The Employee Retention Credit (ERC) — sometimes called the Employee Retention Tax Credit or ERTC — is a refundable tax credit for certain eligible businesses and tax-exempt organizations that had employees and were impacted during the COVID-19 pandemic. Whenever the government implements a large-scale program aimed at getting funds into the hands of those in need as quickly as possible, fraud is bound to result. Due to the high number of cases the IRS has identified as problematic, many taxpayers must go to court to receive the credit. For taxpayers whose claims were not processed, were denied entirely, or were partially denied, litigation may be the only option.

Problematic nature of many ERC claims

On June 20, 2024, the IRS announced plans to reject tens of thousands of ERC claims that it deemed ineligible and high-risk. According to the IRS, it spent months reviewing more than 1 million ERC claims, totaling more than $86 billion in claimed tax credits. Individual taxpayers who were not employers were not eligible for ERC. To be eligible, a business must either:

Failure to meet these requirements will result in total or partial rejection of an ERC claim.

Administrative Refund Claims – The Good, the Bad and the Ugly

An ERC claim is simply a claim for a refund. Like all refund claims, they are subject to the refund procedures. The refund procedures require taxpayers to file a refund claim on either an amended federal tax return or on IRS Form 843, Claim for Refund and Request for Forgiveness. Eligible employers who claim an ERC and did not do so when filing their original return can file an ERC claim by amending their IRS Form 941 and filing IRS Form 941-X, Amended Quarterly Federal Tax Return or Employer Request for Refund.

Rarely is a refund request granted on the first application – regardless of the type of request. In my 15+ years as a tax litigator, I have seen this happen less than 10 times. One of the harshest criticisms we have heard about the way the IRS handles ERC requests is that the denial letters often make no sense in light of the request, are missing important information, or taxpayers are not informed that they have the right to appeal to the IRS’s independent appeals office. I wish I could say this is new IRS behavior, but it is not. I took over handling a refund case and here is a snapshot of what the IRS said when the refund request was denied:

In other words, the claim was denied because the claim was denied! How enlightening. This case was about an inheritance tax refund, not penalties. The description of why the refund claim was denied because the IRS denied a reduction in penalties had nothing to do with what the taxpayer was asking about.

Now consider how the IRS will be able to properly process the massive volume of applications coming through ERC, in addition to the everyday, typical refund applications. The system was already flawed before, and is now even more overloaded.

Major companies bear the brunt of the rejections

Undoubtedly, some of the companies applying for the ERC do not meet the requirements, and some were not even real companies at all. These rejections should not be pursued in court. However, experts like Jennifer Keegan of Plante Moran see that ERC applications that should be accepted are either rejected outright or pose very little risk of being appealed to the IRS’s independent appeals office. Many of these cases involve so-called systemically important companies.

Businesses that are considered “essential” were able to stay open and maintain operations even at the height of the pandemic. But just because they were able to stay open doesn’t mean they weren’t affected by the pandemic. Take hospitals, for example. Many hospitals had to cancel or postpone all non-urgent surgeries. They was affected by the pandemic, even when they were allowed to remain open. According to Keegan, “Over the past year, we have seen IRS auditors interpret the ERC rules in increasingly restrictive ways, particularly for taxpayers seeking to qualify due to a partial suspension of their business. Even taxpayers who were heavily burdened by government orders are seeing their claims denied in audits and receiving low settlement offers on appeal.”

Daniel Mayo, tax partner at Withum, has also had mixed results. He explained, “We are successful in most of the cases we take to the Court of Appeals, but the IRS remains steadfast and refuses to settle when it comes to systemically important companies.”

“The Appellate Division will likely soon be very overloaded, not only with cases from the audit, but also with cases where the denials are being challenged without an audit, which is what we are seeing now,” said Marissa Lenius, senior manager, RSM US LLP, Tax Controversy Practice. “Some taxpayers have received denials claiming there were no government orders and no decline in quarterly gross receipts when in fact the taxpayers had the required quarterly decline in gross receipts. There is no way for the IRS to reach that conclusion without an audit.”

The systemically important companies that were able to remain open – albeit partially or in modified form – but were affected by the pandemic will likely be at the centre of the next wave of ERC defence, namely in the form of litigation.

Next comes a legal dispute

Companies that have a legitimate claim but do not get the expected results in audits or appeals must sue if they want to pursue their claims further. “Clients want to sue to force the IRS to consider their legitimate ERC claims, but are frustrated that they have to incur additional costs to get the IRS to do what should have already been done,” Mayo said. Alina Solodchikova, a managing director at RSM, agrees, adding, “Due to the lack of case law and only procedural guidance from the IRS in the ERC area, we believe many of the large ERC refund claims could end up in court if they are not resolved at the administrative level in the IRS’s appeals process.”

As with all administrative refund claims, once an ERC claim has been filed for six months or more, a taxpayer has the right to file a lawsuit in federal district court or the United States Court of Federal Claims to enforce the refund claim. And as with all administrative refund claims, most taxpayers claiming the ERC will want to wait to file a lawsuit until absolutely necessary. Why? Lawsuits are expensive.

FirstEmployers must determine Where to file the lawsuit. A taxpayer must file a lawsuit for a refund of taxes paid in the U.S. District Court of his or her place of residence (or the principal place of business of a corporation) or in the Court of Federal Claims. The main difference between the U.S. District Court and the Court of Federal Claims is that in the district court, either party may request a jury trial. In the Court of Federal Claims, all cases are decided by a judge and there are no jury trials. In both cases, the cases are handled by attorneys who work in the Civil Division of the Department of Justice, Tax Division. (Cases tried in the U.S. Tax Court are handled by attorneys in the IRS Office of Chief Counsel, not by attorneys in the Department of Justice.)

Secondemployers must decide what resources to devote to litigation. I used to tell my clients who were considering litigation in cases where we believed the IRS was completely wrong that once we filed suit and a Justice Department attorney was hired to look at everything, we could hope to negotiate a settlement quickly. In my recent experience, those days are over. In recent years, I have seen a marked turnaround, and now the Justice Department is unwilling to engage in productive settlement negotiations until substantial evidence is presented. This is costly: the parties must exchange documents, answer written questions in the form of interrogatories, and take and defend testimony.

In my opinion, this is really bad tax policy. As an attorney for my clients and as a taxpayer, I hate it when I can’t get the government to back down from what I consider to be a clearly wrong position without wasting a lot of money — both my clients’ money in fees and taxpayers’ money on what I consider to be an unnecessary review of something I consider obvious. However, I can also see the government’s point of view: The IRS has already done extensive work to investigate a claim and denied that claim, so the Justice Department’s lawyers must assume that the IRS did its job well and look very critically at the taxpayer’s position. The problem with this approach is that refund claims often don’t get the attention they deserve. As a result, taxpayers whose refund claim is not carefully reviewed by the IRS end up paying a lot more for the Justice Department’s careful review of their claims in the end. It is very difficult to get legal fees from the state – more difficult than it should be, in my opinion – but that is another story.

ThirdAs ERC cases work their way through the evidentiary hearing, strategic decisions must be made about which, if any, issues the judge should decide as a question of law without a trial. Under a process called summary judgment, litigants can ask the court to decide certain parts of the case without a trial. This can narrow the issues that must be tried and reduce both the cost of litigation and the time to resolution. Some of the issues that may be ripe for summary judgment are likely to involve whether the IRS’s notices and application of the CARES Act were consistent with the law passed by Congress. Given the sums at stake, litigation is certain to ensue.