ERC Audit Defense – When the IRS’s Own Guidance Becomes Your Shield

The IRS is auditing your Employee Retention Credit claim, demanding repayment of $2.3 million plus penalties. But their audit position contradicts their own published guidance from 2021, specifically IRS Notice 2021-20, which allowed broader interpretations of “suspended operations” than they’re applying now.

This retroactive reinterpretation creates your primary defense. The IRS can’t penalize taxpayers for following official guidance that existed when claims were filed. Courts consistently hold that reasonable reliance on IRS publications provides penalty protection, even if the IRS later changes its position.

Building on this guidance defense, the timing of these changes matters enormously. The IRS issued clarifying notices throughout 2021 and 2022, each slightly narrowing ERC eligibility. But they’re now applying the most restrictive 2023 interpretations to 2020 claims. This temporal mismatch violates basic principles of tax administration – you can’t retroactively change rules then penalize past compliance with old rules.

The Aggregation Rules They Hope You Don’t Understand

Connected to this retroactive problem, the IRS aggregates all entities under common control when calculating ERC limits. But aggregation rules under Section 52 are more complex than they’re applying. They’re using simplified ownership percentages without considering voting rights, board composition, or operational independence.

This matters because many businesses have complex structures for legitimate non-tax reasons. Franchise operations, management companies, and holding structures might share ownership but operate independently. The IRS’s mechanical aggregation often overstates control relationships, artificially reducing ERC eligibility.

The defense requires detailed analysis of corporate governance documents. Voting agreements might limit control despite ownership percentages. Management contracts might demonstrate operational independence. Board compositions might show actual control differs from equity ownership. Each factor potentially breaks aggregation, increasing ERC eligibility.

Supply Chain Disruptions as Suspended Operations

Moving from structural defenses to substantive ones, the IRS now claims supply chain disruptions don’t constitute “suspended operations” under ERC rules. But their own FAQ 10 from March 2021 specifically stated supply chain interruptions could qualify if they prevented normal operations.

This creates a documentation opportunity most businesses missed. You need contemporaneous evidence showing how specific supply chain failures prevented normal business operations. Not general statements about “COVID disruptions” but specific examples: “Could not fulfill orders because semiconductor supplier shut down” or “Restaurant couldn’t operate lunch service due to food supplier limitations.”

The key is connecting specific supply chain failures to specific operational impacts. Generic claims about supply difficulties won’t work. But documented instances where lack of critical supplies forced operational changes can establish suspended operations even under current IRS interpretations. The challenge is reconstructing this documentation now, years after the fact.

The Nominal Compliance Doctrine Defense

This documentation challenge leads to another overlooked defense: nominal compliance with government orders. The IRS argues businesses that remained open can’t claim suspended operations. But “nominal compliance” doesn’t equal normal operations.

Restaurants forced to operate at 25% capacity were nominally compliant – they stayed open. But 75% of their operation was suspended. Gyms required to close shower facilities were nominally open but couldn’t provide core services. Retail stores forced to appointment-only models were technically operating but not normally.

Courts have recognized this distinction in other contexts. Nominal compliance with regulations doesn’t negate the impact of those regulations. The defense requires showing that while you technically complied with orders, the compliance so altered operations that normal business was impossible. This reframes the suspended operations test from binary (open/closed) to proportional (how much normal operation was prevented).

Wage Calculations and the Severance Trap

Shifting to technical calculation issues, the IRS routinely disallows severance payments as qualified wages for ERC purposes. But Revenue Ruling 2021-11 specifically allows severance for employees terminated due to COVID-related business changes.

The distinction turns on timing and causation. Severance paid to employees terminated for cost-cutting might not qualify. But severance to employees whose positions were eliminated due to suspended operations or revenue decline directly relates to COVID impact. The same payment has different treatment based on underlying circumstances.

This nuance extends to other wage types. Hazard pay might qualify as it maintained employment during COVID. Bonuses might not unless tied to retention purposes. The IRS applies bright-line rules, but the statute requires case-by-case analysis. Pushing back on categorical disallowances often recovers substantial qualified wages.

The Quarterly Election Inconsistency

Building on wage qualification issues, businesses made different elections each quarter based on changing circumstances. The IRS now challenges this variability, claiming consistent treatment across quarters is required.

But nothing in the statute mandates consistency. Businesses could qualify under gross receipts tests one quarter and suspended operations another. They could claim ERC for some employees one quarter and different employees the next. The quarterly nature of the credit inherently contemplates changing circumstances.

The defense requires showing why each quarter’s election made sense based on contemporary facts. Q2 2020 might use suspended operations due to lockdowns. Q3 2020 might use gross receipts as reopening occurred but revenue lagged. Q1 2021 might return to suspended operations due to winter restrictions. Each quarter stands alone, despite IRS attempts to demand consistency.

Using PPP Forgiveness Against IRS Positions

This quarterly independence principle connects to another defense: PPP loan forgiveness documentation. Many businesses received PPP forgiveness based on maintaining employment despite revenue declines or operational restrictions. The SBA accepted these circumstances for forgiveness purposes.

The same documentation supporting PPP forgiveness supports ERC eligibility. If the SBA agreed you suffered COVID impacts justifying forgivable loans, the IRS can’t credibly claim no impact existed for ERC purposes. The government can’t take inconsistent positions across programs addressing the same pandemic impact.

This documentary overlap provides powerful evidence. PPP forgiveness applications required detailed explanations of COVID impact. Bank reviews confirmed these impacts. SBA approval validated them. This third-party verification counters IRS claims that COVID impacts are exaggerated or fabricated.

The Statute of Limitations Play

Moving to procedural defenses, ERC claims amended returns that started new statute of limitations periods. But the IRS is auditing original returns, not amendments. The three-year statute for original returns might have expired while the amendment statute remains open.

This creates complex procedural questions. Can the IRS audit original return positions through amended return audits? Does the amendment statute only apply to amended items? Courts have reached different conclusions, creating uncertainty that benefits taxpayers.

The strategic response is challenging audit scope. Demand the IRS specify whether they’re auditing original or amended returns. Force them to identify specific statutory authority for their audit timing. Procedural defects can invalidate entire audits regardless of underlying merit.

Interest Abatement Opportunities

Even if the IRS prevails on ERC disallowance, interest abatement remains available. The IRS delayed ERC processing by months or years. They issued contradictory guidance. They encouraged claims then retroactively disallowed them.

These delays and inconsistencies support interest abatement under Section 6404. Taxpayers shouldn’t pay interest when government inefficiency or confusion caused delays. The key is documenting IRS-caused delays versus taxpayer-caused delays.

Request all IRS correspondence and internal notes through Freedom of Information Act requests. These often reveal processing delays, lost documents, or internal confusion supporting abatement. Even partial interest abatement on large ERC claims saves substantial money.

The Voluntary Disclosure Alternative

Before the audit concludes, consider whether voluntary disclosure might improve outcomes. If the IRS hasn’t raised specific issues, proactively disclosing and correcting errors shows good faith.

But timing matters critically. Disclosure after audit notification generally doesn’t help. Disclosure during audit but before specific findings might. The window is narrow but potentially valuable.

The key is understanding what the IRS knows versus what they suspect. If they’re fishing for issues, voluntary disclosure might prevent worse findings. If they’ve already identified specific problems, disclosure adds little value. This assessment requires experienced reading of IRS information requests and agent behavior.