How to Defend Employee Retention Credit Claims in an IRS Audit

The IRS processed nearly $230 billion in ERC claims before issuing a moratorium on new filings in September 2023 (IR-2023-169). Billions were paid to businesses with invalid claims, fueled by a cottage industry of promoters charging contingency fees. The IRS's response has been an aggressive and targeted audit program. As of 2025, the agency has launched tens of thousands of ERC examinations with more in progress — focusing on claims filed using the suspension-of-operations test based on tangential government orders, inflated wage calculations, and ineligible related-party wages. For CPAs, the work is two-sided: defending legitimate clients whose valid claims are caught in the dragnet, and helping clients who used promoters to understand their options before the IRS contacts them first.

Prerequisites

• Client's Form 941-X (Amended Employer's Quarterly Federal Tax Return) for each quarter claimed, along with the original Form 941 for those quarters
• Payroll records — by employee, by quarter — showing qualified wages and health plan expenses
• Documentation establishing eligibility: either gross receipts by quarter for the applicable period, or the government orders relied upon for the partial or full suspension test
• Any IRS correspondence already received: examination notice, IDR (Information Document Request), disallowance letter, or Letter 105-C
• Copies of any ERC promoter engagement agreements, analysis reports, or marketing materials the client received

Step 1: Understand the ERC Eligibility Framework and What the IRS Is Examining

Before you can build a defense, you need to understand what the IRS is looking for and why it concludes so many claims fail.

The ERC has two eligibility tests for each calendar quarter: (1) a significant decline in gross receipts compared to the same quarter in 2019 (≥50% decline for 2020; ≥20% for 2021) or (2) a full or partial suspension of operations due to a government order — not merely a reduction in revenue or a voluntary closure.

The credit is calculated on qualified wages:

• 2020: 50% of up to $10,000 in qualified wages per employee per year → maximum $5,000 per employee
• 2021: 70% of up to $10,000 in qualified wages per employee per quarter → maximum $7,000 per employee per quarter, or $21,000 for all three eligible quarters

The IRS has identified five recurring patterns that drive improper claims (IRS IR-2023-40):

1. The supply chain argument: claiming suspension because a supplier was shut down, when the business itself was not ordered to close or curtail operations
2. Essential business overclaiming: essential businesses that remained fully open claiming suspension simply because a government order existed in their jurisdiction
3. Nominal effect: government orders that had only a de minimis impact on operations, which do not satisfy the suspension test under IRS Notice 2021-20, Q&A #11–23
4. Ineligible wages for large employers: businesses with more than 100 full-time employees in 2020 (or more than 500 in 2021) claiming wages paid to employees who were still performing services
5. Related-party wages: wages paid to majority owners' spouses or family members, which are expressly excluded under IRC §51(i)(1) as incorporated by §3134(c)(3)(B)

Understanding which category your client's claim falls into determines the entire defense strategy.

Step 2: Assemble the Core Documentation Package

Every ERC defense starts with documentation. The IRS will issue an Information Document Request (IDR) within the first weeks of examination. Assembling your response package in advance gives you control over the narrative.

For the gross receipts test, gather:

• Quarterly gross receipts (not net revenue) for Q1 2019 through Q4 2021, drawn from the client's books and cross-checked against already-filed tax returns. The IRS will reconcile these against 1120-S, 1065, or 1040 Schedule C income as reported
• For businesses with multiple entities: gross receipts must be aggregated across the controlled group per IRC §52(a) and §52(b)

For the suspension of operations test, gather:

• Copies of all government orders cited: the full text of the order, its effective dates, and its scope. Blanket stay-at-home orders do not automatically qualify a business — the order must impose a restriction on that business's operations (IRS Notice 2021-20, Q&A #11)
• A written, contemporaneous narrative (ideally prepared at the time, but reconstructable) documenting how the order impacted the specific business — which portion of operations were curtailed, by what percentage, and for what period
• Internal communications, board minutes, or operational memos created during the relevant quarters

For qualified wages:

• Payroll records by employee and quarter, showing regular compensation and employer health plan contributions separately
• Evidence that each claimed employee was retained and not providing services (for large employer claims) or was a qualified employee (for small employer claims)
• W-2s and Form 941s for the claim period

The IRS statute of limitations for ERC assessments is five years from the date the Form 941-X was filed, extended by the Inflation Reduction Act of 2022 (P.L. 117-169, §80604). Clients should be aware that audits can arrive years after the credit was received.

Step 3: Evaluate Claim Validity Before the Auditor Finalizes Findings

Once you have assembled the documentation, make an honest assessment of claim validity before the IRS does. This is the most important step in the process — and the one most CPAs skip when they inherit a client's ERC filing from a promoter.

Work through the eligibility analysis quarter by quarter:

• Does the gross receipts documentation actually show the required decline? Run the calculation using actual gross receipts, not net income or invoiced amounts
• For each government order cited: does the order specifically restrict the client's operations? Read the order — not a summary of it. Many "full suspension" arguments fail because the underlying order contained essential business exemptions that applied
• Are any wages disqualified due to related-party rules or large-employer-employee-still-working limitations?
• Were PPP loan proceeds taken into account? Wages used to calculate PPP forgiveness cannot also be treated as qualified wages for ERC purposes (IRS Notice 2021-20, Q&A #49)

If you identify significant issues, the client has options before the IRS issues a formal disallowance. Document your analysis and advise the client accordingly. Proactive resolution is almost always less costly than contested examination.

Step 4: Respond to the IRS Examination Notice and Information Document Request

ERC examinations typically begin with a Letter 2205 (examination notice) or Letter 2205-A (examination by mail), followed by an IDR listing the specific documentation requested.

Respond fully, but strategically. Do not volunteer information beyond what is requested. Do not submit bare payroll records without an explanatory narrative — auditors are not accountable for interpreting ambiguous records in the taxpayer's favor.

Structure your response package with a cover letter that:

• States the legal authority for eligibility in plain terms (gross receipts test or suspension test, or both)
• Walks through the quarter-by-quarter analysis
• Identifies the qualified wages calculation methodology
• Attaches documentation in the order it is discussed

For suspension-test cases, the IRS has published detailed guidance in IRS Notice 2021-20 (Q&A #11 through #26) and the more recent Chief Counsel Advice memoranda on supply chain arguments. Your cover letter should directly address the relevant Q&A provisions that support your client's position.

Respond within the timeframe specified in the IDR. If you need an extension, request it in writing before the deadline. Extensions are routinely granted for ERC cases given documentation volume.

Step 5: If the Claim Is Disallowed — Protests, Appeals, and Refund Suits

If the IRS issues a proposed disallowance — typically via Letter 105-C or a 30-day letter — you have formal rights to contest it.

Protest to Appeals: File a written protest with the IRS Independent Office of Appeals within 30 days of the 30-day letter. The protest must:

• State the specific facts you disagree with
• Identify the law and argument supporting the taxpayer's position
• Be signed under penalties of perjury

Appeals Officers handling ERC cases have authority to settle on hazards-of-litigation. A well-documented protest with strong factual records and clear legal argument succeeds more often than the IRS's initial disallowance rate suggests.

Refund suit in federal district court or the Court of Federal Claims: If Appeals does not resolve the case and the IRS issues a formal disallowance (Letter 105-C), the taxpayer has two years from the date of the letter to file suit under 28 U.S.C. §1346(a)(1). This route is expensive but available for well-documented, large-dollar claims.

If the tax is assessed: ERC disallowances generate an employment tax assessment under IRC §6601. Interest accrues from the original filing date, and a 20% accuracy-related penalty under IRC §6662 applies if the disallowance exceeds the reporting threshold. The penalty does not apply if the taxpayer can show reasonable cause and good faith reliance — which includes documented reliance on a CPA or attorney opinion prepared before the claim was filed.

Step 6: If the Claim Was Improper — Voluntary Disclosure and Withdrawal Options

If your client's ERC claim rests on a weak or invalid foundation, proactive resolution before an audit is almost always the better path.

Claim withdrawal: If the Form 941-X has been filed but not yet paid, the IRS allows withdrawal of the claim entirely. The IRS's withdrawal program (announced October 2023) eliminates the credit without penalty or interest. This option is available only if the IRS has not yet processed the amended return.

ERC Voluntary Disclosure Program: The IRS opened a Voluntary Disclosure Program for improper ERC claims in January 2024 (Announcement 2024-3). Under the program, participants repaid 80% of the credit received — the IRS waived the remaining 20% (representing the approximate contingency fee paid to promoters) and did not assess penalties or interest if payment was made by the deadline. The first program closed March 22, 2024.

If a client still has exposure from an improper claim that was received and has not been subject to examination, speak with tax counsel about available options. The IRS has signaled that future VDP rounds may be more limited and less favorable.

Promoter referrals: The IRS is separately auditing ERC promoters under IRC §6700 (promotion of abusive tax shelters). If the client has claims from multiple quarters all originating from the same promoter, this background context is relevant to the examination and to any reasonable cause defense.

Common Mistakes in ERC Audit Defense

Accepting the promoter's analysis at face value. Many ERC promoter reports are conclusory, cite government orders without analyzing their application to the specific business, and ignore large-employer limitations and related-party exclusions. You need to run the analysis yourself.

Failing to aggregate controlled group members. The ERC eligibility tests apply to the entire controlled group, not entity by entity. A practice group with multiple professional entities under common ownership cannot treat each entity independently — gross receipts and employee counts must be aggregated.

Submitting documentation without a narrative. Raw payroll data and copies of government orders, without a written explanation connecting them to the eligibility analysis, leave the auditor to draw their own conclusions. Write the story clearly.

Missing the 30-day protest deadline. Unlike most IRS examination procedures, missing the 30-day protest window results in the disallowance becoming final without Appeals review. Calendar it and confirm it in writing with the client.

Ignoring the accuracy penalty exposure. Clients who received large ERC payments should understand that a disallowance will generate not just repayment liability but penalty and interest — often significant amounts. This changes the economics of settlement vs. litigation.

FAQ

What triggers an IRS ERC audit?

The IRS uses a combination of risk-scoring models and identity signals. Claims with high dollar amounts, short timeframes between filing and payment, suspension-test-based eligibility without gross receipts decline, and filings originating from known ERC promoters are all elevated risk factors. The IRS also cross-references ERC claims against industries that were classified as essential businesses during COVID.

Can a client be audited for ERC even if the IRS already paid the credit?

Yes. Payment of the credit does not constitute acceptance of the claim. The IRS has five years from the date the Form 941-X was filed to assess additional tax under the extended ERC statute of limitations in the Inflation Reduction Act of 2022.

What is the ERC penalty if a claim is disallowed?

The standard accuracy-related penalty under IRC §6662 is 20% of the underpayment. The fraud penalty under IRC §6663 is 75%. Interest accrues from the original due date of the Form 941 at the federal short-term rate plus three percentage points. Penalties can be abated if the taxpayer demonstrates reasonable cause and good faith reliance on professional advice.

Is the ERC Voluntary Disclosure Program still open?

The first ERC VDP closed March 22, 2024. The IRS has indicated it may open additional VDP rounds, but terms and availability are not guaranteed. Check IRS.gov for current program availability.

Does the suspension of operations test require a complete shutdown?

No — but the suspension must be more than nominal. A full suspension means the business could not operate at all due to a government order. A partial suspension is also eligible, but the order must have had more than a nominal effect on the ability to conduct business. Essential businesses that could continue operating normally do not meet this test, even if a general stay-at-home order was in effect.

How does PPP loan forgiveness affect ERC calculations?

Wages used to support PPP loan forgiveness cannot also be treated as qualified wages for ERC purposes. This means CPAs must reconcile PPP forgiveness applications against ERC wage calculations. Overcounting wages across both programs is one of the more common calculation errors the IRS identifies.

What are a CPA's obligations if they discover an improper claim after the fact?

Under IRS Circular 230 §10.21, a practitioner who discovers an error or omission in a previously filed return must promptly notify the client of the error and advise the client of the consequences. The CPA is not required to notify the IRS, but cannot continue representing the client in a matter related to the error without the client taking corrective action.

How should CPAs handle clients who used ERC mills?

Obtain and review the promoter's analysis. Independently apply the eligibility rules. Document whether the claim appears valid or not. If the claim is questionable, advise the client of the options — withdrawal, VDP (if available), or proactive corrective filing — before IRS contact. Circular 230 obligations require you to advise the client of their obligations; they do not require the client to follow your advice, but that advice and the client's response should be documented.

Work with Arvori

Arvori helps CPAs manage ERC examination correspondence, track document production deadlines, and maintain client communication throughout the audit process. See how Arvori supports IRS compliance workflows.