Employee retention credits: IRS' recent "Supply Chain Disruption" qualification analysis

By Thomas E. Bayer, CPA, CExP - Sikich LLP, Indianapolis

As the pandemic is more and more in our rearview mirror, we can’t turn the television or radio on without hearing that there is still an opportunity to take advantage of this $26,000 per employee credit — the Employee Retention Credit (ERC). At the same time, the IRS continues to issue warnings cautioning taxpayers and practitioners alike to beware of aggressive interpretation of the law from promoters (referred to by the IRS as “ERC mills”) regarding this credit.

As we talk to other tax practitioners, there are two consistent themes related to ERC:

1.  Clients are continuing to inquire about their eligibility for the ERC. Some even engage with these ERC providers, even though their tax advisor warns them that they may be relying on an interpretation of the ERC guidance that is not supportable upon audit. Clients are perplexed about what to do in these situations. They are confused: one party tells them they are eligible for the ERC, while another party (often their CPA) informs them they are not. If the client moves forward and files for an ERC refund, then the tax practitioner is faced with amended income tax returns that should be filed where the basis for the ERC refund is not supportable.
2. Tax practitioners are asking for additional guidance from the IRS to better advise our clients. The IRS continues to issue public warnings about ERC mills and aggressive positions being taken, but now they have also issued some additional guidance. Our expectation (hope) is that this will continue and more will follow.

A recent “Generic Legal Advice Memorandum” (“GLAM”) from IRS provides us with that additional guidance.

GLAM Number AM 2023-005 was released on July 21, 2023.

The GLAM addresses five different scenarios and whether the employer would or would not have experienced a Full or Partial Suspension Due to a Government Order from an Appropriate Government Authority (the “Suspension Test”) for ERC purposes under IRC Section 2301 or IRC Section 3134. These scenarios address supply chain disruptions of a trade or business and whether each scenario allows an employer to meet the definition of an “eligible employer,” which in turn would allow the employer to receive ERC for the period of eligibility.

The GLAM points out that neither the statutory language of IRC 2301 nor IRC 3134 includes “supply chain disruption.” The only reference to eligibility under the Suspension Test related to suppliers is found in IRS Notice 2021-20, Question #12. There is also no use of the term “supply chain disruption” in IRS Notices 2021-20; 2021-23; 2021-49; or 2021-65.

Here is Question #12 from IRS Notice 2021-20:

Question 12: If a governmental order causes the suppliers to a business to suspend their operations, is the business considered to have a suspension of operations due to a governmental order?

Answer 12: An employer may be considered to have a full or partial suspension of operations due to a governmental order if, under the facts and circumstances, 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. If the facts and circumstances indicate that the business’s operations are fully or partially suspended as a result of the inability to obtain critical goods or materials from its suppliers because they were required to suspend operations, then the business would be considered an eligible employer for calendar quarters during which its operations are fully or partially suspended and may be eligible to receive the employee retention credit.

"Of the five scenarios presented in the GLAM, in only one scenario does the IRS conclude the employer is an 'eligible employer' and entitled to ERC for the period of the shutdown."

Example: Employer A operates an auto parts manufacturing business. Employer A’s supplier of raw materials is required to fully suspend its operations due to a governmental order. Employer A is unable to procure these raw materials from an alternate supplier. As a consequence of the suspension of Employer A’s supplier, Employer A is not able to perform its operations for a period of time. Under these facts and circumstances, Employer A would be considered an eligible employer during this period because its operations have been suspended due to the governmental order that suspended operations of its supplier.

Many practitioners believe that meeting the standard of an “eligible employer” for ERC purposes would be very difficult under this “supply chain disruption” argument.

The IRS points out in this GLAM that under Question #12 of IRS Notice 2021-20, this “limited exception” may apply to an employer “if, under the facts and circumstances, the business’s suppliers are unable to make deliveries of critical goods or materials due to a government order that causes the supplier to suspend its operations.”

Additionally, if the employer can obtain the goods or materials from an alternate supplier, the employer “may not have had an impact on the employer’s operations that rise to the level of a full or partial suspension.” The GLAM later states that this provision allows the employer to “step into the shoes” of its supplier.

Thus, the employer must fulfill all the same documentation requirements to support their ERC claim by obtaining a government order from the supplier and demonstrating the order did in fact suspend the supplier’s operation. Then the employer must demonstrate that this supplier suspension caused a full or partial suspension of their operations, and that they could not obtain the goods or materials from an alternate supplier.

We believe the IRS will request additional documentation in the form of quantifiable evidence of the partial suspension — from both the supplier and from the employer impacted by the supplier. Ideally this impact would demonstrate a “more than nominal” impact on the business, defined as more than 10%. This level of evidence required causes this argument to be difficult to meet the standard of an “eligible employer” due to a supply chain disruption.

Of the five scenarios presented in the GLAM, in only one scenario does the IRS conclude the employer is an “eligible employer” and entitled to ERC for the period of the shutdown. Scenario 3 provides that the employer is eligible in Q2 2020 where both the employer and their supplier were in a jurisdiction where their operations were fully or partially suspended due to a government order from an appropriate government authority.

The IRS concluded that ERC qualification only applies in that quarter where there existed a government order that suspended operations. The GLAM concludes any “residual delays” in subsequent quarters caused by a governmental order from a prior quarter do not constitute a government order in subsequent calendar quarters once the order has been lifted.

Tax practitioners should note the emphasis in the calendar quarter that the government order is in place for both the employer and the supplier. There are some ERC providers that have taken the position that these ongoing delays after government orders have been lifted continue to allow an employer to be eligible for the ERC. The IRS has a different interpretation. Thus, the facts and circumstances in Scenario 3 do provide a limited window of ERC eligibility under this supply chain argument, and caution is urged in pushing this argument beyond this limited situation. Further, recall that employer that received PPP loans may have paid the wages for that same period as their ERC eligibility, so this employer may have limited the amount of its ERC depending on the “Covered Period” reported on their PPP Loan Forgiveness application.

"The GLAM concludes any 'residual delays' in subsequent quarters caused by a governmental order from a prior quarter do not constitute a government order in subsequent calendar quarters once the order has been lifted."

Scenario 5 of the GLAM presents a scenario where the employer was a retailer and was unable to procure certain products for sale. Further, they raised prices on other products during that time. This presumably would make it more difficult for the employer to qualify for ERC under the alternative “significant reduction in gross receipts test.” The example maintains that the employer was not subject to a governmental order at any time. The example does not refer to whether these specific products represent a “more than nominal” portion of their sales in prior years. There is some question as to what change of facts in this example might result in a different IRS conclusion as to this retailer’s ERC qualification. Notably, the IRS is requiring evidence of a governmental order applicable to the supplier and evidence that this government order caused the supplier to suspend operations fully or partially, causing the employer to experience a full or partial suspension.

In summary, this GLAM is welcome guidance from the IRS. It should combat some of the misinformation campaigns that are filling the airwaves. A careful reading of this GLAM points out that other examples of supply chain disruptions, such as port delays or price increases or changes in inventory levels, do not in and of themselves cause an employer to be eligible for ERC.

WE strongly encourage tax practitioners to review this GLAM's five scenarios closely to better understand where the IRS stands on these ERC issues. Employers and their advisors should follow existing guidance in the statute and the IRS notices. We are now starting to better understand the IRS’ position as they issue further interpretations of existing guidance. Eventually, we expect additional IRS guidance to be released and at some point, decisions will be handed down in the courts related to ERC and offer some definitive interpretations of the ERC guidance.

Go to complete copy of the GLAM.

Reprinted with permission of the Indiana CPA Society.