Can a business qualify for the employee retention credit (ERC) if it experiences a supply chain disruption? Yes, but not without tying it to a governmental order that limits commerce, travel, or group meetings due to COVID-19.

The broader supply chain issues stemming from the pandemic are not automatic qualifiers for the ERC. Taxpayers need to be careful about sweeping assertions of supply chain disruption because ERC claims are likely to receive significant IRS attention in the coming years.

The ERC is a fully refundable tax credit for employers impacted by the COVID-19 pandemic. Eligible employers can receive a maximum benefit of $26,000 per employee for wages paid to employees in 2020 (up to $5,000) and 2021 (up to $21,000). To qualify for the credit, employers need to have had either a significant decline in its gross receipts or a full or partial suspension of its business operations due to a governmental order. To learn more about eligibility, check out our interactive ERC flowchart.

Even if an employer had an increase in gross receipts, it still could claim the ERC if its operations were impacted by a governmental order. Question 12 of IRS Notice 2021-20 considers a business to have a suspension of operations due to a governmental order if an order causes the suppliers to a business to suspend its operations. However, issues in the broader supply chain do not automatically qualify a business to claim the ERC.

Supply Chain Disruption

For an employer to claim a full or partial suspension due to a governmental order that impacts its supplier it must consider all the relevant facts and circumstances. These include:

  • The supplier’s ability to make deliveries of critical goods due to a governmental order;
  • The employer’s ability to purchase critical goods from an alternative supplier; and
  • The consequence on the business due to the inability to purchase critical goods.

It’s important to note that all three relevant facts must be in place for an employer to claim a full or partial suspension of operations.

For the first test, an employer must identify an appropriate governmental order (or orders) that directly impacts its supplier’s ability to deliver critical goods. Any order, proclamation, or decree from the Federal government or any State or local government can qualify as long as it limits commerce, travel, or group meetings due to COVID-19 and relates to the suspension of the supplier’s trade or business.

For example, governmental orders stating that all non-essential businesses must close for a specified period would qualify under the full or partial suspension test, provided that the supplier is considered to be non-essential. However, non-enforceable recommendations, broader demand and supply issues, and even enforceable mask requirements are not considered when determining a full or partial suspension of operations.

Likewise, supply chain disruptions caused by employee shortages, increased demand for raw materials, governmental orders in foreign jurisdictions, and broader economic factors should not be considered when determining if a supply chain disruption qualifies a business to claim an ERC.

One final consideration to keep in mind with respect to the ERC is the definition of qualifying wages under a partial or full suspension of operations. Although an employer qualifies for the quarter in which those government orders are in effect, qualifying wages include only those wages paid to employees during the period where such governmental order is in effect. Temporary suspensions of a supplier’s operations at the start of the pandemic would not automatically qualify a business for subsequent quarters and would therefore significantly limit the amount of potential wages that qualify for a refund.

Need Help Determining Eligibility?

Employers that incorrectly claim an ERC may face stiff penalties. Taxpayers should expect the same with respect to the IRS and its audits of the ERC. With the IRS announcing they planned to hire more than 10,000 workers during 2022, the expectation is that the ERC will be a heavy focus for IRS scrutiny. For this reason, employers should reach out to a qualified ERC specialist to determine eligibility.

Contact Us

For more information on this topic, please contact a member of Withum’s Business Tax Services team.