IRS Is ‘Daring People to Sue’ Over Pandemic Credit Crackdown

IRS efforts over the past year to clean up an embroiled tax credit program have put companies seeking long-delayed payments in a position they’re trying to avoid—going to court.

Many businesses expected to reap thousands or millions in cash in the form of the employee retention tax credit after staying open and keeping employees on the payroll during the Covid-19 pandemic. ERC claims at first came in slower than expected but that quickly changed as pop-up firms skyrocketed, conning companies into claiming the credit when they didn’t qualify.

The IRS was caught flat-footed. It subsequently went on offense to manage the influx—pausing the processing of new claims for months, offering relief options for those that wrongly claimed the credit, and denying invalid claims. The agency became laser-focused on catching fraud.

More than a year after those initial fraud-prevention efforts, there doesn’t appear to be an end in sight to its crackdown, leaving businesses—both those that are still waiting for the credit and those who were denied—to read the tea leaves about what they should do next.

“The IRS is daring people to sue,” said Justin Nelson, a partner at Susman Godfrey. “Bring it on.”

Nelson’s clients are among those who filed suits to compel the IRS to pay delayed or improperly denied ERC. It’s been over a year since these small businesses filed to get the cash they’re owed.

Two big legal issues are coming to a head for the IRS: lawsuits alleging that the agency’s processing freeze violated federal rulemaking procedures, and suits seeking refunds for credits that companies say were improperly delayed or denied.

“As time goes on, it makes less and less sense to just wait for the IRS rather than being aggressive and assertive,” said Brian Bernhardt, a member of Fox Rothschild LLP’s ERC Defense Task Force.

Pleading for Cash

At the time the IRS first paused its processing of new claims in September 2023, it had received more than 3.6 million claims since the program started in 2020, with 600,000 alone filed over the summer. Tax professionals at the time urged businesses to continue to file for the credit and prepared to file a complaint if the agency didn’t act within six months.

Many businesses are still waiting for their refund a year later. The IRS inventory of unprocessed ERC claims stood at 1.4 million as of June 17.

“I really do suspect that in the next six months, one year, there are going to be hundreds, if not more, of these ERC refund lawsuits filed,” said Jeffrey Glassman, a partner at Meadows, Collier, Reed, Cousins, Crouch & Ungerman LLP who has litigated ERC refund suits against the government.

Some say the IRS’s delays and backlog made litigation inevitable.

“The first ones are the slam-dunk cases and there is no question that they qualify,” said Tracy Anagnost Martinez, senior director at Omega Accounting Solutions. The early suits are from businesses that qualify for ERC because they had declines in gross receipts rather than they were ordered by the government to fully or partially suspend operations, which has become a point of contention with the IRS.

Martinez, who previously was an attorney at the IRS and US Department of Justice, said she’s watching from the sidelines to see how long it takes for the DOJ to settle these cases and how the courts respond to the cases on the suspension of operation test before jumping into litigation with her clients.

But suing is costly and may not be the best path if the credit isn’t big enough. The burden of proof also shifts, requiring businesses to establish the facts that they are eligible for the credit.

“Someone who has $100,000 in ERC claims out there, compared to someone who might have $50 million spread out over six or seven quarters, the cost of litigation is a lot easier for you to stomach when your return on investment is $50 million,” Bernhardt said.

Why the Denial?

Some businesses are beginning to hear from the IRS as part of its latest wave of letters disallowing the tax credit. But about 10% of these letters were sent in error, the IRS said, prompting tax professionals to defend their clients’ eligibility and weigh litigation or an an appeal to the IRS.

The decision on how best to move forward with the claim is made more difficult because the IRS has been close-lipped when it comes to sharing its criteria for denying the credits. The agency doesn’t want to give fraudsters a blueprint for skirting enforcement or detail the status of specific claims in process.

Without IRS criteria for processing, employers and their tax professionals say they’re left with little information to decide their best course of action, including whether to sue or participate in the agency’s voluntary disclosure program for improper ERC payouts.

Michelle Abroms Levin, a shareholder at Dentons, wants the IRS to share internal guidance that its revenue agents use to examine returns claiming the credit, so employers can make more informed decisions.

She requested records under the Freedom of Information Act in October 2023 under the premise that increased transparency could help boost taxpayer confidence that their claims will be properly processed, informing their decision of whether to file a refund suit. It could also put at ease—or lay bare—fears of internal inconsistencies, she said.

Employers that are among the thousands denied their tax credit can also use records lawsuits as a possible path to get more information on why their claim was denied.

Still, thousands of employers will be left with one question: sue, or wait?

“It just doesn’t seem to me to be fundamentally fair that taxpayers should have to bear the cost of filing in federal district court. Unlike Tax Court, that’s a much more expensive forum to proceed in,” Levin said. “Is it fair to make all these taxpayers bear the cost of filing refund suits?”