IRS clarifies that most supply chain disruptions won’t qualify a business for ERC

The employee retention credit (ERC) has become a sticky topic for employers and the IRS alike. Originally enacted as part of the CARES Act in March 2020, the ERC was extended, expanded, and modified a number of times in 2020 and 2021. The ERC, which was created to assist employers affected by the COVID-19 pandemic, has become fraught with promoters encouraging taxpayers to claim credits to which they may not be entitled. The IRS is examining these claims carefully and providing guidance on the types of claims that likely don’t meet the requirements of the law.

One of the most frequent areas of confusion among taxpayers and providers is how to determine if an employer experienced a “full or partial shutdown” of operations during 2020 or 2021. This topic has recently generated several pieces of guidance from the IRS. Businesses considering a claim in this area should be aware of the IRS’ narrow interpretation of what qualifies as a full or partial shutdown and the detailed records necessary to support a claim under this provision.

Applying for the ERC

Eligible employers still have time to file amended payroll tax returns to claim the ERC, but they must fulfill one of the three following conditions. According to the IRS’ website, the employer:

• Was “shut down by a government order due to the COVID-19 pandemic during 2020 or the first three calendar quarters of 2021, or 
• Experienced the required decline in gross receipts during the eligibility periods during 2020 or the first three calendar quarters of 2021, or 
• Qualified as a recovery startup business for the third or fourth quarters of 2021.”

Can supply chain issues cause a full or partial shutdown?

One type of claim that seems to be causing significant concern at the IRS is a claim by a business that it suffered a full or partial shutdown as the result of supply chain disruptions. In many cases, these claims are very generic in nature and fail to identify the specific supplier(s), the governmental order(s) such suppliers were subject to, and the dates for which such shut down orders were in place. In its “Frequently Asked Questions” posted on July 28, 2023, the IRS stated that there is “a narrow, limited exception if an employer was not fully or partially suspended but their supplier was” and the supplier was unable to provide a key product due to a government ordered shutdown. This exception would only apply when the employer “absolutely could not operate without the supplier’s product and the supplier itself was fully or partially suspended under a government order.”

The IRS guidance states that for a business to make a successful claim that it suffered a qualifying full or partial shutdown based on a supplier shutdown, it must obtain a copy of the governmental order that covered the supplier and must show that:

• The government order caused the supplier to suspend operations.
• The business couldn't obtain the supplier's goods or materials anywhere else (regardless of cost).
• The unavailability of the supplier’s goods caused a full or partial suspension of business operations.

This FAQ echoed internal guidance from the IRS in June of this year. The memorandum included five scenarios that basically reiterated the IRS position that the only wages eligible for an ERC claim due to a full or partial shutdown were those paid during the time of a shutdown resulting from a government order. The internal guidance notes that “supply chain disruptions” weren’t mentioned specifically in the CARES Act or any subsequent legislation. The concept arose from informal guidance in IRS Notice 2021-20 which stated, “An employer may be considered to have a full or partial suspension of operations due to a governmental order if … the business’s suppliers are unable to make deliveries of critical goods or materials due to a governmental order that causes the supplier to suspend its operations.”

The June internal IRS guidance stresses that this exception is “narrow” and “limited” to “employers that had to fully or partially suspend their business operations because the employers’ suppliers who provided critical goods or materials to the employer were fully or partially suspended during the calendar quarter due to orders from an appropriate governmental authority.” Rather directly, the IRS states: “A supply chain disruption, by itself, does not rise to the level of a full or partial suspension primarily because no governmental order applies to the employer’s operations.”

Take an ERC approach that can be documented and sustained

The key takeaway from this discussion is that any business looking to claim an ERC based on a government ordered shutdown at a supplier faces significant challenges in documenting:  

• The government action that caused the supplier to shut down.
• The unavailability of replacement products.

While many businesses faced challenges and slowdowns because of supply chain uncertainties during this period, very few of the problems resulted from the direct impact of a government order on a critical supplier.

On the other hand, that shouldn’t stop taxpayers who do meet one of the three conditions mentioned above (government shutdown, decline in receipts, or “recovery startup business”) from claiming this credit. The ERC was designed to help businesses get through an unstable and highly unpredictable time in the American economy, and it can make a significant difference for those who qualify. Even if your business didn’t claim the credit on its original returns, there is still time to file amended returns for legitimate claims.

Both the IRS and reputable tax practitioners are devoting considerable efforts to counseling taxpayers who have seen too-good-to-be true ads promising big refunds and charging exorbitant contingent fees based on ERC-driven claims that are unlikely to hold up on audit. If you’re thinking about reviewing your business’ ERC eligibility based on solicitations from an “ERC expert” you’ve never heard of before, the best course of action is to contact your trusted tax advisor and get their opinion.