In the Generic Legal Advice Memorandum (AM 2023-05),[1] the IRS scrutinized some of the questionable supply chain-based justifications for claiming the employee retention credit. The memorandum emphasizes the necessity of documenting the specific government orders that the employer relied upon, demonstrating how these orders created challenges for the supplier. Moreover, it highlights the employer's inability to procure critical and necessary supplies due to these issues and how such circumstances resulted in a qualifying suspension of the employer's own business. By clarifying these requirements, the IRS aims to ensure more accurate and substantiated claims for the employee retention credit.

The Supply Chain Question in Notice 2021-20

The IRS did offer a very specific scenario in which government orders placed on a supplier of a critical component for an employer could potentially qualify as a suspension of business for the purposes of claiming the employee retention credit. This information can be found in Question 12 of Notice 2021-20, which provides further guidance on how certain supply chain disruptions may lead to eligible qualifying suspensions for the credit.

Question 12: If a governmental order causes the suppliers to a business to suspend their operations, is the business considered to have a suspension of operations due to a governmental order?

Answer 12: An employer may be considered to have a full or partial suspension of operations due to a governmental order if, under the facts and circumstances, the business’s suppliers are unable to make deliveries of critical goods or materials due to a governmental order that causes the supplier to suspend its operations. If the facts and circumstances indicate that the business’s operations are fully or partially suspended as a result of the inability to obtain critical goods or materials from its suppliers because they were required to suspend operations, then the business would be considered an eligible employer for calendar quarters during which its operations are fully or partially suspended and may be eligible to receive the employee retention credit.

Example: Employer A operates an auto parts manufacturing business. Employer A’s supplier of raw materials is required to fully suspend its operations due to a governmental order. Employer A is unable to procure these raw materials from an alternate supplier. As a consequence of the suspension of Employer A’s supplier, Employer A is not able to perform its operations for a period of time. Under these facts and circumstances, Employer A would be considered an eligible employer during this period because its operations have been suspended due to the governmental order that suspended operations of its supplier.[2]

Employee retention credit (ERC) mills rapidly seized on this specific example provided by the IRS, interpreting it in a way that potentially broadened the applicability of the credit. They argued that the disruptions in supply chains, which were experienced by numerous businesses due to various factors unrelated to domestic government orders related to COVID-19, made the credit accessible to almost every U.S. business.

The Latest IRS Memorandum

The new memorandum presents five distinct scenarios where employers are asserting their eligibility for the employee retention tax credit, grounded in various supply chain issues they encountered. The memorandum commences with an in-depth analysis that examines how these supply chain challenges align with the statutory provisions of the COVID-19 related employee retention tax credits in their different forms. By delving into these scenarios and applying them to the relevant statutory provisions, the memorandum aims to offer clarity on the potential applicability of the employee retention tax credit for businesses navigating supply chain disruptions.

The memorandum initiates by acknowledging that the statute itself does not specifically address supply chain disruptions. Instead, the first instance of guidance addressing these issues was introduced in Notice 2021-20, particularly in Question 12. This question provided the initial framework for considering supply chain disruptions as a potential factor in determining eligibility for the employee retention tax credit.

The statutory language in section 2301(c)(2)(A)(ii)(I) of the CARES Act and section 3134(c)(2)(A)(ii)(I) of the Code does not include supply chain disruptions. Instead, section III.D., Q/A-12 of Notice 2021-20 provides a narrow, limited exception for employers that had to fully or partially suspend their business operations because the employers’ suppliers who provided critical goods or materials to the employer were fully or partially suspended during the calendar quarter due to orders from an appropriate governmental authority. This limited exception provides that “[a]n employer may be considered to have a full or partial suspension of operations due to a governmental order if, under the facts and circumstances, the business’s suppliers are unable to make deliveries of critical goods or materials due to a governmental order that causes the supplier to suspend its operations.”[3]

The analysis highlights that the presence of a supply chain disruption alone is insufficient to qualify for the employee retention tax credit. Instead, it underscores that the disruption must result in a full or partial suspension of the employer’s business to meet the eligibility criteria for the credit. A mere supply chain issue, without causing an actual suspension of the employer’s business operations, would not warrant qualification for the tax credit.

Section 2301(c)(2)(A)(ii)(I) of the CARES Act and section 3134(c)(2)(A)(ii)(I) of the Code require that the operation of the employer’s trade or business be fully or partially suspended due to orders from an appropriate governmental authority. A supply chain disruption, by itself, does not rise to the level of a full or partial suspension primarily because no governmental order applies to the employer’s operations. In addition, the goods or materials that are disrupted may not have had an impact on the employer’s operations that rises to the level of a full or partial suspension, or the employer may have been able to obtain the goods or materials from an alternate supplier.[4]

The analysis concludes by outlining the specific circumstances in which a supply chain disruption could potentially qualify an employer for the Employee Retention Credit (ERC). It emphasizes that these situations are rare and limited, and the supply chain disruption must directly lead to a full or partial suspension of the employer’s business operations. The memorandum aims to provide clarity on when a supply chain issue could be a viable factor for eligibility for the ERC but underscores that such cases are exceptional and must adhere to the specific requirements outlined in the statute and IRS guidelines.

The guidance provided by section III.D., Q/A-12 of Notice 2021-20 allows the employer to “step into the shoes” of its supplier for purposes of the suspension test. To meet the terms of this exception, as explained in Q/A-12, the supplier must have been subject to a governmental order that causes the supplier to suspend its operations. In addition to having a governmental order, the employer must substantiate its eligibility for the credit by providing records or documentation demonstrating 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. See Section III.N., Q&A 70 of Notice 2021-20; see also Treas. Reg. § 31.6001-1 and Treas. Reg. § 1.6001-1. If the facts and circumstances dictate that the employer’s operations are fully or partially suspended because of the governmental order suspending the supplier from providing the critical goods or materials, then the employer may be considered an eligible employer under the guidance provided by Q/A-12.[5]

To provide the necessary documentation and evidence to prove eligibility based on supply chain disruptions to defend an ERC claim, the employer must be able to present:

Specific government orders: Documentation that proves the existence of relevant government orders imposed on a supplier or business that affected the supply chain.
Issues caused for the supplier: Evidence illustrating how the government orders or other issues directly caused challenges for the supplier, forcing the supplier to suspend operations.
Inability to obtain critical supplies: Documentation indicating the employer’s inability to procure critical and necessary supplies due to the issues faced by the supplier.
Impact on the employer’s business: Clear documentation showcasing how these supply chain issues led to a full or partial suspension of the employer’s own business operations.[6]

The scenarios discussed in the memorandum clearly highlight the substantial amount of specific documentation that employers would need to gather to support each of the points required for claiming the Employee Retention Credit (ERC) based on supply chain disruptions. As the IRS places the burden of proof on the employer to demonstrate eligibility, obtaining detailed and specific documentation is crucial.

Employers seeking to claim the Employee Retention Credit (ERC) must be aware that a vague belief or a simple questionnaire notation regarding supply chain issues will not be sufficient to sustain the claim if examined by the IRS. The burden of proof lies with the employer, requiring them to provide significant and specific documentation that supports their eligibility for the credit. ERC mills that merely rely on superficial information without proper substantiation could put employers at risk of IRS scrutiny and potential disallowance of the credit. To ensure a successful claim, employers should diligently gather comprehensive documentation, including government orders, supplier communications, evidence of supply chain issues, and the impact on business operations, aligning with the statutory requirements and IRS guidelines.

Scenario 1 – Taxpayer Had Inventory of Supplies on Hand

The first scenario involves a taxpayer who had critical goods already on hand, enabling the employer to maintain operations despite supply chain disruptions.

Employer A was not subject to any governmental orders limiting commerce, travel, or group meetings due to COVID-19 at any time. However, during 2020 and 2021, Employer A experienced several delays in receiving critical goods from Supplier 1. At all times during 2020 and 2021, Employer A continued to operate because Employer A had a surplus of the critical goods normally provided by Supplier 1. Employer A assumed that Supplier 1’s delay in delivering critical goods was caused by COVID-19. Employer A inquired and Supplier 1 vaguely confirmed that the delay was due to COVID-19. Supplier 1 did not provide a governmental order from an appropriate governmental authority and Employer A was unable to locate one.[7]

Based on the provided information, this employer does not qualify for the Employee Retention Credit (ERC) because it fails to meet the necessary criteria. The employer could not produce a government order that applied to the supplier, which is an essential requirement for claiming the ERC based on supply chain disruptions. Furthermore, the employer never experienced a shortage of critical supplies at any point, making it ineligible for the credit, even if disruptions occurred in the supplier’s operations.

Employer A does not meet the definition of eligible employer provided under section III.D., Q/A-12 of Notice 2021-20 because Employer A cannot demonstrate that a governmental order applicable to Supplier 1 fully or partially suspended Supplier 1’s trade or business operations.

Even if Employer A received or could locate the governmental orders applicable to Supplier 1, Employer A did not have to cease operations because Employer A had a reserve of critical goods allowing Employer A to continue operations; thus, Employer A did not experience a full or partial suspension of operations due to an inability to obtain Supplier 1’s critical goods. The relevant inquiry is whether Employer A’s trade or business operations could continue; since Employer A was able to continue its own business operations despite the supply chain disruption, it was not subject to a full or partial suspension of operations.[8]

Scenario 2 – Critical Supplies Restricted Due to Bottleneck at Port, Multiple Causes and No Identified Government Order

In the second scenario, the taxpayer encountered trouble receiving supplies due to slowdowns at a port, which is a situation often highlighted by ERC mills. However, the specific cause of these slowdowns was not linked to any identified government orders.

Employer B was not subject to any governmental orders limiting commerce, travel, or group meetings due to COVID-19 at any time. However, certain critical goods from Supplier 2 were stuck at port in State X. Employer B assumed the bottleneck at the port was a result of COVID-19. Employer B could not identify any specific governmental order applicable to Supplier 2 or any specific governmental order that caused the bottleneck at the port. Some news sources stated that COVID-19 was the reason for the bottleneck, while others cited reasons such as increases in consumer spending and aging infrastructure. In addition, Supplier 2 mentioned to Employer B that other critical goods that were not stuck at port would be delayed due to a truck driver shortage. Employer B saw some discussion on social media that the truck driver shortage was because drivers were out sick due to COVID-19.[9]

In this second scenario, the employer lacks sufficient documentation to establish eligibility for the Employee Retention Credit (ERC). Since the employer cannot identify any government orders that applied to the port, and even if such orders were considered as the “COVID-19” link, there is no evidence to demonstrate that they were the true cause of the delays in receiving supplies. Furthermore, other issues identified may have contributed to the slowdowns, making it difficult to conclusively attribute the disruptions to qualifying government orders related to COVID-19.

Employer B does not meet the definition of an eligible employer under section III.D., Q/A-12 of Notice 2021-20 because Employer B cannot demonstrate that a governmental order applicable to Supplier 2 fully or partially suspended Supplier 2’s trade or business operations. In addition, while COVID-19 may have been a contributing factor to the bottleneck at the port or the truck driver shortage, Employer B could not substantiate that any specific governmental order caused a bottleneck at the port. Even if Employer B could identify governmental orders applicable to the bottleneck, Employer B must substantiate that the bottleneck and thus the suspension of Supplier 2 was due to the orders.[10]

Scenario 3 – Supply Disruptions Continued Past the End of the Identified Government Order

In the third scenario, the employer successfully identifies relevant governmental orders that initially contributed to the supply disruptions. However, even after those orders ceased to apply, the supply disruptions persisted, leading the employer to argue that these ongoing disruptions are sufficient to qualify them for the Employee Retention Credit (ERC).

Employer C and Supplier 3 are located in a jurisdiction that issued governmental orders suspending both of their business operations for the duration of April 2020. Employer C and Supplier 3’s jurisdiction lifted all orders related to COVID in May 2020. For the remainder of 2020 and 2021, Employer C experienced a delay in receiving critical goods from Supplier 3. Supplier 3 does not provide a reason for the delay, but Employer C assumes the delay is due to the governmental order in place in April 2020.[11]

In this case, the employer can only qualify for the Employee Retention Credit (ERC) during the period in which the identified government order is in effect. The ERC is applicable based on the actual time during which the governmental order caused supply disruptions, and it does not extend beyond the period of the order’s application.

In the third scenario, the employer does identify governmental orders, but after those orders ceased to apply the supply disruptions continued which the employer wishes to claim are sufficient to qualify the employer for the ERC. Employer C is an eligible employer in the second calendar quarter of 2020 because its business operations were fully or partially suspended due to a governmental order. However, only wages paid with respect to the period during which Employer C is fully or partially suspended due to a governmental order may be considered qualified wages. See section III.D., Q/A-22 of Notice 2021-20.

Employer C does not meet the definition of an eligible employer under section III.D., Q/A-12 of Notice 2021-20 for any subsequent calendar quarter in 2020 or 2021 because Employer C cannot demonstrate that a governmental order applicable to Supplier 3 fully or partially suspended Supplier 3’s trade or business operations. The residual delays caused by a governmental order in place during a prior calendar quarter will not constitute a governmental order in subsequent calendar quarters once the order has been lifted.[12]

Scenario 4 – Alternate Supplier of Goods Available at a Higher Cost

In this scenario, the employer had to resort to using a different supplier due to the regular supplier's inability to provide the necessary materials, resulting in a 35% higher cost. As a consequence, the business became less profitable than it would have been under normal circumstances.

Employer D was not subject to any governmental orders limiting commerce, travel, or group meetings due to COVID-19 at any time. During 2020 and 2021, Employer D could not obtain critical goods from Supplier 4. However, Employer D was able to obtain the goods from an alternate supplier. The critical goods from the alternate supplier cost 35% more than those from Supplier 4. Employer D could continue to operate its trade or business even though it was not as profitable as in 2019.[13]

Given the employer’s ability to continue operating the business exactly as before, despite experiencing reduced profits due to the supply chain disruptions, there was no full or partial suspension of the employer’s business.

Employer D does not meet the definition of an eligible employer under section III.D., Q/A-12 of Notice 2021-20 because Employer D could continue to operate its trade or business. Employer D was not prevented from operating its trade or business at any point during 2020 or 2021. Incurring a higher cost for critical goods does not result in a full or partial suspension of operations.[14]

Scenario 5 – A Limited Number of Products Unavailable

In the final case, a retailer that typically carries a wide range of products faced supply chain disruptions that resulted in the inability to stock a limited number of products. As a result, the retailer encountered challenges in maintaining a complete inventory of certain items due to the supply chain issues. But the inventory it did maintain was more than enough to maintain normal operations.

Employer E operates a large retail business selling a wide variety of products. Employer E was not subject to any governmental orders limiting commerce, travel, or group meetings due to COVID-19 in 2021. Due to various supply chain disruptions, Employer E was not able to stock a limited number of products and was forced to raise prices on other products that were in limited supply. However, at no time did the product shortage prevent Employer E from continuing to fully operate as a retail business during 2021.[15]

The impact on the retailer’s business was considered too limited to qualify as a partial suspension, despite facing challenges in stocking a limited number of products due to supply chain disruptions. The inability to stock a few items did not result in a significant enough disruption to meet the criteria for partial suspension of the business operations required to claim the Employee Retention Credit (ERC).

Employer E does not meet the definition of an eligible employer under section III.D., Q/A-12 of Notice 2021-20 during calendar year 2021 because Employer E cannot demonstrate that a governmental order applicable to a supplier of critical goods or materials caused the supplier to suspend operations and that Employer E was unable to obtain critical goods and materials causing a full or partial suspension of Employer E’s business operations. At all points during 2021, Employer E was able to operate its retail business. While a limited number of products were not available, Employer E was still able to offer a wide variety of products to its customers and Employer E was not forced to partially suspend operations.[16]

This is “Only” the IRS’s View – But That is an Important One

The memorandum represents the view of the IRS, and it is essential to acknowledge that their interpretation of the law can change over time or in response to new information or developments. However, it is equally crucial not to underestimate the significance of such IRS guidance.

The memorandum presents a comprehensive legal analysis of the application of the law to the specific scenarios at hand. It offers valuable insights into the IRS’s current position and serves as a significant reference point for taxpayers and tax professionals alike. Anyone seeking to challenge the IRS’s holdings would indeed need to undertake their own thorough analysis of the law and identify potential weaknesses or flaws in the IRS’s analysis.

From a practical standpoint, it is crucial for clients who are being counseled to take positions contrary to the guidance in this memorandum or have already filed claims for refund based on such positions to be advised of its existence and its potential impact.

Clients need to be aware that the IRS’s position outlined in the memorandum is likely to be followed if their claims for the Employee Retention Credit (ERC) are examined. If the IRS challenges their claims based on supply chain disruptions, there is a high risk that the client may need to go to court to contest the IRS’s position and attempt to overcome the impact of the memorandum on their case.

The IRS’s position in this memorandum appears to align with what could be the original Congressional intent for the provision related to the Employee Retention Credit (ERC) and its eligibility criteria concerning supply chain disruptions.

Prevailing in court against the IRS’s position, after incurring significant legal expenses, is indeed far from assured. Challenging the IRS’s interpretation and prevailing in court can be a complex and costly process, and the outcome is uncertain. It is essential for taxpayers and their representatives to carefully assess the potential risks and benefits of challenging the IRS’s position in court.

Given the alignment of the IRS’s view with the potential Congressional intent, prevailing against the IRS’s position would require a robust and well-supported legal argument to demonstrate the validity of the taxpayer’s claim for the ERC based on supply chain disruptions. Engaging in such legal battles should be carefully considered, taking into account the potential costs, uncertainties, and risks involved.

[1] Generic Legal Advice Memorandum AM 2023-05, July 21, 2023, https://www.irs.gov/pub/lanoa/am-2023-005.pdf (retrieved July 21, 2023)

[2] Notice 2021-20, March 1, 2021, https://www.taxnotes.com/research/federal/irs-guidance/notices/irs-issues-q%26a-guidance-on-employee-retention-credit/38wlw?highlight=2021-20 (retrieved July 21, 2023)

[3] Generic Legal Advice Memorandum AM 2023-05, July 21, 2023

[4] Generic Legal Advice Memorandum AM 2023-05, July 21, 2023

[5] Generic Legal Advice Memorandum AM 2023-05, July 21, 2023

[6] Generic Legal Advice Memorandum AM 2023-05, July 21, 2023

[7] Generic Legal Advice Memorandum AM 2023-05, July 21, 2023

[8] Generic Legal Advice Memorandum AM 2023-05, July 21, 2023

[9] Generic Legal Advice Memorandum AM 2023-05, July 21, 2023

[10] Generic Legal Advice Memorandum AM 2023-05, July 21, 2023

[11] Generic Legal Advice Memorandum AM 2023-05, July 21, 2023

[12] Generic Legal Advice Memorandum AM 2023-05, July 21, 2023

[13] Generic Legal Advice Memorandum AM 2023-05, July 21, 2023

[14] Generic Legal Advice Memorandum AM 2023-05, July 21, 2023

[15] Generic Legal Advice Memorandum AM 2023-05, July 21, 2023

[16] Generic Legal Advice Memorandum AM 2023-05, July 21, 2023