IRS Sends Confusing ERC Denial Letters

By Stanley Rose August 14, 2024

Introduction

The Employee Retention Credit (“ERC”) has proven to be simultaneously one of the most useful, but misunderstood, features in the country’s tax rules, and some recent correspondence from the IRS has added to the confusion.

Designed to benefit businesses hurt by the COVID-19 pandemic, interpretation of the ERC’s somewhat fluid qualifications led to confusion over its applicability and outright misuse of it, often by third-party, fly-by-night “credit mills” that misled taxpayers into falsely believing they qualified for the credit. That, in turn, led to the IRS providing multiple off-ramps for those who had applied, allowing them to unwind their receipt of benefits before subsequent audits by the IRS did the same, or to yank applications after they were filed but before they were processed. The IRS also suspended processing of many claims, allowing it to catch up and more closely scrutinize the applications.

Recently, the IRS renewed its processing of applications, and tax practitioners are seeing an increase in responses from the IRS, often taking the form of denials of the claims. Some denials are expected due to aggressive applications encouraged by the aforementioned credit mills. However, in other cases, legitimate applications, filed by taxpayers who clearly qualify, are being denied. Equally as troubling is the language in the IRS denial letters, which states that if the taxpayer disagrees with the denial, the only recourse is through the court system. That assertion is clearly wrong because other administrative avenues are available. The IRS recently conceded this, and taxpayers who received these denials should be aware of their options.

Content of the Denial Letters

We have seen some letters in which the IRS has denied the applicant’s ERC claim, accompanied by a brief explanation regarding why. However, there are multiple methods by which an applicant can qualify for the ERC, but in some cases, the IRS notes that it denied the claim because the taxpayer did not qualify under a specific method – but not the method that the taxpayer used. No mention is made of qualification under the proper method (the one used in the application), suggesting that the denial was inappropriate, or at least premature. The application might have been approved if the IRS reviewed the specs associated with the proper method. (To be clear, taxpayers only need to meet one method’s criteria to qualify for the credit, even if they fail to qualify under another method. They do not have to qualify under each method.)

The IRS goes on to state that taxpayers who disagree with the denial can file suit in district court or a court of claims. While true, this is an expensive and time-consuming process that most taxpayers would use only as a last resort. Many denial letters fail to point out that taxpayers also can simply appeal the IRS decision administratively – a process that involves little more than requesting a second set of eyes on the claim, perhaps while urging that the focus be directed towards reviewing the qualification method used in the application (as opposed to another method that all parties might agree was a non-starter). By omitting language referencing all recourse alternatives, the IRS implies that, in this instance, only one recourse (the most formidable one) exists.

IRS reaction

In news release IR-2024-203 from a few days ago, the IRS admitted that it may have made a few mistakes when issuing its denial letters.

The IRS rather subtly conceded that it failed to share that taxpayers can protest their denials using methods other than through court. The release states that recipients “have options available to file an administrative appeal by responding back to the address on the denial letter” and that the “IRS learned that some of the recent early mailings have inadvertently omitted a paragraph highlighting the process for filing an appeal to the IRS or district court, and the agency is taking steps to ensure this language is mailed to all relevant taxpayers.”

Even more subtly, the IRS appears to have conceded that some of their denials were issued without anything approaching a full review of the taxpayer’s facts. Instead of addressing the material provided in the application on its face, the IRS sent thousands of “disallowance letters to businesses whose claims showed a high risk of being incorrect.” Meanwhile, the IRS identified thousands of valid ERC claims it plans to approve, based on its determination that those filings were “part of a low-risk group of claims.”

The IRS noted that “more than 90% of its disallowance notices were validly issued.” This implies, of course, that it discovered that around 10% of its denials were improperly issued. It promised to “adjust its processes and filters.”

Filters can obviously be useful as part of a process, but it appears possible that the IRS may have used them to actually render their decision, rather than as a steppingstone accompanied by a traditional review of the application.

In fairness to the IRS, the ERC was thrust upon the IRS by Congress in the heart of the pandemic and during a historically busy period for its agents, without providing any additional resources in terms of personnel. The ERC is a massive undertaking, and IRS agents were undoubtedly forced to be spread very, very thin.

Conclusion

Those who received ERC denial letters from the IRS should consider one of the following approaches:

Many claims were filed in which the qualifying criteria simply was not met. Most often, this involved a taxpayer who clearly did not meet the objective measures based on decreases in revenue, who instead relied upon a method available only to businesses closed by order of a government-imposed shutdown. Many filers tried to claim their businesses were hampered by federal guidelines, like CDC advice, which is not sufficient, and does not rise to the level of mandatory restrictions, which, in nearly every case, involve powers held by a state, rather than federal, government. Alternatively, businesses reluctantly, but voluntarily, closed after state-imposed orders made it impractical for them to operate profitably. While a devastating result, this does not meet the definition of a government-ordered shutdown. After seeing significant abuse or misinterpretation, the IRS made no secret that it is coming hard after inappropriate filings, especially those that were shepherded through by so-called credit mills. It created a couple of off-ramps for filers to “undo” their applications, including sending back their refunds. If you have second thoughts about your qualification after a harder look at the rules, but did not utilize one of those off-ramps, you may choose to simply accept the results of the denial.

If instead you believe your application was entirely proper, note that your denial may have been made based on filters, rather than an actual review. The odds of this seem higher if the denial references a method of qualifying for the ERC other than the one your application reported. If so, you should question the results. If you disagree with the results in your denial letter, you do not have to jump straight to taking the IRS to court. You can call or write back to assert that the denial appears to be improper and ask for it to be reviewed again. This is the easiest approach. You could also (now or following the easy approach) file a formal protest, which is an administrative process within the IRS – a step in between mere “pushback” and going to court. Normally, it is only after failure of a formal protest that a taxpayer would consider the hassle and expense of filing suit.

When in doubt, contact your tax professional. We will do our best to help you navigate to the proper conclusion.

For more information, please contact Stanley Rose or your BNN tax advisor at 800.244.7444.