax credit (“ERTC”) has garnered a lot of “buzz” lately – both from the IRS and businesses who have either received the credit or are seeking the credit. The buzz is well deserved, as the IRS has recently published several items of new guidance revealing what businesses should expect when claiming the ERTC. This article summarizes the IRS’s recent guidance with respect to the ERTC, analyzes the statute of limitations for the IRS to challenge an ERTC claim, describes the documentation that should be maintained to defend an ERTC audit and discusses certain implications of ERTC claims for M&A transactions.
What is the ERTC?
The ERTC is a refundable payroll tax credit that was introduced as part of the CARES Act to incentivize employers to keep their employees on the payroll during a government shutdown or significant decline in gross receipts resulting from the COVID-19 pandemic.
The credit is available to eligible employers that paid qualified wages to employees after March 12, 2020, and before January 1, 2022. Eligible employers can claim the ERTC on an original or amended employment tax return for a period within those dates. Taxpayers that claim the ERTC must reduce their deduction for wages by the amount of the credit for the applicable period. Therefore, they may need to amend their income tax return to reflect that reduced deduction.
The eligibility requirements, applicable time periods, and dollar limitations for claiming the ERTC have changed several times due to the passage of a series of federal bills, resulting in a complex set of rules for calculating and claiming the credit.
Beware of ERTC Promoters
Despite the intricacies of ERTC eligibility and computation, some have viewed the ERTC simply as a money-making opportunity, resulting in a proliferation of businesses promoting the ERTC and offering to help taxpayers claim the credit. In many cases, these promoters have presented misleading claims about the credit’s eligibility requirements, inducing many taxpayers to unknowingly submit invalid ERTC claims to the IRS. These arrangements often involve the promoter offering to file for the ERTC on a taxpayer’s behalf in exchange for a percentage of the taxpayer’s ERTC recovery.
The prevalence of abusive ERTC promoters has prompted the IRS to add ERTC promoters to the IRS’s annual “Dirty Dozen” list of tax scams for 2023, signaling that the IRS is taking the matter seriously. In light of these developments, taxpayers seeking to claim the ERTC should avoid abusive ERTC promoters and instead consider working with a reputable CPA (in consultation with tax counsel, as needed) when considering claiming the ERTC.
Recent IRS Guidance on the ERTC
The ERTC is only available to “eligible employers.” The CARES Act defined an “eligible employer,” in part, as an employer whose business is fully or partially suspended during the applicable 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 COVID-19. Notice 2021-20 Q&A 12 later clarified 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 employer’s suppliers are unable to make deliveries of critical goods or materials due to a governmental order that causes the supplier to suspend its operations.
On July 21, 2023, the IRS issued a generic legal advice memorandum (GLAM 2023-005), which further clarified its position on claiming the ERTC on the basis of disruptions to a supplier’s business. To meet the terms of this exception, the employer must substantiate its eligibility for the credit by providing records or documentation demonstrating that (i) a governmental order caused the supplier to suspend operations, (ii) the inability to obtain the supplier’s goods or materials caused a full or partial suspension of the employer’s business operations, and (iii) the employer was not able to obtain these critical goods or materials from an alternate supplier. GLAM 2023-005 sets forth five examples that highlight the following limitations for supporting an ERTC based on a governmental order affecting a supplier:
- Proof of a specific government order affecting the supplier will be required. News articles and social media postings do not constitute sufficient substantiation of the relationship of a delay in goods and services to government orders for COVID-19.
- An employer may not claim full or partial suspension of operations related to a supply chain disruption if the employer held sufficient supplies on hand to operate or was able to obtain sufficient supplies from an alternate supplier. Higher costs for critical goods resulting in lower profit margins do not qualify as a full or partial suspension of operations.
- Bottlenecks in ports or delays due to a truck driver shortage may not be used to support an ERTC claim without identifying the specific government orders and substantiation of their impact on the bottleneck or shortage.
- Residual supply disruptions due to government orders do not constitute support for a full or partial suspension of operations during a subsequent quarter for which the relevant governmental orders have been lifted.
- Inability to stock a limited number of products (for a retail business that sells a wide variety of products) is not by itself sufficient to support a claim for full or partial suspension of operations.
Many businesses promoting ERTC claims emphasize supply chain disruption as a basis for claiming the ERTC. This guidance highlights the difficulty of claiming an ERTC based on supply chain issues.
In addition to GLAM 2023-005, the IRS also released final regulations on July 24, 2023 with respect to the ERTC. Under the final regulations, erroneous refunds of ERTC are treated as underpayments of taxes and are, therefore, subject to assessment and administrative collection procedures (including the possible imposition of interest and penalties for improperly claimed credits).
Statute of Limitations for ERTC Challenges
Generally, the IRS’s ability to audit and collect tax on a payroll tax return is limited by statute to three (3) years from the date the original payroll return is considered filed by the IRS – which for assessment and collection purposes, is April 15th of the following calendar year that the payroll tax return was due. However, the IRS’s collection statute expiration date was extended to five (5) years for any ERTC claimed for the third and fourth calendar quarters of 2021. The impact of these moving pieces is that the statute of limitations won’t pass until April 15, 2024 and 2025 for the ERTC claimed for 2020 and 2021, respectively, and April 15, 2027 for any ERTC claimed in the last two quarters of 2021. However, the statute of limitations can be expanded in certain situations, including where the IRS finds that a return is fraudulent, in which case, no statute of limitations applies.
Aside from the periods discussed above, Section 7405(b) of the tax code may allow the government to recover an erroneous ERTC claim by filing a civil action in federal court within two years of the refund being paid. Thus, even if the general statute of limitations expires, the government can file a civil action for an erroneous refund within two years of payment. The two-year period under Section 7405(b) is extended to five years in cases where any part of the refund was induced by fraud or misrepresentation of a material fact.
ERTC Audit Defense
With the recent increase in IRS funding, a similar increase in IRS audits is expected. We recommend that taxpayers who claimed the ERTC prepare now for an audit by building their file showing the substantiation documentation supporting their ERTC claim.
The IRS recently outlined the level of substantiation it will be expecting from businesses that claimed the ERTC as follows:
Q1. What records do I need to support my eligibility for the employee retention credit? (added July 27, 2023)
A1. In general, you need to have the records you relied on to show:
- That your business operations were suspended, including the specific government order;
- You experienced the required decline in gross receipts;
- Which employees received qualified wages and in what amounts;
- That you paid qualified wages only to employees who were not providing services, if you are a large eligible employer;
- How you allocated qualified health plan expenses;
- Your relationship to other businesses or entities and how it affects your ERTC claim (see aggregation rules in Notice 2021-20, Part III, Section B);
- Any completed Forms 7200 that you submitted to the IRS;
- Any completed federal employment and income tax returns related to your claim for ERTC.
Implications of ERTC for M&A Transactions
The ERTC raises a number of issues in M&A transactions. Below is a list of certain ERTC considerations buyers should take into account before acquiring a seller’s business. Potential sellers would likewise be well-advised to analyze their ERTC claim in order to be prepared to address ERTC-related concerns raised by potential buyers.
Thorough due diligence should be performed (and appropriate representations and warranties should be provided by sellers) with respect to any potential tax issues of the target business, including the ERTC. If the target business claimed an ERTC, the buyer should fully review the target’s eligibility for the ERTC and whether supporting documentation (e.g., governmental orders and documentation of the necessary decline in gross receipts, as applicable) has been maintained to defend the ERTC claim on audit. A buyer should also confirm that the target business properly reduced its wage deduction by the amount of the ERTC in the year the wages were paid.
Purchase agreements should be drafted to include comprehensive indemnity coverage for any loss relating to the potential disallowance of an improperly claimed ERTC. Importantly, this loss may include not only the ERTC itself, but also associated penalties and interest. Depending on the size of the ERTC claimed, the support therefore, and the seller’s creditworthiness, additional protections beyond a right of indemnity should be considered (e.g., indemnity escrows, deferred purchase price, representation and warranty insurance, etc.).
Notably, the ERTC is a tax credit against employment taxes, which are assessed at the entity level (including entities that are so-called “disregarded entities” for U.S. federal income tax purposes). Accordingly, the acquisition of a wholly-owned LLC that is a disregarded entity (though structured to be treated as an acquisition of assets for U.S. federal income tax purposes) does not prevent an IRS claim against the target LLC for any ERTC that was improperly claimed.
For employers who qualify and can substantiate their qualification, the ERTC can be a valuable tax credit. However, in the words of the IRS, “[b]usinesses need to think twice before filing a claim for these credits” and ought to proceed only after fully analyzing their ability to qualify for the ERTC, documenting their qualification and examining associated risks with claiming the ERTC. To speak with one of our attorneys about your particular situation, please contact Aaron Pinegar or Ashley Withers.
 IRS News Release 2023-49 (March 20, 2023)
 See “IRS opens 2023 Dirty Dozen with warning about Employee Retention Credit claims; increased scrutiny follows aggressive promoters making offers too good to be true,” (March 20, 2023), https://www.irs.gov/newsroom/irs-opens-2023-dirty-dozen-with-warning-about-employee-retention-credit-claims-increased-scrutiny-follows-aggressive-promoters-making-offers-too-good-to-be-true
This alert is not intended to provide legal advice, and no legal or business decision should be based on its contents. Please consult with your legal counsel for guidance. For assistance related to the employee retention tax credit, please contact Aaron Pinegar at firstname.lastname@example.org, Ashley Withers at email@example.com, or any member of the Tax practice.
Aaron P. Pinegar concentrates his practice on U.S. federal income tax structuring and planning for a wide range of business transactions, including domestic and international mergers, acquisitions, divestitures, joint ventures, tax-free reorganizations, spin-offs, tax-deferred rollovers, financings, and restructurings. In addition, transactional lawyers and law firms across the country regularly engage Aaron to serve as outside tax co-counsel on matters for their clients.
Ashley P. Withers advises clients on a wide variety of tax matters. She has a broad-based tax practice that includes representing businesses, family offices, tax-exempt organizations, and individuals on tax strategies, compliance, and tax-efficient organizational structuring. Ashley’s practice also includes representing businesses and individuals in tax controversy matters. In her controversy practice, she has successfully defended clients in IRS audits and appeals and secured favorable private letter rulings.