Employee Retention Credit Compliance for Nonprofits

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Many nonprofits that were affected by the COVID-19 pandemic have financially benefited from claiming the Employee Retention Credit (ERC). But the ERC has become the source of considerable notoriety over the last several years and is now the focus of significant government enforcement activity. Originally enacted in 2020 as […]

Many nonprofits that were affected by the COVID-19 pandemic have financially benefited from claiming the Employee Retention Credit (ERC). But the ERC has become the source of considerable notoriety over the last several years and is now the focus of significant government enforcement activity. Originally enacted in 2020 as part of the Coronavirus Aid Relief and Economic Security (CARES) Act [and, after amendments, codified at IRC section 3134], the ERC is a refundable tax credit available for certain employment tax quarters in 2020 and 2021.

Congress intended the ERC to subsidize employers who kept employees on payroll during the period of financial pressure due to the pandemic. But over the past two years, the IRS has publicly sounded the alarm that many ineligible taxpayers were filing ERC claims. In particular, the IRS identified as especially dubious ERC promoters who charged contingency fees based on the amount of ERC refunds secured. Consequently, the IRS has made the ERC a priority in both its civil and criminal enforcement efforts, dedicating significant resources to training IRS personnel who will conduct audits and criminal investigations.

The IRS’s ERC enforcement campaign is ramping up in early 2024. Many organizations that claimed the ERC will be subject to audits and investigations in the coming days. Nonprofit employers who claimed the ERC are just as likely to be subject to scrutiny as their for-profit counterparts.

Some evidence, and this author’s own experience, suggests that certain ERC promoters heavily targeted particular nonprofit industries with the marketing of their ERC services. Of course, not all ERC claims solicited or submitted by promoters were necessarily incorrect—but the IRS is likely to closely scrutinize such claims due to the identity of the preparer. For nonprofits that relied on promoters to determine their eligibility for the ERC, there may be a significant risk of an audit.

Before turning to the potential compliance issues, a basic overview of the requirements for ERC eligibility is essential. To be eligible to claim the ERC, an employer must have made payments of “qualified wages” and experienced during a particular quarter either 1) a sufficient decline in gross receipts or 2) a full or partial suspension of business operations due to a government order imposed due to the pandemic. For 2020 quarters, if the employer had an average of more than 100 full-time employees in 2019, qualified wages included only wages paid to employees who were not providing services. For 2021 quarters, if the employer had an average of more than 500 full-time employees in 2019, the same rule applies. If an employer fell beneath the 100/500 full-time employee threshold, all wages paid to employees were deemed to be qualified wages during a particular 2020/2021 quarter. Similarly, the amount by which gross receipts must have declined varies based upon the particular quarter at issue.

Nonprofits pose unique ERC compliance issues. Many nonprofits may lack an easily identifiable trade or business that can be neatly considered under the government order test. IRC section 501(c)(3) encompasses a wide variety of tax-exempt organizations. An examination of all the potential scenarios that might result in possible risk of an erroneous ERC claim is outside of the scope of this article, but the two examples discussed below may be helpful.

Religious Organizations

In the spring of 2020, churches, mosques, synagogues, and other faith-based organizations were generally subject to general shutdown orders issued by state governments. To the extent that such organizations ceased to hold regular services, they would seem to be clearly eligible for the ERC under the government order test. Many religious organizations were quick to adapt regular in-person services to livestream or recorded video; a Pew Research study conducted in July 2020 found that 36% of all U.S. adults had watched religious services online or on television within the last month, whereas only 13% had attended religious services in person—suggesting that such adaptation may have been widespread (Pew Research Center, “How the Pandemic Has Affected Attendance at U.S. Religious Services,” Mar. 28, 2023, https://tinyurl.com/4bkemd5n).

Did switching to virtual services preclude a full or partial suspension—and thus ERC eligibility—for certain employment tax quarters? IRS guidance suggests that it would consider that to be the case. In Notice 2021-20, the IRS posed the following Q&A:

Question 15: If a governmental order requires an employer to close its workplace, but the employer is able to continue operations comparable to its operations prior to the closure by requiring employees to telework, is the employer considered to have a suspension of operations?

Answer 15: No. If an employer’s workplace is closed by a governmental order, but the employer is able to continue operations comparable to its operations prior to the closure, including by requiring its employees to telework, the employer’s operations are not considered to have been fully or partially suspended as a consequence of a governmental order. However, if the closure of the workplace causes the employer to suspend business operations for certain purposes, but not others, it may be considered to have a partial suspension of operations due to the governmental order.

Although the Q&A is ambiguous as to what exactly it means for operations to be “comparable,” it is possible that the IRS will consider a virtual version of a typical in-person religious service to meet the standard.

It is important to note that the Q&As in Notice 2021-20 do not have the force of law and may be subject to legal challenge. Even so, Notice 2021-20 (and other guidance issued by the IRS) previews the positions that the IRS will stake out in audits and litigation. Religious organizations that wish to avoid disputes with the IRS may be well advised to determine whether they were truly eligible for all quarters claimed for the ERC if relying on the government order test. If the IRS’s position holds up, religious organizations that switched to “comparable” virtual services might only be eligible for only a limited ERC amount for any period when no services were held.

Healthcare Organizations

In 2020, organizations providing healthcare services were often deemed essential businesses and exempted from governmental shutdown orders. Healthcare organizations whose doors stayed open during the pandemic thus face an uphill battle in claiming ERC eligibility under the government order test. The IRS has already identified as dubious several arguments on which some healthcare organizations based their ERC eligibility. For example, Notice 2021-20 allows for a limited circumstance in which a taxpayer can qualify for the ERC based on a supply disruption attributable to a full or partial suspension of one of the taxpayer’s suppliers.

Some promoters have argued that shortages of personal protective equipment (PPE) due to the pandemic constituted such a circumstance for healthcare organizations. The IRS has since issued guidance that takes the position that a supply chain disruption is “a limited exception” that “allows the employer to ‘step into the shoes’ of its supplier for purposes of the suspension test” (IRS AM 2023-005, July 21, 2023). IRS guidance states that to qualify for the exception, the taxpayer must establish that “(i) the governmental order caused the supplier to suspend operations, (ii) the inability to obtain the supplier’s goods or materials caused a full or partial suspension of the employer’s business operations, and (iii) the employer was not able to obtain these critical goods or materials from an alternate supplier” (AM 2023-005). In the case of healthcare organizations, it may be difficult to argue that any government orders “caused” PPE suppliers to “suspend operations” with the resulting supply shortage in turn causing a suspension to the taxpayer’s operations. On the contrary, federal, state, and local governments strongly encouraged production and distribution of PPE during the pandemic, with any resulting supply chain disruptions typically being attributable to extremely high demand.

Another argument sometimes made in favor of ERC eligibility for healthcare organizations is that certain guidance or recommendations issued by federal agencies constituted a government order that resulted in a full or partial shutdown. Again, the IRS has indicated that it will push back on this line of argument. In IRS AM 2023-007 (Nov. 3, 2023), the IRS took aim at the argument that Occupational Safety & Health Administration (OSHA) guidance constituted orders that suspended operations for taxpayers. The guidance focuses on the plain meaning of the term “order” as “a command or mandate delivered by a government official,” and flatly states that “recommendations, guidelines, and suggestions do not constitute orders for purposes of the employee retention credit.” Unless a recommendation or guidance was binding under federal or state law, the IRS is likely to challenge ERC claims made on this basis.

Risks of Noncompliance

Nonprofit taxpayers who are selected for examination of their ERC claims face potentially significant bills for tax, penalties, and interest if they are unable to establish their eligibility. Treasury Regulations deem erroneous refunds of ERC to be “underpayments” of federal employment tax [Treasury Regulations sections 31.3111-6(b); 31.3134-1(a)]. Having an underpayment will trigger the penalty and interest mechanisms of the tax code, potentially including late payment additions to tax [section 6651(a)(2)], accuracy-related penalties [section 6662(a)], and civil fraud penalties [section 6663]. For taxpayers that may have been subjectively aware that their ERC claims were false, potential criminal exposure is an additional concern, as the IRS continues to pursue criminal investigations.

Finally, penalty exposure may well persist years into the future. As of this writing, the IRS generally can no longer assess penalties with respect to 2020 quarters and generally has until April 15, 2025 to assess penalties with respect to Q1 and Q2 of 2021 [IRC section 6501(a), (b)(2)]. For Q3 2021, the IRS generally has five years after the filing or deemed filing of a Form 941 to assess penalties under IRC section 3134(l). But for all quarters for which ERC was claimed, pending legislation (H.R. 7024) would reopen and extend the period to assess to up to six years, measured from the later of the date on which a claim for refund was made or an original Form 941 was filed or deemed filed.

Nonprofits that are concerned about their eligibility for claimed ERC should move quickly to consult with professional advisors and potentially take action to get back into tax compliance. If eligibility is unlikely or uncertain, options may be available to avoid more severe consequences, including withdrawing any still-pending ERC claims or filing an amended Form 941-X return. As of this writing, the IRS has closed the ERC Voluntary Disclosure Program, which allowed taxpayers to disclose their ineligibility and return 80% of the ERC claimed, in exchange for keeping the remaining 20% (along with any overpayment interest received) and avoiding liability for penalties and interest. There is a possibility that the IRS will announce a new voluntary disclosure program in the months or years ahead.

Michael Waalkes, JD, LLM (Tax) is an associate at Kostelanetz LLP, Washington, D.C.

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