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ERC Denied by Auditor, Taxpayer Sues IRS to Invalidate Guidance

December 6, 2023 by Max Shenker

A taxpayer whose ERC claim was denied by an IRS auditor has filed suit against the IRS and Treasury Department. However, the case does not seek restoration of the tax credits but instead seeks “a mandatory, national injunction barring the IRS from enforcing the unlawfully promulgated Notice [2021-20] in any administrative forum or proceeding.”

Southern California Emergency Medicine (SoCal EM) filed a Form 941-X with an ERC claim in June 2021. In a surprisingly rapid timeline, the IRS disallowed the claim on October 31, 2021. The taxpayer protested the audit result, and the IRS rebutted the protest in November. The lawsuit was filed on December 1.

Southern California Emergency Medicine Inc. v. Werfel alleges that Treasury failed to comply with the Administrative Procedure Act when it promulgated Notice 2021-20 without public notice and opportunity for comment. A recent Viewpoint article in Tax Notes analyzed whether the IRS Notices had the force of law and concluded:

“Because the IRS is relying on Notice 2021-20 as if it has the force and effect of law and imposing penalties when taxpayers deviate from that guidance, many commentators would argue that it is a legislative rule. To be eligible for Chevron deference — and thus binding on courts — Notice 2021-20 must meet the APA’s notice and comment provisions (which it did not) or qualify for one of the APA’s exceptions (which it did not). Thus, the notice is procedurally defective, does not have the force and effect of law, and is ineligible for Chevron deference. The usual procedure here is for courts to simply disregard the notice and look to whatever law remains — in this case, the statute.”

SoCal EM claims that Notice 2021-20 “set forth material changes to the ERC program. Many of the IRS’s positions imposed substantial obligations on regulated businesses that might claim the ERC, or significantly narrowed employer eligibility under that program,” and that the Notice “included definitions of various terms, factors or elements necessary to claim the credit, imposed record-keeping requirements, and created thresholds for claiming the credit. Those new provisions were not sourced from the Internal Revenue Code but were instead created by the IRS to govern payouts under the credit.”

The complaint especially takes issue with the “more than nominal” rule introduced by IRS guidance:

“Notice 2021-20 installs minimum thresholds for ERC eligibility. Thus, even businesses that were directly shuttered by governmental orders do not qualify unless that shutdown affected a certain minimum percentage of its business. Here under IRS’s novel rule, a business qualifies under the ERC only if the governmental order caused more than a ‘nominal’ disruption of business…. Having established that new requirement—which is absent from the CARES Act—the IRS then arbitrarily defined ‘nominal portion’ of business operations to mean either ‘(i) the gross receipts from that [suspended] portion of the business operations is not less than 10 percent of the total gross receipts (both determined using the gross receipts from the same calendar quarter in 2019), or (ii) the hours of service performed by employees in that portion of the business is not less than 10 percent of the total number of hours of service performed by all employees in the employer’s business’ … Under the IRS’s rule, a business suffering from a 9.5% reduction in receipts has not suffered an adequate ‘partial suspension’ of business, but yet 10% qualifies. Of course, for many small businesses operating on narrow margins, a nine percent reduction in business operations is significant.”

In audit documents supplied as exhibits to the lawsuit, the IRS denies the credit claim in part by saying:

“Moreover, even assuming the documentation provided by the Taxpayer constitutes a governmental order, the taxpayer has not established that more than a nominal portion of its business operations are suspended by a governmental order. The Taxpayer remained fully open and operational without any restrictions on more than a nominal portion of its operations. As set forth in Notice 2021-20, a portion of an employer’s business operations will be deemed to constitute more than a nominal portion of its business operation if either (i) the gross receipts from that portion of the business operations is not less than 10 percent of the total gross receipts (both determined using the gross receipts of the same calendar quarter in 2019), or (ii) the hours of service performed by employees in that portion of the business is not less than 10 percent of the total number of hours of service performed by all employees in the employer’s business (both determined using the number of hours of service performed by employees in the same calendar quarter in 2019). The Taxpayer has failed to provide any evidence of a decline in gross receipts, nor established that any of the guidance it relies upon had any impact on the number of hours of service performed by its employees.”

The IRS appears to apply the 10% rule described in Q&A 11 of Notice 2021-20 as a baseline requirement for any ERC eligibility.

Among other accusations, the lawsuit claims that “IRS Notice 2021-20 violates 5 U.S.C. § 706(2)(A) and (C) because it imposes arbitrary thresholds and obligations (e.g., a 10% threshold for ‘nominal’ effects on a business) without explanation, inconsistent with Congressional intent, and without Congressional authority,” and that “The IRS fundamentally altered the scope of eligible governmental orders, replacing Congress’s unambiguous definition with its own that significantly narrowed employer eligibility.”

While detailed information about audit conclusions is not widely available, this example clearly indicates that the IRS is applying the guidance articulated in Notice 2021-20 in the narrowest and most conservative ways to argue that employers are not entitled to the ERC.

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