The IRS has issued increasingly urgent warnings about aggressive promoters who are encouraging businesses to claim the Employee Retention Credit without meeting the eligibility requirements. In its most recent alert, IR-2023-40, the Service identified ERC mills as a top compliance concern and cautioned employers that improper claims could result in significant penalties, interest, and potential criminal prosecution. For business owners who have already claimed the credit—or who are being solicited to do so—the time to evaluate the legitimacy of those claims is now.

Overview of the Employee Retention Credit

The Employee Retention Credit was created by the CARES Act in March 2020 as a refundable payroll tax credit designed to encourage employers to keep workers on their payroll during the economic disruptions caused by the COVID-19 pandemic. The credit was subsequently expanded by the Consolidated Appropriations Act of 2021 and the American Rescue Plan Act. For 2020, the credit was worth up to $5,000 per employee; for the first three quarters of 2021, it was worth up to $7,000 per employee per quarter—a potential total of $26,000 per employee across the eligible period.^[1]

The size of the credit has attracted widespread attention, and with it, a cottage industry of promoters and third-party firms that aggressively market ERC claims to businesses regardless of whether they actually qualify. The IRS has placed the ERC on its annual "Dirty Dozen" list of tax scams and has devoted significant resources to examining questionable claims.

Who Actually Qualifies

The Government Order Test

The first pathway to ERC eligibility requires that the employer's trade or business was fully or partially suspended during a calendar quarter due to a governmental order limiting commerce, travel, or group meetings on account of COVID-19. This test has proven to be one of the most frequently misapplied elements of the ERC. A general economic slowdown does not constitute a suspension of operations. The employer must identify a specific government order—federal, state, or local—that directly affected its operations. Moreover, the suspension must be more than nominal; the order must have had a material effect on the employer's ability to conduct its business in its normal manner.^[2]

Many promoters have encouraged businesses to claim the credit based on general COVID-19 conditions without identifying a specific qualifying government order. The IRS has made clear that vague references to the pandemic or to general business disruptions are insufficient. Employers must be able to point to a particular order and explain how it caused a full or partial suspension of their operations during the relevant period.

The Gross Receipts Decline Test

The second pathway requires a significant decline in gross receipts. For 2020, an employer qualified if its gross receipts for a calendar quarter were less than 50 percent of gross receipts for the same quarter in 2019. For 2021, the threshold was relaxed to a 20 percent decline compared to the same quarter in 2019. This test is more objective than the government order test, but it still requires careful analysis. Employers must use the same accounting method consistently, and the IRS has cautioned that receipts cannot be selectively defined to manufacture eligibility.

The Supply Chain Disruption Question

One of the most contested areas of ERC eligibility involves the so-called supply chain disruption theory. Some promoters have argued that if an employer's suppliers were subject to a government order that caused supply chain disruptions, the employer itself qualifies for the ERC even if no government order directly affected the employer's own operations. The IRS addressed this issue in Notice 2021-20, stating that a government order that affects a supplier can potentially qualify the employer, but only if the supplier's inability to deliver critical goods or materials caused the employer to suspend its own operations more than nominally.^[3]

This is a high bar. The employer must demonstrate that it could not obtain the critical goods or materials from an alternative supplier, that the disruption was directly attributable to a government order rather than to general market conditions, and that the disruption caused a more-than-nominal suspension of the employer's own business operations. General supply chain tightness or price increases, without a direct link to a specific government order affecting a specific supplier, do not satisfy this test. The IRS has signaled that claims based on supply chain disruptions will receive heightened scrutiny.

Risks of Improper Claims

The consequences of filing an improper ERC claim are substantial. An employer that claims a credit to which it is not entitled faces repayment of the full credit amount plus interest, which currently accrues at a rate that makes the cost of an erroneous claim significantly greater than the benefit received. In addition, the IRS may assert accuracy-related penalties of 20 percent of the underpayment, or in cases involving fraud, a 75 percent civil fraud penalty. Where a promoter has assisted in the preparation of a fraudulent claim, criminal penalties may also be pursued against both the promoter and the employer.^[4]

Equally important is the reputational risk. Businesses that claim the ERC improperly may find themselves subject to IRS examination, which can be time-consuming and costly even if the claim is ultimately resolved without penalties. The examination process itself can disrupt business operations and divert management attention from core activities. For businesses that rely on government contracts or that operate in regulated industries, an IRS examination related to improper tax credits can have broader consequences.

What To Do If You Have Filed a Questionable Claim

Business owners who have already filed ERC claims should review those claims carefully in light of the IRS guidance. If the claim was prepared by a third-party promoter, it is particularly important to evaluate whether the promoter conducted a thorough analysis of the employer's eligibility or simply applied a one-size-fits-all approach. Many promoters charge contingency fees based on the amount of the credit and have little incentive to conduct a rigorous eligibility analysis.

For employers who determine that a previously filed claim may be improper, the most prudent course of action is to file an amended return correcting the claim before the IRS initiates an examination. Voluntary correction substantially reduces the risk of penalties and demonstrates good faith. The IRS has indicated that it will treat voluntary corrections more favorably than claims that are discovered during examination. Employers in this situation should consult with qualified tax counsel to evaluate their options and develop a correction strategy that minimizes exposure.

The ERC remains a legitimate and valuable credit for businesses that genuinely qualify. The challenge lies in distinguishing legitimate claims from those driven by aggressive promotion. Business owners who take the time to evaluate their eligibility carefully—and who seek independent professional advice rather than relying on promoter representations—will be best positioned to withstand IRS scrutiny and avoid the potentially severe consequences of an improper claim.