IRS Shuts Down ERC “Supply Chain” Shutdown Theory

The employee retention credit (ERC) provided many employers a tax savings opportunity to help keep employees on their payroll during the COVID-19 pandemic. Many organizations claimed the credit based on a supplier shutdown provision. Now, the Internal Revenue Service (IRS) has clarified what criteria an organization must meet to be able to claim the credit — and in many cases, employers who previously claimed the credit may not be eligible.

Let’s dig into details to understand how your ERC eligibility could be impacted by this new guidance.

Qualification exception opened a door

Generally, an employer can claim the ERC when either:

1. The employer experienced a significant decline in gross receipts for a calendar quarter
2. The employer’s trade or business operations experienced a full or partial suspension during a quarter due to a governmental COVID order limiting commerce, travel, or group meetings

Thus, qualification under either test generally looks only to the business operations of the employer itself.

In its initial guidance, the IRS expanded the full or partial suspension qualification category by creating an exception. It allowed an employer to qualify by “stepping into the shoes” of a supplier whose business operations were fully or partially suspended due to a governmental COVID order.

Specifically, if a supplier’s operations were suspended due to a governmental COVID order, the supplier may be unable to make deliveries of critical goods or materials. In turn, the employer is unable to obtain those critical goods or materials — suspending its operations — so the employer may qualify for the ERC under a full or partial suspension [IRS Notice 2021-20 Q&A 12].

Some service providers got creative

Some ERC service providers expanded this exception by creating their own “supply chain” qualification theory. They began promoting the position that an employer may qualify for the ERC due to general supply chain disruptions.

While the IRS has been quite vocal as of late denouncing “ERC mills” and fraudulent ERC refund claims, it has not provided much in the way of additional technical guidance.

That changed July 21 when it released an advice memorandum in response to the supply chain qualification theory [GLAM 2023-005]. In the memorandum, the IRS provides five common fact patterns where employers experience supply chain disruptions, delays, price increases, etc.

In four out of the five fact patterns, the IRS concludes the employer is not eligible for the ERC, noting the following items are insufficient to substantiate qualification:

• Vague confirmations from suppliers about “COVID delays”
• Generic statements about bottlenecks at ports or truck driver shortages
• Incurring higher costs for critical goods/materials
• Not being able to stock or produce a few or limited number of products, or having to increase prices

The only fact pattern where the IRS concluded the employer qualified for the ERC was explained in Notice 2021-20: Supplier’s operations were suspended due to a governmental COVID order, which in turn caused the employer’s operations to be suspended due to lack of critical goods or materials.

What the IRS does clarify in this example is that the employer’s qualification period ends when the order ends — the same as if the order directly applied to the employer. Residual issues after the order ends do not qualify the employer.

IRS cleared the air

Long story short, the IRS confirmed that to qualify under a supplier shutdown (and not a “supply chain” shutdown) an employer must demonstrate:

1. A governmental COVID order suspended the supplier’s operations
2. The lack of the goods/materials caused employer’s business operations to be suspended
3. The employer was not able to obtain the goods/materials from an alternate supplier

How we can help

CLA understands the factors affecting eligibility for the ERC, knows the wages and benefits that may be used in calculating the credit, and has the experience to prepare the associated tax return. Our tax professionals can work with you to revisit your eligibility and file a claim or assess whether your organization qualifies for the ERC. We can also provide a review and second opinion if you’ve had your ERC eligibility evaluated by another service provider. Contact us for assistance.