Recent developments regarding employee retention credit
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The Internal Revenue Service (“IRS”) recently published new guidelines related to the Employee Retention Credit (“ERC”), which is a refundable tax credit available to certain employers who paid qualified wages to their employees during certain periods in 2020 and 2021, in the context of the COVID-19 pandemic.
On July 21, 2023, the IRS released Chief Counsel Advice Memorandum (“CCAM”) No. AM 2023-005 (“AM 2023-005”), which provides further guidance for determining if an employer qualifies for the ERC through a full or partial suspension of operations due to a supply chain disruption. While CCAMs may not be generally used or cited as precedent, they may nonetheless prove to be a useful tool when interpreting whether your business may qualify for ERC. This is especially true because there is not substantial official guidance when it comes to justifying ERC eligibility based on supply chain disruptions.
Summary of ERC eligibility criteria
To be eligible for the ERC, an employer must have carried on a trade or business during the applicable periods in 2020 and 2021 and must generally meet at least one of the criteria outlined below. Please note that this is a summary of the criteria.
- Significant Decline in Gross Receipts
This eligibility criteria may be met if an eligible employer experienced a significant decline in gross receipts during certain calendar quarters in 2020 and 2021. The formulas used for evaluating the decline in gross receipts vary depending on the period in question. As a brief overview, an employer is generally considered to have experienced a significant decline in gross receipts for applicable calendar quarters in 2020 if its gross receipts for any calendar quarter are less than 50% of its gross receipts for the same calendar quarter in 2019. In contrast, the criteria is more flexible for applicable quarters in 2021 as an employer may generally qualify for a quarter during which its gross receipts are less than 80% of its gross receipts for the same calendar quarter in 2019.
- Full or Partial Suspension of Operations
The employer may also be eligible for ERC benefits to the extent it sustained a full or partial suspension of operations due to COVID-19-related orders issued by an appropriate governmental authority. Qualifying government orders may impose restrictions on commerce, travel, or group meetings due to COVID-19. A full or partial suspension can occur when an employer’s trade or business operations are limited by an applicable mandatory order, issued by the government due to COVID-19, in a manner that affects the employer’s ability to conduct its ordinary course of business operations. Examples of governmental orders can include stay-at-home orders, curfews, mandatory closures, or capacity restrictions.
Supply chain disruptions – a ‘narrow, limited exception’
The IRS Office of Chief Counsel emphasized in AM 2023-005 that the applicable statutory language in section 2301(c)(2)(A)(ii)(I) of the CARES Act and section 3134(c)(2)(A)(ii)(I) of the Internal Revenue Code do not include “supply chain disruptions.” Instead, a “narrow and limited exception” is provided through Answer 12 of IRS Notice 2-21-20, section III.D. The exception provides that an employer may be considered to have a full or partial suspension if, under the facts and circumstances, the business’ suppliers were unable to make deliveries of critical goods or materials due to a government order that causes the supplier to suspend its operations.
For this exception to apply, the following key elements must be considered:
- The business must have closed or significantly limited its operations because it was unable to obtain critical goods from its supplier or an alternate supplier;
- Residual delays after the lifting of a government order do not qualify. ERC qualification is only permitted during the period in which the government order exists; and
- Experiencing higher costs for critical goods does not mean a business experienced a full or partial suspension of operations.
Substantiation requirements
As emphasized in AM 2023-005, an eligible employer must substantiate its eligibility for the ERC through records or documents demonstrating that:
- the supplier was subject to an applicable government order,
- the government order caused the supplier to suspend operations,
- the inability to obtain the supplier’s goods or materials caused a full or partial suspension of the employer’s business operations, and
- the employer was not able to obtain these critical goods or materials from an alternate supplier.
Examples and analysis
The CCAM provides useful insight into the proper analysis of the limited exception by providing five different fact-based scenarios as examples. The examples are summarized below:
Example 1:
Facts: Employer was not subject to any governmental orders due to COVID-19 at any time. However, during 2020 and 2021, Employer experienced several delays in receiving critical goods from Supplier. At all times during 2020 and 2021, Employer continued to operate because it had a surplus of the critical goods normally provided by Supplier. Employer inquired and Supplier vaguely confirmed that the delay was due to COVID-19, and did not provide a governmental order from an appropriate governmental authority.
Conclusion: Employer does not qualify for the exception because it cannot demonstrate that a governmental order, applicable to the Supplier, fully or partially suspended the supplier’s operations. In addition, even if the employer could have located the governmental orders applicable to the supplier, Employer is not an eligible employer because it did not experience a full or partial suspension of operations due to a surplus of the critical goods normally provided by Supplier.
Example 2:
Facts: Employer was not subject to any governmental orders due to COVID-19 at any time. However, certain critical goods from Supplier were stuck at port in another state. Employer assumed the delay at the port was a result of COVID-19, but could not identify any specific governmental order applicable to Supplier or any specific governmental order that caused the delay at the port. Some news sources stated that COVID-19 was the reason for the delay, while others cited reasons such as increases in consumer spending and aging infrastructure. In addition, Supplier mentioned to Employer that other critical goods that were not stuck at port would be delayed due to a truck driver shortage. Employer saw some discussion on social media that the truck driver shortage was because drivers were out sick due to COVID-19.
Conclusion: Employer was also not an eligible employer — even though critical goods were delayed at port — because it could not demonstrate that the supplier’s operations were suspended due to a specific governmental order. The employer’s mere assumption (that the issues were caused by COVID-19) does not meet eligibility criteria.
Example 3:
Facts: Employer and Supplier are in a jurisdiction that issued governmental orders suspending both of their business operations for the duration of April 2020. Employer and Supplier’s jurisdiction lifted all orders related to COVID in May 2020. For the remainder of 2020 and 2021, Employer experienced a delay in receiving critical goods from Supplier. Supplier does not provide a reason for the delay, but Employer assumes the delay is due to the governmental order in place in April 2020.
Conclusion: While Employer was an eligible employer during the second quarter of 2020, it did not meet the definition for subsequent periods in 2020 or 2021. This is so because the Employer could not demonstrate that Supplier’s operations were fully or partially suspended by an applicable governmental order, even if the previously lifted government order provoked subsequent residual delays.
Example 4:
Facts: Employer was not subject to any governmental orders related to COVID-19 at any time. During 2020 and 2021, Employer could not obtain critical goods from Supplier. However, Employer was able to obtain the goods from an alternate supplier. The critical goods from the alternate supplier cost 35% more. Employer could continue to operate its trade or business even though it was not as profitable as in 2019.
Conclusion: The CCAM emphasized that merely incurring a higher cost for critical goods will not result in a full or partial suspension of operations, even if it represented a 35% increase in cost through an alternate supplier.
Example 5:
Facts: Employer operates a large retail business selling a wide variety of products and was not subject to any governmental orders related to COVID-19 in 2021. Due to various supply chain disruptions, Employer was not able to stock a limited number of products and was forced to raise prices on other products that were in limited supply. However, at no time did the product shortage prevent Employer from continuing to fully operate as a retail business during 2021.
Conclusion: Even though Employer faced various supply chain disruptions and was forced to raise the prices of other products due to limited supply, the definition of eligible employer was not met. This is because the product shortage did not prevent the employer from fully operating.
Bottom line
It would seem like the IRS’ official position on supply chain disruptions is very limited, to the point many employers will not be able to use this exception to qualify for ERC. This paints a clearer picture, since AM 2023-005 was released following IRS warnings about fraudulent ERC claims, taxpayer audits, and increased scrutiny in response to some third parties that continue to widely advertise their services targeting taxpayers who may not be eligible for the ERC. As stated in an IRS news release from March 20, 2023, “advertisements, along with the increased prevalence of websites touting how easy it is to qualify for the ERC, lend an air of legitimacy to abusive claims for refund.” The IRS Office of Professional Responsibility also issued a special bulletin earlier this year, Issue No. 2023-02, emphasizing the core responsibilities for tax professionals in the context of ERC claims.
All the above seems to emphasize the importance of conducting a thorough analysis of ERC eligibility, based on substantiated facts and circumstances, carefully and/or with the help of trusted advisors.
Although the ability to file ERC claims expire on April 15, 2024, for 2020 payroll tax returns and April 15, 2025 for 2021 payroll tax returns, businesses must exercise careful consideration regarding qualification, especially given the IRS’ increased audit activity and scrutiny.
At RSM Puerto Rico, our trusted advisors may assist with the detailed evaluation that is necessary to determine if your business could be eligible for claiming the ERC for applicable periods in 2020 and 2021. Please contact our tax advisors at (787) 751-6164 | [email protected] for help or more information.
