Understanding the Employee Retention Credit and Why Lawsuits Matter
The Employee Retention Credit, commonly called the ERC, is a tax credit created by the federal government during the COVID-19 pandemic. Established through the CARES Act in March 2020, this credit was designed to help businesses keep workers on payroll during economic disruption. The credit allowed eligible employers to claim up to $5,000 per employee in 2020, and this amount increased to $7,000 per quarter in 2021 and 2022—meaning some businesses could potentially claim $28,000 per employee across all qualifying quarters.
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The credit worked differently than other pandemic relief programs. Rather than a grant or loan, the ERC functioned as a reduction in payroll taxes owed to the federal government. Employers could claim the credit retroactively, meaning they could file amended returns for years already passed. This created a significant backlog at the Internal Revenue Service as hundreds of thousands of businesses filed claims—many for the first time years after the pandemic began.
As the program expanded and claims increased, interpretations of who could claim the credit became disputed. Some business owners, accountants, and third-party claim processors argued that the IRS was wrongfully denying legitimate claims or underpaying the amounts owed. Others contended that they had been incorrectly advised and filed claims they later realized didn't meet the legal requirements. This disagreement led to lawsuits—both by businesses against the government and by the government against businesses seeking repayment.
Understanding how the ERC program works and why disputes arise is the foundation for understanding the legal landscape surrounding it. The credit itself was never controversial; the disputes center on interpretation of the rules, calculation methods, and who actually met the legal requirements. By learning about the program's structure, you can better understand the positions various parties take in litigation.
Practical Takeaway: The ERC is a real tax credit with real rules, and lawsuits exist because people disagree about how those rules apply to specific situations. Understanding the basic structure of the program helps you evaluate any claims about your own situation.
Types of ERC-Related Lawsuits and Who Gets Sued
ERC lawsuits fall into several distinct categories, and understanding which type might apply to your situation helps you navigate your options. The first major category involves businesses suing the IRS over denied claims or partial denials. When a business files an ERC claim and the IRS denies it or pays less than requested, the business may file a lawsuit in federal court to challenge that decision. These cases typically argue either that the IRS misinterpreted the law or that the business actually did meet the legal requirements despite what the IRS decided.
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A second category involves the IRS suing businesses to recover ERC payments already made. The government has initiated thousands of audits of ERC claims, and when audits conclude that a business was not entitled to the credit, the IRS demands repayment plus interest and penalties. Some businesses have received notices demanding repayment of hundreds of thousands or even millions of dollars. When businesses dispute these demands, litigation ensues.
A third category involves lawsuits between businesses and third-party claim processors. Many businesses hired accounting firms, law firms, or specialized ERC processors to file their claims. When claims were denied or businesses faced government repayment demands, some sued their processors, alleging they were given bad advice or that their claims were filed incorrectly. Conversely, some processors have sued businesses for non-payment of their fees.
A fourth category involves class action lawsuits. Some attorneys have filed class actions on behalf of groups of businesses with similar circumstances—for example, restaurants that received PPP loans and were initially told they couldn't also claim the ERC, or businesses in specific industries that faced systematic claim denials.
Finally, there are regulatory and legislative disputes. Some industry groups and business associations have challenged the IRS's interpretation of ERC rules through comments on proposed regulations or lobbying efforts, sometimes resulting in legal disputes about what regulations can and cannot require.
Practical Takeaway: Know which type of lawsuit applies to your situation. If the IRS denied your claim or demanded repayment, you're in a different position than if you hired a processor and now dispute their fee. Your situation determines which legal options you may want to explore.
The IRS Audit and Repayment Demand Process
Many businesses first encounter ERC-related legal issues not through a lawsuit but through an IRS audit notice. The process typically begins with a letter from the IRS requesting documentation to support an ERC claim. This letter, often called a "document request" or "audit notice," asks for specific records: payroll records, evidence of business disruption, calculations used to determine the credit amount, and documentation of how the credit was claimed.
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The timeline for responding to an audit notice is generally 30 days, though extensions can be requested. During this period, many businesses work with tax professionals or attorneys to gather and organize documents. The quality and completeness of your response can significantly affect the audit outcome. Some businesses provide thorough documentation; others struggle to locate records from years earlier.
After reviewing the response, the IRS either concludes the claim was proper, requests additional information, or issues a Notice of Proposed Adjustment (NPA). An NPA states the IRS's position that the claimed credit was improper and specifies the amount the business owes, including interest and penalties. The interest accrues from the date the credit was claimed, meaning interest can accumulate to substantial amounts over several years.
When an NPA is issued, the business has the right to dispute it. This typically happens in one of three forums: the IRS Office of Appeals, the U.S. Tax Court, or the U.S. Court of Federal Claims (if the business first pays the amount and then sues for a refund). Each forum has different procedures, timelines, and rules about what evidence is considered. Many business owners don't realize they have options for where to contest an IRS decision; choosing the right forum can affect the likelihood of a favorable outcome.
The repayment demands can be substantial. Businesses have reported receiving notices demanding repayment of amounts ranging from tens of thousands to tens of millions of dollars. These demands include the original credit claimed, plus interest (typically compounding at the federal rate, which has ranged from 4-8% depending on the period), plus penalties (often 20% for substantial understatement of tax, or higher if fraud is involved).
Practical Takeaway: If you receive an IRS audit notice about ERC, know that you have rights and options. You are not required to simply accept the IRS's position. Understanding the audit process and the forums available for disputes helps you make informed decisions about next steps.
Your Options When Facing an ERC Audit or Denial
When the IRS audits your ERC claim, you have several options for how to respond. The first step is understanding what specific issues the IRS is raising. Some audits focus on whether your business truly experienced the type of disruption required by law to claim the credit. Others challenge how you calculated the credit amount. Still others question whether you improperly claimed the credit while also claiming certain other benefits. Reading the audit notice carefully—or having a professional read it—helps you understand exactly what the IRS questions.
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One option is to gather additional documentation and make a factual argument that you did meet the legal requirements. Many ERC claims were filed years after the pandemic; businesses often lack complete contemporaneous records. Gathering bank statements, email exchanges, supplier communications, public records about local restrictions, and other evidence can sometimes demonstrate to the IRS that your business did experience qualifying disruption. Some businesses succeed with this approach because they can show they genuinely did have revenue decline or business operations interrupted.
A second option is to work with a tax professional to argue that the IRS has misinterpreted the law. ERC rules are genuinely complex, and reasonable people disagree about what the statutes and regulations require. For example, there is legitimate disagreement about whether certain industries were "more than insubstantially affected" by government orders, whether supply chain disruptions counted as qualifying disruptions, and how to calculate the credit when businesses had partial operation changes. Presenting legal arguments about interpretation is different from presenting factual arguments about what actually happened, and both approaches may be relevant.
A third option is to request a hearing before the IRS Office of Appeals. Appeals is a division within the IRS that independently reviews disputes. An Appeals Officer hasn't seen your case before and isn't bound by the audit division's position.