Employee Retention Credit Refund Suits: Why Taxpayers Are Bringing Tax Refund Suits to Expedite Unprocessed Refund Claims

Originally introduced in 2020 to encourage employers to retain employees during the pandemic, the Employee Retention Credit (ERC) has become a flashpoint federal tax controversy issue. Lately, some taxpayers have begun to take a more active approach to try to expedite the processing of long-awaited ERC refund claims.

Even after the COVID-19 pandemic ended, ERC refund claims made on amended payroll tax returns continued to be filed. The continued filings resulted in a processing backlog at the IRS. In part to address the backlog, but also out of concern about potentially frivolous claims, the IRS introduced a moratorium on processing new claims after September 14, 2023.¹ The moratorium was not lifted until August 8, 2024, and then, only for claims filed before January 31, 2024.²  Many employers who claimed ERC refunds have still not received the funds. For these taxpayers, there are several options available.

First, the most proactive approach is to file a refund suit in U.S. District Court or the Court of Federal Claims. A refund suit has the advantage of pushing the IRS to engage with employers who claimed the credit. In response to litigation, the IRS would have to address the claim on the merits.

Alternatively, taxpayers waiting on refunds can request assistance from their representative in Congress or from the Taxpayer Advocate Service. This approach is less aggressive, and neither could actually process claims.

Some taxpayers may decide to keep waiting until the IRS processes their claim. The problem with this approach is that while the IRS has ramped up ERC refund claim processing, there is no statutory obligation to process claims quickly. ERC refund claims filed after January 31, 2024 are still not being processed. So, taxpayers playing the waiting game may be in limbo for a long time.

Some ERC Claims Are Especially Ideal for a Tax Refund Suit

The ERC has some facets that make bringing a refund suit ideal in certain circumstances.

First, the taxpayers most in need of ERC refunds are sympathetic. The majority are small or mid-sized businesses. These are employers who did the right thing during the pandemic. They kept their employees on the payroll and faced incredible odds to stay in business. These are the people that Congress was trying to help when the ERC was implemented. The IRS has engaged in a widespread public relations campaign to paint the ERC as rife with fraud, but these allegations have largely not been supported. Instead, the employers that are bringing refund suits now appear to have legitimately claimed the credit.

Second, guidance surrounding how the ERC should be administered is unclear. Congress passed the ERC through waves of legislation. The actual codification of the credit, Section 3134 of the Internal Revenue Code of 1986, as amended (the “Code”), is basic, and the IRS has not promulgated any regulations interpreting eligibility requirements. Instead, most of the guidance surrounding ERC eligibility is contained in frequently asked questions on the IRS website, Chief Counsel Memoranda, and Notice 2021-20 . The most comprehensive guidance received to date regarding ERC eligibility is contained in Notice 2021-20.³

Since it has not undergone a notice and comment period as required by the Administrative Procedure Act (APA), 5 USC § 553, to be considered a legislative rule, taxpayers can be anticipated to argue that Notice 2021-20 is interpretive and thus lacking the force and effect of law. Under the APA, it “remains the responsibility of the court to decide whether the law means what the agency says,” and a court will only be required to give effect to Notice 2021-20 to the extent that the guidance is persuasive in its interpretation of the law.⁴

Many of the alleged requirements contained in Notice 2021-20 are not found in the codification of the ERC in Code Section 3134. It is an open question whether this guidance will be persuasive to a court. This means that some taxpayers who will receive a denial, or no response from the IRS, may have stronger cases than the IRS has acknowledged.

Tax Refund Suit Considerations

Refund suits cannot be initiated until at least six months have passed from the date of filing the claim for refund unless the IRS renders a decision on the claim within that time. And the suit must be brought before two years have passed after a disallowance has been mailed by the IRS.⁵

Unlike a Tax Court petition, the taxpayer must have actually paid the tax to file a refund suit in U.S. District Court or in the Court of Federal Claims. This requirement is generally met by ERC refund claims because the employment taxes have been paid in 2020 or 2021, and the taxpayer is requesting a refund on an amended Form 941X.

The next consideration for the refund suit is where to file. If bringing the case in U.S. District Court, then the taxpayer can file suit in the federal district in which it has its primary place of business.⁶ Otherwise, if filing in the Court of Federal Claims, then venue is always Washington, DC, although trials may be held all over the country.⁷

In choosing a forum, it is important to consider jurisdictional requirements. For example, the Court of Federal Claims does not have jurisdiction over constitutional claims where there is no money-mandating provision, because it does not have equity jurisdiction in a tax refund suit. Likewise, the Court of Federal Claims lacks jurisdiction to review an agency’s decision under the APA.⁸  So, if the employer plans to challenge Notice 2021-20 using constitutional, equity-based arguments or the APA, then the Court of Federal Claims may not be the best forum.

Risks Associated with Refund Suits

Bringing a refund suit does have some risk. For example, the suit may not be successful. In which case, the taxpayer will be out of pocket for litigation costs and still not receive their refund claim. Alternatively, a refund suit may be successful but have high upfront costs.

As an alternative, taxpayers who have not received a letter of disallowance and no longer believe in the strength of their refund claims can also evaluate whether participation in the IRS’s claim withdrawal process is a better option. The IRS provides procedures for withdrawing the claim on its website.⁹ There is also a second Voluntary Disclosure Program available for taxpayers who have received funds from the IRS related to potentially erroneous refund claims.

Evaluating Whether to File an ERC Refund Suit

Taxpayers considering whether to file a tax refund suit should carefully review the claim, starting with documentation supporting eligibility for the credit and the calculation of the amount of the refund. This documentation should include a narrative explanation for why the employer is eligible for the credit. Additionally, workpapers supporting the calculation of gross receipts to support eligibility for the credit (if based on the gross receipts test) and the calculation of the credit itself should be maintained and reviewed. Careful analysis should be conducted to ensure that wages paid to related individuals, wages related to Paycheck Protection Program forgiveness, and amounts paid to employees providing services (for large eligible employers) were not included in the calculation.

Finally, if credit eligibility was not predicated on gross receipts, then documentation of full or partial suspensions of operations, government orders related to COVID-19 to which the employer was subject, and modifications that had to be made to stay open and their effect on operations should be prepared. As compared to taxpayers with ERC claims based on full or partial suspensions of operations which are fact intensive, taxpayers with brightline gross receipts ERC refund claims may have a more straightforward case.

Next, an employer evaluating whether to bring the claim should consider whether eligibility for the ERC is dependent on challenging IRS guidance, such as the requirements found in Notice 2021-20. Following the Supreme Court’s decision in Loper Bright Enterprises,¹⁰ challenges to federal agency action are expected to be more well-received than in previous years. However, this is still a tougher argument to make than a showing that the employer checked all the boxes under Notice 2021-20.

Finally, taxpayers should assess their risk tolerance for litigation and the associated costs. Litigation takes time and money. But, waiting entails its own risks, especially as documentary evidence may be more difficult to obtain and the memories of potential witnesses fade or those with knowledge leave the company. For taxpayers that have already waited over a year for much-needed ERC refund proceeds, or employers that filed refund claims after January 31, 2024 – for which there is no end to the moratorium in sight – the risks of inaction may be greater than those associated with litigation.

1. IR-2023-169 (9/14/2023). ↩︎
2. IR-2024-203 (8/8/2024). ↩︎
3. See Guidance on the Emp. Retention Credit Under Section 2301 of the Coronavirus Aid, Relief, & Econ. Sec. Act, 2021-11 I.R.B. 922 (2021). ↩︎
4. Loper Bright Enterprises, et al v. Raimondo, 144 S. Ct. 2244 (2024), overruling Chevron, U.S.A., Inc. v. Nat. Resources Def. Council, Inc., 467 U.S. 837 (1984) (citing Perez v. Mortgage Bankers Ass’n, 575 U.S. 92 , 109 (2015)). ↩︎
5. Code Section 7422 ; Treas. Reg. 601.103(c)(3). ↩︎
6. 28 USC § 1402(a)(2). ↩︎
7. 28 USC § 173. ↩︎
8. 28 U.S.C.A. § 1491(a)(1); Ballard v. United States, , 1008-1009 (Fed. Cir. 2017). ↩︎
9. Withdraw an Employee Retention (ERC Claim), IRS.gov. ↩︎
10. Loper Bright Enterprises, et al v. Raimondo, 144 S. Ct. 2244 (2024), overruling Chevron, U.S.A., Inc. v. Nat. Resources Def. Council, Inc., 467 U.S. 837 (1984). ↩︎