IRS Update on ERC Eligibility: 5 Scenarios That Do Not Qualify as Supply Chain Disruptions
August 22, 2023
Contributor: Asaph Bashioum, Senior Associate, Tax Credits & Incentives Advisory
New IRS General Legal Advice Memorandum
The Internal Revenue Services (IRS) released a general legal advice memorandum (GLAM) that lists additional guidance on whether supply chain disruptions can create a partial suspension of operations on employers for purposes of the Employee Retention Credit (ERC). The IRS has been dealing with fraudulent and misguided applications surrounding a partial suspension of operations, including those caused by supply chain disruptions, causing a temporary halt on processing. For the first time since passage of the ERC, the IRS has released a document with specific examples of what not to do when applying for the ERC based on a supply chain disruption.
Qualifying for ERC
To qualify for ERC, an employer must demonstrate either a significant decline in 2020 or 2021 quarterly gross receipts as compared to 2019, or demonstrate that its operations were partially suspended from a COVID-19 government order limiting commerce, travel or group meetings.
Supply Chain Disruption and ERC
The supply chain disruption argument is a subset of the government mandate argument. Rather than citing government orders that suspend an employer’s business directly, the employer can rely on a supplier’s operations being partially suspended by COVID-19 orders as long as that resulted in a partial suspension of the employer’s operations. The IRS guidance provided in Notice 2021-20 created the ability for an employer to rely on a partial suspension of the operations of its suppliers for the sake of the determining ERC eligibility.
As noted in the GLAM, two factors must be identified for a supply chain disruption to cause a partial shutdown on an employer:
- There must have been a COVID-19 order limiting commerce, travel or group meetings imposed on the supplier.
- The partial suspension on the supplier must cause partial suspension on the employer.
- There were five examples from the IRS memo of invalid supply chain disruptions. The IRS interprets this rule very narrowly.
These five situations all have commonalities:
- Either the applicant does not clearly specify the government mandates, or
- The applicant does not clearly document the partial suspension its business because of the partial suspension of supplier operations.
Partial Suspension Examples
In some cases, the IRS infers that the applicant “had a general sense” of COVID-19, causing supply chain disruptions. In other cases, the IRS highlights that the applicant did not have a partial suspension of its business, except for some delayed supplies. It is worth noting the examples below:
Example 1
The employer experienced delays in receiving critical goods from their supplier but continued to operate because they had a surplus of goods. The supplier vaguely confirmed that the delay was due to COVID-19 but did not provide a governmental order from appropriate governmental authority, and the employer was unable to find one.
- Problem 1: The employer cannot demonstrate that a governmental order applicable to their supplier fully or partially suspended their business operations.
- Problem 2: The employer did not have to cease operations due to surplus of goods.
Example 2
The employer had certain critical goods from their supplier which were stuck at port, and assumed it was a result of COVID-19. Some news sources stated that COVID-19 was the reason, and the supplier mentioned that critical goods were further delayed due to a truck driver shortage caused by COVID-19. The employer and supplier could not identify any specific government orders applicable to the supplier or causing a bottleneck at a port.
- Problem 1: COVID-19 may have contributed to the bottleneck, but the employer cannot identify a specific government order that caused the bottleneck.
- Problem 2: Even if the employer could identify governmental orders applicable to bottleneck, they would have to prove that the bottleneck was due to the governmental orders.
Example 3
The employer and their supplier were both suspended by governmental orders for April 2020. For the remainder of 2020 and 2021, the employer experienced a delay in receiving critical goods from their supplier. The employer assumed the delay was due to the governmental order in place in April 2020.
- Problem: The residual delays caused by a governmental order in place during a prior quarter do not constitute a partial suspension once the order has been lifted.
Example 4
The employer could not obtain critical goods from their supplier, but was able to obtain these goods from an alternate supplier at a 35% higher cost. The employer could continue to operate its trade or business, even though it was not as profitable as 2019.
- Problem: Incurring a higher cost for critical goods does not result in a full or partial suspension of operations.
Example 5
The employer operates a large retail business selling a wide variety of products. Due to various supply chain disruptions, the 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 was the employer prevented from fully operating as a retail business.
- Problem: While a limited number of products were not available, the employer was still able to offer a wide variety of products to its customers and was not forced to partially suspend its operations.
An organization can qualify as an eligible employer based on government orders affecting its suppliers if the employer’s facts and circumstances are such that the partial suspension of operations by its suppliers results in a partial suspension of the employer’s operations. The employer needs to show that there was a valid COVID-19 order affecting its supplier, and it needs to show that it suffered a partial suspension of operations because of this supplier’s partial suspension during the duration of the government order affecting the supplier.
Related Guidance
IRS Suspends ERC Claims – What You Need to Know
2023 Most Frequently Asked Questions about the Employee Retention Credit (ERC)
Be Prepared for IRS ERC Audits