Employer's Guide to IRS ERC Disallowance Notices (Dispute & File Refund Suit)
The IRS has been disallowing Employee Retention Credits at very high rates. The agency claims that a significant portion of these credits were claimed improperly, and if you filed amended 941 payroll tax returns to claim the Employee Retention Credit for 2020 or 2021, you should be aware that the IRS may disallow your credit if it has not yet been processed.
This blog explains what to expect if you get an ERC disallowance letter, how to respond if you agree or disagree, and when you may need to file a refund suit. To get help now, use TaxCure to search for an experienced tax professional in your local area.
What Are IRS Notices 105C and 106C?
The agency sends the following notices about disallowed credits:
- Notice 105C - The IRS has disallowed your ERC.
- Notice 106C - The IRS has disallowed part of your ERC.
To dispute either of these letters, you must contact the IRS within 30 days to explain why you should be able to keep the credit. The IRS will do an informal review, and if they still believe that you are not entitled to the credit, you will need to appeal with the Independent Office of Appeals.
If you do not get a favorable result from Appeals, the only option may be to bring a refund suit against the IRS in Court. You only have two years from the disallowance letter to file suit, and in fact, the IRS cannot issue an ERC refund after the two-year period. If Appeals is taking too long to process your case or issue your refund, you may need to file suit as well, as explained below.
Reasons the IRS Disallows ERC Claims
The IRS disallows ERC claims for a variety of reasons. If you want to keep your credit, you need to understand why it was disallowed, and then, you need to explain to the IRS why you're entitled to keep some or all of the credit.
The IRS can disallow any credit that is not claimed properly, but in particular, the agency is disallowing credits on returns that show the following red flags:
- Claiming the ERC in all available quarters - Although the ERC was available for multiple quarters, it's very doubtful that employers were likely to be eligible for every quarter the credit was offered. Even eligibility for a full quarter may be rare.
- Non-qualifying orders - Businesses that were not likely to be affected by government shutdown orders may see their credits disallowed. The IRS does not consider government recommendations about health and safety to be the same as government orders.
- Too many employees in 2019 - If you had 100 or more employees in 2019, there are restrictions on claiming the 2020 ERC, and if you had 500 or more employees in 2019, there are restrictions on claiming the ERC in 2021.
- Supply chain disruptions - Unfortunately, supply chain issues alone are not enough to qualify for the ERC. Your supplier must have been affected by a government order. If you noted supply change issues when you amended your return, you may receive a disallowance letter.
- Essential businesses without a decline in revenue - If your business was allowed to stay open because it was deemed essential, you do not qualify to claim the credit unless you have the required drop in revenue.
- Credit claimed on family member wages - You cannot claim the ERC on wages paid to the owner's spouse, child, grandchild, brother, sister, step-brother or sister, father, mother, grandfather, grandmother, step-parent, step-grandparent, niece, nephew, aunt, uncle, son-in-law, or daughter-in-law. You also cannot claim this credit on an employee who lives with the employer.
- Overlap between ERC wages and PPP wages - If you use a Paycheck Protection Program (PPP) loan to pay your wages, you cannot claim the ERC on the same wages.
- Incorrect calculations - The IRS is also disallowing partial or full credits based on incorrect calculations. However, if the error can be easily fixed, the IRS may just update your return and send you the newly calculated refund, rather than sending you a disallowance letter.
- Lack of wages or existence during the claim period - Some businesses claimed this credit for quarters before they were in existence or even before they received an Employer Identification Number (EIN).
Unfortunately, many ERC mills convinced business owners to claim this credit, even if they weren't eligible. Then, the mills took a significant portion of the credit as payment, and now, in the wake of that activity, many businesses are receiving disallowance letters.
Does a Disallowance Letter Mean I'm Not Eligible for the ERC?
A disallowance letter means that the IRS spotted high-risk factors on your return and decided to disallow the credit. However, that doesn't necessarily mean that you are not eligible.
Your return may have high-risk factors but still be valid. For example, perhaps the IRS flagged your return as suspicious because you claimed the ERC in four quarters. However, you have proof to back up the fact that you experienced a decline in revenue and/or suspended operations throughout that time. You also have documents that support your employees' eligibility for the program.
Remember, the IRS makes mistakes. The agency is also extremely overwhelmed with both legitimate and illegitimate ERC claims. In September 2023, the agency stopped processing new ERC claims, and in June 2024, it announced that it would resume processing the 1.4 million pending claims. However, the agency's leaders also stated that they would be sending disallowance letters to employers whose returns showed high-risk factors.
If you receive a disallowance letter and you believe that you are entitled to the credit, reach out to a tax pro or start the response process on your own as soon as possible.
How to Respond to IRS Notices 105-C and 106-C
If you agree with the IRS's full or partial disallowance of your penalty, you don't have to do anything. If you ignore the notice, the IRS will simply disallow your credit and not send you an ERC refund.
If you disagree, you must respond to the letter within 30 days. In your response, you will need to provide a written explanation of why you are entitled to the credit. For example, you may say that on x date, the government issued x orders, and then, outline exactly how those orders affected your ability to run your business as usual.
Then, you also need to include documents to support your claims. For instance, if you claimed the ERC based on a decline in revenue, you should send the IRS sales reports from the quarter(s) you claimed the credit and the reference quarter(s). You should also include payroll reports showing how much you paid employees and other documents substantiating employee eligibility.
Here are some of the most common supporting documents you may need when disputing an ERC disallowance:
- Sales reports and gross receipts comparisons.
- Proof of government shutdown orders.
- Written explanations of how the orders affected your business.
- A description of your usual operations.
- Payroll records.
- Other information about your employees such as details about if they receive the wages while working or while not in service and whether or not they are related to an owner.
When you send in the information, you should also note if you would like to request an appeal.
The Appeal Process for ERC Claim Disallowance
When you dispute an ERC disallowance, the IRS will review your response, and if they agree, they will send you Letter 916-C to let you know that you can keep some or all of the credit. If they need more info, they will send you Letter 3064-C.
If the IRS does not agree with your details and you have not requested to appeal, they will send you a notice alerting you that the disallowance remains in effect. At that point, you may still be able to appeal, but you should also be aware that you only have two years from the date of your original disallowance letter to file a refund suit in court.
In contrast, if the IRS doesn't agree with your response but you have requested an appeal, the agency will send your information to appeals. Then, the Independent Office of Appeals will review your case, and they may also contact you if you need additional information.
Appeals may make the following decisions:
- Allow the ERC in full.
- Allow part of the ERC.
- Disallow the full ERC.
If you disagree with Appeals' response, you can file a refund suit with the District Court in the jurisdiction where you live or operate your business or with the federal courts. However, as explained below, you may also need to file a refund suit if Appeals takes too long to process your case or the IRS hasn't issued your refund and it's getting close to the two-year deadline.
When to File a Refund Suit for ERC Claims
You have two years from the date on the disallowance letter to file a refund suit. Keep a close eye on this deadline because if you miss it, you will not be able to claim the ERC.
Consider filing a refund suit in the following situations:
- IRS Appeals has upheld your disallowed credit.
- IRS Appeals is still hearing your case but the two-year deadline is getting close.
- IRS Appeals has agreed with your claim, but the IRS has not issued the refund check yet, and the two-year deadline is getting close.
You can opt to extend the deadline by filing Form 907 (Agreement to Extend the Time to File Suit). If you take this route, send the form to the IRS before the deadline, and verify that they have received it.
If you decide to file suit, you can represent yourself, but when dealing with such a complicated tax issue, you should work with an experienced tax attorney. When talking with potential attorneys, ask if they have experience with refund suits, and keep in mind that this process is different than litigating an issue in Tax Court. Also, be aware that with the district courts, you may need to hire local representation.
What to Expect During the Refund Lawsuit
Your attorney will help you decide whether you should file suit in the U.S. District Court or the U.S. Court of Federal Claims. There are nuances to both options, and an experienced tax attorney can help you decide on the best approach for your situation.
When you file, the courts will serve a summons to the IRS. The IRS's legal counsel has 60 days to respond to the summons. During that time, they will review your tax returns and any correspondence you sent when you received the disallowance letter. They will also review your Appeals case if necessary.
At the same time, your attorney will be reviewing your case and putting together an argument to support your claim that you're entitled to the Employee Retention Credit. Whenever possible, your attorney will try to work out an agreement with the IRS's attorney before the case goes to court. However, if the IRS is not willing to see your side of the story, the case will move on, and there will be a formal discovery process where each side requests information from the other side.
The results of the refund lawsuit are final. You cannot appeal the court's decision. That's why it's critical to work with an experienced attorney. Your attorney can tell you if you have a legitimate case that you should pursue in court, and if so, they will fight to get you the best result possible.
Challenges and Considerations During the ERC Dispute Process
The IRS has pursued criminal charges against some ERC mills that promoted this credit and encouraged businesses to claim it erroneously, but the agency is unlikely to pursue criminal or civil fraud charges against most business owners. In fact, the agency has steered clear of the fraud verbiage in its most recent press releases about this credit.
You may need to appeal if you received a disallowance letter, but you should be aware that appealing does not stop the two-year time frame for requesting a refund. If you are in the midst of the Appeals process and the deadline passes, you will not be able to get your refund regardless of Appeals' decision.
FAQs
Does 105-C mean the IRS is auditing my payroll returns?
No, this letter means that the IRS has disallowed your ERC claim. If the IRS selects you for an ERC audit, they will send you notice 6612 or a similar audit notice.
Are there penalties for disallowed ERCs?
Generally, if you receive 105-C or 106-C, the IRS is just disallowing your credit but not assessing penalties. In contrast, if the IRS audits your return and then decides to disallow your credit, you may face audit penalties.
Will the IRS assess interest?
If your ERC claim was on an amended 941-X and the IRS disallows it before paying it, you will not incur any interest. However, if the IRS has already issued your refund and you fail an audit, then, you will owe interest on the portion of the credit that you're required to repay.
How do you withdraw an ERC claim?
You do not need to withdraw your ERC claim if you have received a disallowance letter. However, if you're worried that your claim was illegitimate and you have not received a disallowance letter, you can request a withdrawal. You may also request a withdrawal if you are currently under audit.
To qualify, you must have claimed the ERC on an amended payroll tax return, and you only want to remove the credit. If you want to remove part of the credit or if you made other changes to your amended return, you cannot use the withdrawal program.
You can also withdraw if the IRS has issued you a refund check but you haven't cashed it yet. In that case, write "void" on the check and send it back to the IRS with your withdrawal request.
What if I received the ERC erroneously?
If you have already received your ERC but believe that you claimed it erroneously, you may be able to participate in the Voluntary Disclosure Program (VDP). The IRS is accepting Voluntary Disclosures on ERCs from 2021 until November 22, 2024. To participate, you must reach out to the IRS voluntarily before they contact you, and you must repay 85% of the credit.
If you're dealing with 2020 ERCs or if the deadline for a 2021 VDP has already passed, reach out to a tax pro to get advice tailored to your situation.
Get Help From a Tax Attorney Today
The Employee Retention Credit had extremely complicated rules, and because it was a limited-time credit, not all tax pros are fully aware of the intricacies. If you have received a disallowance letter or an audit request, you should reach out to a tax attorney who is experienced with these credits in particular and with refund suits in general.
You may also want to reach out to a tax pro if you have claimed the credit but are worried that the claim wasn't legitimate. Use TaxCure to find a high-quality experienced pro in your area. Start your search below, and then, use the filters to narrow down the results to pros with relevant experience.
Sources:
https://www.irs.gov/coronavirus/employee-retention-credit-voluntary-disclosure-program
https://www.irs.gov/individuals/understanding-your-cp106-notice