Evolving ERC Guidance

ERC Strategies for PEOs: Navigating the History of ERC  Program Legislation

Information about the Employee Retention Credit (“ERC”) program, primarily from Congress and the IRS, is a work in progress. Lots of guidance has been released over time. Below is an overview of the main items.

A. First Law

Congress enacted the Coronavirus Aid, Relief, and Economic Security Act in March 2020. It generally provided that an eligible employer could claim ERCs against certain employment taxes equal to 50 percent of the qualified wages paid to each employee for each quarter.

An eligible employer meant one that was carrying on a trade or business in 2020 and met one of the following two tests. First, the employer’s operations were partially or fully suspended because of an order from an appropriate governmental authority that limited commerce, travel, or meetings for commercial, social, religious, or other purposes because of COVID-19 (governmental order test). Second, the employer suffered a significant decline in gross receipts (reduced gross receipts test).

The notion of qualified wages depended on the number of full-time employees working for an eligible employer before things went downhill. There were two categories of eligible employers. When an eligible employer had an average of more than 100 full-time employees (large eligible employer), qualified wages meant those paid to any employee who was not providing services. Conversely, when an eligible employer had an average of 100 or fewer full-time employees (small eligible employer), qualified wages meant all wages paid during a quarter, regardless of whether the employees were actually working. In addition to the amounts described above, qualified wages included the qualified health plan expenses paid by the eligible employer that were allocable to the qualified wages.

Benefits were limited under the CARES Act. In particular, the amount of qualified wages for any one employee could not exceed $10,000 for all quarters combined in 2020. Thus, after applying the 50 percent limit, the maximum ERC per employee for all of 2020 was $5,000. Coverage of the ERC changed several times but it originally applied to qualified wages paid by eligible employers during the second, third, and fourth quarters of 2020. Congress instructed the IRS to issue “such forms, instructions, regulations and guidance as are necessary” to accomplish a long list of things related to the ERC.

B. Notice 2021-20

The IRS released its first major guidance in March 2021. Notice 2021-20, 2021-11 IRB 922, was massive. It filled more than 50 pages, replete with rules, terminology, examples, and more.

C. Second Law

Congress passed the Taxpayer Certainty and Disaster Tax Relief Act of 2020 in December 2020. That legislation modified the existing ERC law in several ways, some of which are explored below.

Eligible employers originally could claim ERCs only for the second, third, and fourth quarters of 2020. The relief act broadened the scope, adding the first and second quarters of 2021.

The relief act made several changes related to qualified wages, too. For example, it increased the relevant percentage. The CARES Act contemplated an eligible employer getting an ERC equal to 50 percent of the qualified wages paid to each employee for each quarter. The relief act raised that to 70 percent. Moreover, the relief act favorably adjusted the cap on qualified wages. The amount was initially $10,000 per employee for all quarters, creating a maximum ERC of $5,000 per employee. The relief act increased this to $10,000 for each employee, for each quarter.

The relief act also modified the standards for being a small eligible employer and a large eligible employer, thereby making it easier to claim ERCs for all wages paid to employees during certain quarters, not just to those who were not providing services. Large eligible employers became those whose average number of full-time employees during the relevant period was more than 500 (instead of more than 100), while small eligible employers were those with an average of 500 or fewer. The relief act also eliminated the earlier rule that the qualified wages paid by a large eligible employer to an employee cannot surpass the amount that the employee would have been paid for actually working the same amount of time during the 30 days immediately before the period when the governmental order test or reduced gross receipts test was met. The standards for meeting the reduced gross receipts test were lowered under the relief act, which made achieving eligible employer status easier. Instead of gross receipts having to fall below 50 percent of the previous mark, they only had to be less than 80 percent during the same quarter in 2019.

The relief act also gave employers the power to elect, in determining whether they met the reduced gross receipts test, to compare the gross receipts of the immediately preceding quarter to those for the corresponding quarter in 2019, instead of using the quarter for which the ERC is claimed.

D. Notice 2021-23

The IRS needed to provide yet more administrative direction after Congress released the relief act. This time, it came in the form of Notice 2021-23, 2021-16 IRB 1113. The new guidance was hefty again, occupying more than 10 pages with data specific to the relief act.

E. Third Law

Congress passed the American Rescue Plan Act of 2021 in March 2021. That law further expanded the ERC, allowing eligible employers to claim benefits for the third and fourth quarters of 2021. Thus, at that point, the ERC was available for the second, third, and fourth quarters of 2020 (under the CARES Act), the first and second quarters of 2021 (under the relief act), and the third and fourth quarters of 2021 (under ARPA). ARPA also created a new type of eligible employer, the so-called recovery startup business. That was an employer that began carrying on a trade or business after February 15, 2020, and whose average annual gross receipts during the relevant period did not exceed $1 million. 

ARPA added new rules about “severely financially distressed employers,” too. These are employers whose gross receipts during the relevant quarter were less than 10 percent of those in the previous comparable quarter. For this narrow category of struggling businesses, the term “qualified wages” means all wages paid to employees during all relevant quarters.

In terms of enforcement, ARPA granted the IRS more time to audit taxpayers who might be misbehaving. In particular, the law created an exception to the general three-year rule on assessments; it allowed the IRS five years from the date on which the relevant employment tax return was filed or deemed filed to audit, propose taxes and penalties, and issue a final notice.

F. Notice 2021-49

Notice 2021-49, 2021-34 IRB 316, was next in the series of IRS guidance. It contained supplemental guidance on different issues that had arisen since Congress first introduced the ERC. Like the earlier releases from the IRS, this one was substantial, consisting of nearly 20 pages. The information generally applied to all quarters covered by the ERC under all legislation to date. In other words, the guidance from the IRS, first released to the public in August 2021, was retroactive back to March 2020. That triggered the filing of many Forms 941-X, “Adjusted Employer’s Quarterly Federal Tax Return or Claim for Refund,” to make changes to incorporate the IRS’s new direction about the definition of full-time employees, treatment of tips, special rules for related parties, using inconsistent quarters for making gross receipt comparisons, and unique rules in cases in which employers acquire a business.

G. Rev. Proc. 2021-33

The IRS created a safe harbor that allows taxpayers to exclude certain items from gross receipts when calculating that figure for ERC purposes, including loans forgiven under the Paycheck Protection Program.

Rev. Proc. 2021-33, 2021-34 IRB 327, says that an employer can ignore various things, among them any PPP loan forgiveness, when analyzing its eligibility to claim ERCs for a particular quarter, as long as the employer “consistently applies” this safe harbor. This means that the employer must disregard the loans for all relevant quarters, and not include and exclude amounts at its whim to satisfy a particular standard or percentage. The safe harbor applied to all periods relevant to the ERC, namely, the second quarter of 2020 forward.32 This retroactive stance by the IRS obligated many eligible employers to file yet more Forms 941-X.

H. Fourth Law

Congress enacted the Infrastructure Investment and Jobs Act in November 2021. That legislation announced the end of the ERC and it shortened the periods for claiming benefits. Eligible employers, except recovery startup businesses, could no longer solicit ERCs for the fourth quarter of 2021. As a result, ERCs for most eligible employers could not surpass a total of $26,000, an amount based on $5,000 for 2020 in its entirety, plus $7,000 for each of the first, second, and third quarters of 2021.

I. Notice 2021-65

The IRS issued Notice 2021-65, 2021-51 IRB 880, to clarify the IIJA. It began, of course, with confirmation that most eligible employers could not claim ERCs for the fourth quarter of 2021. The next logical step for the IRS was recouping funds. It did so by explaining that advance ERC payments received by most eligible employers for the fourth quarter of 2021 constituted “erroneous refunds” that must be repaid and that delinquencies would be penalized.

J. ‘Dirty Dozen’ List

The next guidance from the IRS, loosely defined, was the placement of improper ERC claims atop the “Dirty Dozen” list in March 2023.

K. Office of Professional Responsibility Alert

The IRS’s Office of Professional Responsibility issued an alert in March 2023 underscoring that ERC claims implicate several aspects of Circular 230. First, referencing due diligence and reliance under section 10.22 and section 10.34, the alert reminds practitioners that they must make reasonable inquiries of the taxpayer to confirm its eligibility for, and the correct amount of, ERCs. It stated the following in this regard: “If the practitioner cannot reasonably conclude . . . that the client is or was eligible to claim the ERC, then the practitioner should not prepare an original or amended return that claims or perpetuates a potentially improper credit.” Moreover, the alert explained that if a practitioner discovers that a current client violated the ERC requirements in a prior period, the practitioner has a duty to inform the client of the noncompliance and related penalties.

Second, again alluding to section 10.34 of Circular 230, the alert told practitioners that all tax positions must have at least a reasonable basis. Expanding on this notion, the alert recommended that practitioners with clients that previously made unwarranted or excessive ERC claims advise them of the option to file Forms 941-X.

Third, the alert warned practitioners that they might not be able to rely on opinions, reports, analyses, and similar documents prepared by others when it comes to making ERC claims. It explained that, if the previous adviser has a conflict of interest with the taxpayer because of the amount or type of fee he charged (for example, a prohibited contingent fee), then the practitioner might not be able to reasonably rely on the documents from the adviser.

L. Legal Memo About Supply Chain Issues

The IRS supplied additional guidance in July 2023. This time it came as a generic legal advice memorandum (GLAM) centering on the interplay between the governmental order test and supply chain problems.

The GLAM summarized the IRS’s position as follows. An employer can “step into the shoes” of its supplier. However, this is not easy, since an employer must show that (1) the supplier was subject to an acceptable governmental order during the relevant period, (2) that order caused the supplier to suspend its operations, (3) the inability to obtain goods or materials from the supplier caused a full or partial suspension of the employer’s operations, and (4) it was unable to procure goods or materials from an alternative source. The IRS examined five scenarios in the GLAM against that backdrop.

In Scenario 1, Employer A was not subject to a governmental order at any time. However, during 2020 and 2021, Employer A experienced several delays in receiving critical goods from Supplier 1. At all times during 2020 and 2021, Employer A continued to operate because it had a surplus of the critical goods normally provided by Supplier 1. Employer A assumed that Supplier 1’s delay in delivering critical goods was caused by COVID19. Employer A inquired in this regard, and Supplier 1 vaguely confirmed that the delay was because of COVID-19, but it did not provide a copy of any governmental order, and Employer A was unable to locate one independently. The IRS ruled that Employer A was not an eligible employer because it could not demonstrate that a government order applicable to Supplier 1 partially or fully suspended Supplier 1’s operations. Moreover, even if Employer A received or could locate a governmental order applicable to Supplier 1, Employer A was not forced to cease operations because it had a reserve of critical goods. Consequently, Employer A did not experience a suspension of operations because of an inability to obtain Supplier 1’s critical goods. The relevant inquiry, emphasized the IRS, is whether Employer A’s operations could continue. Because Employer A was able to continue its own business operations despite the supply chain disruption, it was not subject to a suspension.

In Scenario 2, Employer B was not subject to a governmental order at any time. However, certain critical goods from Supplier 2 were stuck at port. Employer B assumed that the bottleneck was a result of COVID-19, but it could not identify any specific governmental order to that effect. Some news sources stated that COVID-19 was the reason for the bottleneck, while others cited different causes, such as increases in consumer spending and aging infrastructure. Also, Supplier 2 mentioned to Employer B that other critical goods that were not stuck at port also would be delayed because of a shortage of truck drivers. Employer B saw discussions on social media indicating that the truck driver shortage was caused by drivers being out sick with COVID-19. The IRS concluded that Employer B was not an eligible employer because it could not demonstrate that a governmental order applicable to Supplier 2 partially or fully suspended Supplier 2’s operations. Also, while COVID-19 may have been a contributing factor to the bottleneck at the port or to the truck driver shortage, Employer B could not substantiate that any specific governmental order caused these problems.

In Scenario 3, Employer C and Supplier 3 were located in a jurisdiction that issued governmental orders suspending both of their business operations during April 2020. The orders were lifted in May 2020. For the remainder of 2020 and 2021, Employer C experienced a delay in receiving critical goods from Supplier 3. Supplier 3 did not provide a reason for the delay, but Employer C assumed that it was because of the governmental order in place back in April 2020. The IRS determined that Employer C was an eligible employer in the second quarter of 2020 because its business operations were partially or fully suspended because of a governmental order. However, only those wages paid during the second quarter of 2020, when Employer C’s operations were actually suspended, were qualified wages. The IRS further explained that Employer C was not an eligible employer for any other quarter in 2020 or 2021 because it cannot show that a governmental order applicable to Supplier 3 partially or fully suspended Supplier 3’s operations. The residual delays caused by a governmental order in place during a prior quarter will not constitute a governmental order in subsequent quarters once the order has been lifted.

In Scenario 4, Employer D was not subject to a governmental order at any time. During 2020 and 2021, Employer D could not obtain critical goods from Supplier 4, but it managed to get them from an alternative supplier. The alternative supplier charged 35 percent more than Supplier 4. This meant that Employer D could continue operating its business, but it was not as profitable as it had been in 2019. The IRS indicated that Employer D was not an eligible employer because it was not prevented from operating at any point during 2020 or 2021, and incurring a higher cost for critical goods, alone, does not constitute a partial or full suspension of operations.

In Scenario 5, Employer E operated a large retail business selling a variety of products. It was not subject to a governmental order in 2021. Because of several supply chain disruptions, Employer E was not able to stock a limited number of products, and it was obligated to raise prices on other products that were in short supply. However, the product shortage did not prevent Employer E from continuing to fully operate during 2021. The IRS explained in the GLAM that Employer E was not an eligible employer during 2021 because it could not demonstrate that (1) a governmental order applicable to a supplier of critical goods or materials caused the supplier to suspend operations, and (2) it was unable to obtain critical goods and materials elsewhere. The IRS observed that Employer E was able to operate its business at all times in 2021. While certain products were unavailable, Employer E was still able to offer a wide variety of products to its customers and it was not forced to partially suspend operations.

M. Guidance on Governmental Employers

The IRS later turned its attention to those working at a federal credit union (FCU).

The CARES Act, which pertained to the second, third, and fourth quarters of 2020, prohibited governmental employers from benefitting from ERCs. That initial law said that the incentives will not apply to “the Government of the United States, the government of any State or political subdivision thereof, or any agency or instrumentality of any of the foregoing.”

Notice 2021-20 also made that restriction quite clear. It first underscored that the ERC “does not apply to the Government of the United States, the government of any State or political subdivision thereof, or any agency or instrumentality of those governments, [such that] these entities are not Eligible Employers.” Next, Notice 2021-10, 20217 IRB 888, pondered how an organization can determine whether the IRS will consider it an “instrumentality” of the federal, state, or local government for ERC purposes. It explained that the IRS generally considers six factors, none of which is determinative by itself.

The second round of ERC standards, derived primarily from the relief act, dramatically changed things. The relief act preserved the original ban on governmental employers but created a notable exception. It provided that the existing restriction will not apply to (1) any organization described in section 501(c)(1) and exempt from tax under section 501(a), or (2) any governmental employer that is a college or university, or whose principal purpose or function is providing medical or hospital care. The corresponding guidance from the IRS, found in Notice 2021-23, contained much of the same information, with a few extra touches. Among other things, it said that governmental employers could only be eligible employers, and thus apply for ERCs, from the first quarter of 2021 forward. They did not enjoy retroactive eligibility for the second, third, and fourth quarters of 2020.

Talk about governmental employers fell silent, but it returned in August 2023 when the IRS published a chief counsel advice memorandum. It began by summarizing the relevant portions of the ERC legislation and related IRS guidance. It then turned to FCUs. The IRS explained that the Federal Credit Union Act, introduced nearly a century ago, allowed the creation of FCUs to combat limited credit availability and high interest rates by encouraging average citizens to pool their resources. It further indicated that each FCU acts as a “fiscal agent” of the U.S. government, performing various services associated with collecting, lending, borrowing, and repaying money. The IRS went on to note that the National Credit Union Administration Board has authority to investigate FCUs, suspend or revoke their charters, and even place them into involuntary liquidation. Finally, the IRS underscored that FCUs are exempt from all income taxes.

Consistent with its earlier guidance in Notice 2021-10, the IRS said that it contemplates six primary factors when determining whether an entity is an instrumentality of a federal, state, or local government. The IRS concluded that FCUs are instrumentalities for ERC purposes because they are created by federal statute, serve the governmental purpose of fomenting the economic well-being of underserved populations, perform governmental functions when they act as fiscal agents, and are controlled and supervised by a public authority. The IRS explained that, because FCUs are instrumentalities of the federal government, and because they are tax exempt, they might qualify as eligible entities in the context of ERCs.

The chief counsel advice came to the following four conclusions. FCUs cannot claim ERCs for the second, third, and fourth quarters of 2020 because the CARES Act explicitly prohibits instrumentalities of the federal government from doing so. FCUs can claim ERCs for the first and second quarters of 2021 because, although they are instrumentalities, they meet the exception introduced by the relief act. FCUs can claim ERCs for the third quarter of 2021 in accordance with ARPA because they are excepted instrumentalities. Finally, FCUs can claim ERCs for the fourth quarter of 2021 for the same reason, as long as they are also recovery startup businesses.

N. Legal Memo About OSHA Communications

The IRS issued a GLAM in October 2023 addressing the relationship between the governmental order test, partial or full suspension of business operations, and “communications” by the Occupational Safety and Health Administration. Notably, the GLAM was published more than three-and-a-half years after Congress created the CARES Act, more than two and-a-half years after the IRS published Notice 2021-20, and some time after many taxpayers had already filed ERC claims with the IRS.

The specific issue addressed in the GLAM was whether an employer can rely on OSHA communications about preventing the spread of COVID-19 in the workplace in order to meet the definition of eligible employer for ERC purposes.

The GLAM described three documents that OSHA issued in connection with COVID-19. The first was the Interim Enforcement Response Plan, which recommended multiple safety controls, including social distancing, maintaining ventilation systems, and using masks. The GLAM emphasized that OSHA’s website features a disclaimer, stating that OSHA rules are set by statute, standards, and regulations, and interpretations of these sources, including those in the Interim Enforcement Response Plan, “cannot create additional employer obligations.” The GLAM went on to explain that the Interim Enforcement Response Plan is not addressed to any specific employer, does not establish a blanket mandate or new requirements for all workplaces, and represents nothing more than instructions to field personnel about evaluating workplace hazards triggered by COVID-19.

The second OSHA communication was called Protecting Workers Guidance. The GLAM explained that, although this document references “mandatory OSHA standards,” it merely contains recommendations that are “advisory in nature and informational in content,” and does not constitute a law, standard, or regulation.

The third item mentioned in the GLAM was an OSHA directive, providing personnel guidance regarding policies and procedures for home-based worksites. The GLAM explained that the directive underscores that “OSHA respects the privacy of the home and has never conducted inspections of home offices.”

The GLAM then began its analysis. It pointed out that the CARES Act, later codified with certain changes as section 3134, requires a governmental order, and never mentions “recommendations, guidelines, or other information standards.” Moreover, because the CARES Act does not specifically define the term “order,” the IRS must use principles of statutory interpretation. The GLAM thus turned to the ordinary meaning of the word, as found in the dictionary. According to that source, an “order” normally means a command or mandate given by a government official, and the OSHA communications described above do not command or mandate an employer to take any action. The GLAM then got more specific, looking at the law that created OSHA, the Occupational Safety and Health Act. It explained that nonbinding guidance, such as that in the Interim Enforcement Response Plan and the Protecting Workers Guidance, is not considered an “order” under that legislation.

The IRS was not finished yet, though. The GLAM further explained that the OSHA communications probably would not support an ERC claim, even if they were to be considered governmental orders. Why? The rules require that an employer be subject to a governmental order and that the order cause a partial or full suspension of operations. The GLAM suggests that the recommendations by OSHA to wear masks, offer sanitation supplies, and encourage social distancing likely would not have more than a “nominal effect” on an employer’s ability to operate its business. The GLAM concluded by applying its reasoning to two scenarios. In the first one, the employer is located in a jurisdiction that lifted all COVID-related orders in the first quarter of 2021. At that time, the employer ceased all mitigation measures, other than encouraging employees to wear masks and use routine hygiene practices. The employer claimed ERCs for the second and third quarters of 2021 on the grounds that its business operations were partially suspended because of the OSHA communications. The IRS concluded that (1) the OSHA communications did not constitute an order for ERC purposes, and (2) even if they did, the employer could not demonstrate that the limited measures in place during the second and third quarters of 2021 had more than a nominal effect on its business operations.

The second scenario was the same as the first, except that, before 2020, the employees had teleworked two or three times per week. Starting the first quarter of 2020 and continuing through the third quarter of 2021, the employer allowed the employees to telework on a full-time basis. The IRS concluded that (1) the OSHA communications did not constitute an order for ERC purposes; (2) even if they did, the employer could not demonstrate that the limited measures in effect during the second and third quarters of 2021 had more than a nominal effect on its business operations; (3) the employer was able to continue operations in a comparable manner, as its employees were already equipped to telework before COVID-19 hit; and (4) as stated in its directive, OSHA does not inspect home offices.

O. Frequently Asked Questions

Approximately one month after Congress enacted the CARES Act, the IRS first posted frequently asked questions about ERC issues on its website in April 2020. The IRS has added, deleted, and otherwise changed those FAQs over the years.  For instance, it made major changes in July, September, and November 2023.

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