IRS Limits Supply Chain Disruption Basis for COVID-Era ERC Qualification

Countless businesses relied on the employee retention tax credit to keep their employees on the payroll during the height of the COVID-19 pandemic. Now, the IRS has focused significant resources on reviewing those business owners’ eligibility for the credit. While many enforcement efforts have focused on third-party scam artists who have worked to convince business owners to retroactively claim the credit based on promises of sky-high tax refunds, others are taking aim at whether businesses qualified for the credit in the first place. When the credit was first unveiled, many businesses claimed the credit with only the bare bones letter of the law as guidance on their qualification. In hindsight, the IRS is offering its interpretation of the law based on more specific scenarios. The most recent guidance focuses on businesses that claimed the ERC based on supply chain disruptions under the government shutdown order prong of the ERC eligibility test.

ERC Qualification: The Basics

The ERC was a refundable tax credit designed to help employers who retained employees during the COVID-19 pandemic crisis.

The credit, which was taken against employment taxes, was originally equal to 50 percent of the first $10,000 of qualified wages paid to the employee between March 12, 2020 and January 1, 2021. These rules essentially limited the credit to $5,000 per employee in 2020. In 2021, the limit on qualified wages per-employee increased from $10,000 per year to $10,000 per quarter. Businesses could either take the credit on an original tax return or file an amended return.

To qualify for the ERC, the employer had to meet certain criteria to show that the employer had either (1) experienced a significant decline in gross receipts or (2) shut down operations due to a governmental order.

Businesses that did not qualify for the ERC under the gross receipts test may have qualified if a governmental order related to COVID-19 forced the business to suspend operations (whether the suspension was total or partial in nature).

The IRS GLAM: ERC Qualification Based on Supply Chain Disruption

Back in 2021, IRS Notice 20210 offered business owners a path toward ERC qualification based on supply chain disruptions. To qualify, the employer was required to establish that: (1) the supplier was unable to deliver critical goods or materials due to a suspension of its business due to a government order, (2) the business could not obtain the goods or materials from an alternate supplier, and (3) the business was forced into a total or partial shutdown as a result.

The IRS released a generic legal advice memorandum (GLAM) to clarify when and whether a business owner could have properly qualified for the ERC based on supply chain disruptions based on government shutdown orders. While the GLAM is not official guidance that can be used as precedent, it sheds light on the IRS’ position on the issue. The GLAM contained five different scenarios where supply chain disruptions did not qualify the business for the ERC.

Under the guidance, the unifying concept is that some type of governmental order must have caused the supplier to suspend its operations during the pandemic. That suspension, in turn, must have caused the business claiming the ERC to suspend its own business operations.

It is up to the business to provide documentation to prove that the governmental order applied to the supplier. The business owner must also substantiate the link between that governmental order and the business owner's own suspension of operations (i.e., proving that the business could not obtain needed goods or services from the supplier, and so was forced to suspend operations as a result). If the business cannot substantiate the governmental order, the business will also not be treated as having a partial suspension of operations (general statements from the supplier are not enough—the specific government order must be identified).

Importantly, business owners should be aware that the IRS position in the GLAM is that even dramatic price increases or inability to offer some (but not all) of the business’ goods and services does not equate to a partial suspension. That’s true even if the business’ hardships were created by the pandemic. Residual delays that occurred after the government order in question was lifted are also insufficient.

Further, governmental orders that are not in effect during the quarter that the business claims the ERC will not be a valid basis for the business’ partial suspension of operations. If the business sold a wide range of products, limited shortages of certain products are also not sufficient to support an ERC claim.

Conclusion

Business owners who justified ERC claims based on supply chain disruptions should maintain careful documentation in anticipation of a future IRS challenge—noting that the IRS appears to be evaluating qualifications based on a strict construction of the law itself.

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