The Employee Retention Credit was one of the largest pandemic-era relief programs the federal government ever created. Billions of dollars went out to businesses that qualified. Billions more went to businesses that did not. Now the IRS is coming back for it, and if your business claimed the ERC, you need to understand what that means.
This post covers what the IRS is looking for, what triggers an audit, how the exam works, and what your options are if the agency disallows your claim.
What the Employee Retention Credit Was
The ERC was a refundable payroll tax credit created under the CARES Act in 2020 and expanded through 2021. Qualifying businesses could claim a credit of up to $5,000 per employee for 2020 and up to $7,000 per employee per quarter for 2021, for a potential maximum of $26,000 per employee across both years.
To qualify, a business had to meet one of two tests: either it was fully or partially suspended due to a government order related to COVID-19, or it experienced a significant decline in gross receipts compared to the same quarter in 2019. Wages paid during the qualifying period could not overlap with wages used for PPP loan forgiveness.
The credit was legitimate. Many businesses that claimed it were fully entitled to every dollar. The problem is that a wave of third-party promoters, commonly called ERC mills, aggressively marketed the credit to businesses that did not qualify, filed returns on their behalf, and collected large contingency fees. The IRS estimates that a significant portion of the claims it received were either fraudulent or based on incorrect eligibility determinations.
Why the IRS Is Auditing ERC Claims Aggressively Now
In September 2023, the IRS placed a moratorium on processing new ERC claims and warned that it had identified hundreds of thousands of questionable filings. That moratorium was later extended. The IRS has since created a dedicated ERC examination program and assigned significant audit resources to reviewing both individual claims and the promoters who filed them.
The enforcement push is operating on two tracks. Civil audits are reviewing claims for eligibility and demanding repayment with interest and penalties. Criminal investigations are targeting the promoters and, in some cases, the business owners themselves, particularly where records suggest intentional misrepresentation.
If you claimed the ERC, the question is not whether the IRS might look at your return. The question is whether you can substantiate your claim when they do.
What the IRS Is Looking For in an ERC Audit
ERC audits are document-intensive. The examiner will want to verify that your business actually met the qualifying criteria for each quarter you claimed the credit. The two qualification tests work differently, and the IRS scrutinizes them differently.
ERC Qualification Tests
| Suspended Operations Test | Gross Receipts Test | |
|---|---|---|
| Definition | Business was fully or partially suspended due to a government order limiting commerce, travel, or group meetings related to COVID-19 | Business experienced a significant decline in gross receipts compared to the same calendar quarter in 2019 |
| What Qualifies | A qualifying government order must have more than a nominal effect on the business’s operations. Applies to 2020 Q1-Q4 and 2021 Q1-Q3 | 2020: gross receipts below 50% of same quarter 2019. 2021: gross receipts below 80% of same quarter 2019. Recovery startup businesses had separate rules. |
| What the IRS Checks | The specific government order cited, its effective dates, which portion of the business was affected, and whether the impact was more than nominal. Supply chain disruption claims face heightened scrutiny. | Quarterly gross receipts figures from business tax returns and financial records for both the claim year and 2019 comparison quarters. |
Beyond the qualification tests, the IRS will also verify that wages claimed were actually paid, that the amounts are consistent with payroll tax filings, and that no double-dipping occurred with PPP-forgiven wages. If your PPP loan was forgiven, the wages that supported that forgiveness cannot also be used as the basis for ERC credits.
The Three Most Common ERC Audit Triggers
Supply Chain Disruption Claims Without Supporting Documentation
A number of ERC promoters told businesses they could qualify under the Suspended Operations Test because their suppliers were affected by government orders, even when the business itself was not directly subject to any such order. The IRS has been clear that indirect effects of government orders on a business’s suppliers do not automatically qualify the business for the credit. To use a supply chain argument, the business must show that it was unable to obtain critical goods or materials specifically because of a government order imposed on its supplier, and that it could not obtain those goods or materials from an alternative source. Claims based on vague supply chain disruption without that level of detail are being disallowed at a high rate.
Nominal Impact Claims That Don’t Meet the Standard
Partial suspension of operations only qualifies if the government order had more than a nominal effect on the business. The IRS uses a 10% threshold as a guideline: if less than 10% of the business’s gross receipts or services were affected by the restriction, the impact is generally considered nominal. Businesses that claimed the ERC on the basis of minor operational changes, such as reduced dining room capacity that represented a small fraction of total revenue, face significant risk of disallowance.
Claims From Periods That Do Not Qualify
The ERC eligibility window was specific. For 2020, it covered wages paid after March 12 and before January 1, 2021. For 2021, it covered Q1 through Q3 only. The Infrastructure Investment and Jobs Act retroactively ended the 2021 Q4 credit for most employers. Many businesses filed amended returns claiming credits for periods outside their actual qualifying window, often because a promoter told them they qualified for more quarters than they did.
What an ERC Audit Notice Looks Like and What Happens During the Exam
ERC audits are generally conducted through correspondence or as field exams. You may receive an IRS Letter 6577, which is a notice that the IRS is examining your ERC claim and needs documentation. You may also receive a standard examination notice for the tax year on which the amended return was filed.
The examiner will typically request a specific set of records: copies of the government orders you relied upon, evidence of how those orders affected your operations, quarterly payroll records, quarterly gross receipts figures, PPP loan forgiveness applications if applicable, and documentation showing how you calculated the credit.
If the IRS determines that your claim was partially or fully improper, it will issue a proposed adjustment. You will have the opportunity to respond before any final determination is made. If you disagree with the examiner’s conclusions, you can request an appeal. This is not a process you should handle without professional audit representation. The documentation requirements are detailed, the legal standards are specific, and the amounts at issue are often substantial.
The ERC Voluntary Disclosure Program
In late 2023 and into 2024, the IRS offered an ERC Voluntary Disclosure Program that allowed businesses to repay erroneous ERC credits at a reduced rate, initially 80% of the credit received, without penalties or interest, provided they had not already been audited. The first VDP closed in March 2024. A second program opened later in 2024 with different terms.
If you believe your ERC claim was erroneous and you have not yet been contacted by the IRS, there may still be options to proactively resolve the issue before enforcement begins. Whether any current program is available and whether it makes sense for your situation depends on your specific facts. This requires a direct consultation, not a general answer.
Your Options If the IRS Disallows Your ERC Claim
If the IRS issues a disallowance, you have three main paths.
The first is to accept the adjustment and repay the credit, plus interest and potentially penalties. The interest rate on underpayments has been running at 8% in recent periods. Penalties for negligence or substantial understatement of tax can add another 20% on top of the tax owed. If you received a large ERC refund, this exposure can be significant.
The second is to appeal. If you have documentation to support your claim and the examiner’s determination was incorrect, you can request review by IRS Appeals. Appeals is an independent function within the IRS and can sometimes reach a different result than the examining agent. An appeal requires a written protest that clearly identifies the facts and legal arguments supporting your position.
The third option, in some situations, is to seek penalty abatement. If you relied in good faith on a qualified tax professional or on IRS guidance that was later clarified, there may be grounds to reduce or eliminate penalties even if the underlying tax is owed. First-time abatement is also available to taxpayers with a clean compliance history. Abatement does not eliminate the tax or interest, only the penalty portion.
If you are also dealing with related back taxes or installment issues arising from an ERC repayment demand, those can often be addressed as part of the same resolution strategy.
Why ERC Audit Defense Is Specialized Work
ERC audits are not routine income tax audits. They require familiarity with the specific statutory and regulatory framework governing the credit, the IRS guidance issued under Notices 2021-20, 2021-23, and 2021-49, and the evolving enforcement posture the IRS has taken as it works through the backlog of questionable claims.
A representative handling your ERC audit will review your original claim against the qualification criteria, identify which quarters have strong documentation and which are exposed, gather and organize the records the IRS needs, communicate directly with the examiner so you do not have to, and advocate for the most favorable outcome the facts support. If your claim was entirely proper, that defense is about proving it. If part of your claim was erroneous, that defense is about limiting your exposure.
The IRS is moving through these cases. The time to prepare is before you receive an audit notice, not after.
Work With an Enrolled Agent Who Handles ERC Cases
Luisa N. Victoria is a Federally Authorized Enrolled Agent with the authority to represent taxpayers before the IRS at every level, including examinations, appeals, and collections. If your business claimed the ERC and you have concerns about your documentation, received an audit notice, or were told by a promoter that you qualified, contact this office to review your situation before the IRS reaches out first.