With the deadline for filing Forms 941-X, Adjusted Employer’s QUARTERLY Federal Tax Return of Claim for Refund, to claim the Employee Retention Credit (“ERC”) for calendar quarters in 2020 looming just a few months away, new rumblings from Congress hint at a potential early end for the ERC. At the same time, questions continue to arise among practitioners about how to evaluate whether an employer’s operations were “fully or partially suspended during the calendar quarter due to orders from an appropriate governmental authority…”
For employers whose eligibility for the ERC is not yet fully determined, or for those who have received the ERC but are concerned about a potential reversal of the credit that could lock in a negative income tax consequence, a protective claim may provide the ability to navigate these issues that could arise.
The “protective claim” is a judicially created opportunity for a taxpayer to effectively hold open a statute of limitations period (that would otherwise lapse) with respect to a specifically identified issue on the relevant tax return.
In general, section 6402(a) of the Internal Revenue Code (the “Code”) provides the rule for the treatment of overpayments of tax. The IRS may credit the amount of any overpayment, including interest, against any tax liability of the person who made the overpayment within the applicable limitations period. Any balance over the amount of any tax liability is generally refunded to the taxpayer.
For the purpose of overpayments of tax, the applicable limitations period under Code section 6511(a) is three years from the time the return was filed, or two years from the time the tax was paid, whichever is later. If the taxpayer did not file a return to which the overpayment is related, the applicable limitations period is two years from the time the tax was paid.
In the event of an overpayment, the taxpayer must file a claim for a refund within the limitations period. If the taxpayer is not able to perfect a claim for a refund prior to the expiration of the limitations period, the taxpayer may be able to file a protective claim prior to the expiration of the statute of limitations in order to preserve the ability to claim the refund.
The Supreme Court first articulated the concept of a protective claim in its decision in US v. Kales, 62 S.Ct. 214 (1941).
In Kales, the taxpayer sold shares of stock that she owned, reported the gain on the sale and paid tax on the amount of the gain reported. Several years later the Commissioner assessed a deficiency, stating that the taxpayer had essentially overstated the basis in the stock on the tax return that reported the sale. The taxpayer paid the additional assessment but also filed a protest to contest the assessment. In that protest, the taxpayer stated that if the IRS or a court changed the determination of the value of her stock at some point in the future, she would then argue that the Commissioner’s valuation was flawed and would seek recovery of the excess tax she paid on the sale.
The valuation of her stock was subsequently upset by the IRS decision, and she accordingly fought the assessment and won. After winning her lawsuit, the taxpayer filed a claim for a refund.
The Supreme Court concluded that her statement in the protest document related to her intention to claim a refund in the event of a certain contingency was a valid information claim for a refund.
Subsequent courts have required that a valid protective claim meet four “requirements” based on the opinion in Kales:
In general, the claim must be contingent on future events, such as an expected change in tax law, other legislation, or expected regulations or case law that would affect the taxpayer’s ability to claim the refund.
Although the protective claim concept is judicially created, courts have looked to the regulations that relate to refund claims generally to provide the basis for a protective claim. The regulations at Treas. Reg. section 301.6402-2 provides that any claim for refund must state in detail each ground upon which a credit or refund is claimed and must provide facts sufficient to apprise the Commissioner of the exact basis of the claim for refund. The taxpayer must also verify in writing, under penalties of perjury, the grounds for the claim and the facts supporting the claim.
Protective claims are required to be based on a specific issue or basis for a potential refund; it isn’t enough that unclear rules lead to multiple potential conclusions. In general, there must be an identifiable “contingency” that can be described to a sufficient level of certainty.
One example of this in the payroll tax context arose in 2014 when the Supreme Court agreed to review the Sixth Circuit decision in U.S. v. Quality Stores.1 The Sixth Circuit’s decision held that severance payments paid to terminated employees did not constitute wages, and thus were not subject to FICA tax withholding.
Following the Sixth Circuit’s decision, taxpayers who had withheld FICA tax from prior severance payments began filing refund claims with the IRS.2 The IRS initially declined refund requests, as well as appeals of such denials, for taxpayers residing outside of the Sixth Circuit. Ultimately, the IRS suspended action on all claims, including those from taxpayers within the Sixth Circuit, until the outcome of the Supreme Court case was known.
In early 2014, taxpayers were faced with an interesting situation – the Supreme Court was not expected to issue its decision in Quality Stores before April 15, 2014.3 The date represented the end of the limitations period for filing amended payroll tax returns (Forms 941-X) for quarters during the 2010 year. If the Supreme Court ultimately agreed with the Sixth Circuit, employers would have been entitled to seek a refund of prior FICA taxes paid. However, if this ability did not arise until after the end of the limitations period, then employers would have been time-barred from seeking such refunds.
Because of this, numerous advisors published articles, blogs, and other resources encouraging employers to consider filing protective claims for refund of FICA taxes paid.4
A protective claim needs to clearly identify and describe a contingency, the resolution of which will guide the IRS determination on whether the employer is eligible to claim the credit. However, if a protective claim for a refund does not initially state the contingent issue with sufficient specificity, the claim can nonetheless be remedied with a later filing. The Supreme Court held in Kales that:
a notice fairly advising the Commissioner of the nature of the taxpayer's claim, which the Commissioner could reject because too general or because it does not comply with formal requirements of the statute and regulations, will nevertheless be treated as a claim where formal defects and lack of specificity have been remedied by amendment filed after the lapse of the statutory period.
So, if a taxpayer files a protective claim for a refund that is “based on the uncompleted transactions or events,” the taxpayer still “may in a later amendment articulate the precise theory upon which his claim is based.” See Cooper v. U.S., 81 AFTR 2d 98-1372, (DC-NC 1998).
Protective Claims Related to the Employee Retention Credit
An employer might consider filing a protective claim in two distinct situations related to the ERC; first, an employer may wish to file an amended Form 941-X to claim the credit prior to the expiration of the time for filing, although at the time of filing the employer’s theory of eligibility is not certain. This would generally occur when the employer reasonably expects that events occurring after the deadline for filing will solidify the employer’s eligibility.
Second, an employer who has already claimed the credit and received its refund may consider a protective claim related to the amended income tax return that it files to conform with the requirements of Code section 280C.
Claiming the ERC
In general, employers can determine whether they are eligible to claim the ERC based on existing laws and guidance issued by the IRS. The rules originally established by the CARES Act, which were modified through Congressional action and ultimately codified in section 3134, provide three methods for qualifying as an “Eligible Employer” for the purpose of the ERC.
In general, eligibility based on a significant decline in gross receipts or as a recovery start-up business presents very few controversial interpretive issues. However, the determination of whether an employer experienced a full or partial suspension of business operations involves interpretation of concepts that are not clear from the application of the rules, as well as subsequent IRS interpretive guidance.
There are several “open” issues that arise based both on IRS guidance, as well as tax practitioner/commentator analysis, that could be the basis of a protective claim for the ERC.
Plain Meaning Analysis of Suspension of Business Operations
As various commentators have pointed out, the CARES Act legislative language, IRS guidance, and IRS statements have at times used different language to discuss ERC qualification based on a full or partial suspension of business operations.5 Specifically, the IRS has sought to define certain statutory terms and standards in sub-regulatory guidance that, in some cases, presents a more restrictive view of the statutory language. As an example, the statutory phrase “partially suspended” has been defined by the IRS in Q/A-17 of Notice 2021-20 as requiring the closure of “more than a nominal portion” of business operations, or a “more than nominal effect” on such business operations. In either case, the imposition of a 10% “threshold” for qualifying as partially suspended is potentially more restrictive than the plain meaning of the statutory language.
Eligibility Because of Supply Chain Suspension
In Notice 2021-20, Q/A-12, the IRS provides guidance on when the suspension of an employer’s supplier’s operations will give rise to a deemed suspension of the employer’s operations. Notably, the language of the Notice requires that the supplier’s operations be suspended by a governmental order in order for the employer to claim that its operations were suspended. The IRS outlined additional restrictions on supply chain-based eligibility in Generic Legal Advice Memorandum (“GLAM”) 2023-005, which was released on July 21, 2023. The GLAM outlined 5 examples of potential supply chain suspensions, and in each case concluded that the facts would not establish a full or partial suspension for the employer based on the suspension or disruption of its supply chain.
Determination of What is an Order
The CARES Act legislative language, which continues in Code section 3134(c)(2)(A)(ii)(I), provides for eligibility when an employer’s operations are suspended “due to orders from an appropriate governmental authority limiting commerce, travel, or group meetings (for commercial, social, religious, or other purposes) …” In Notice 2021-20, Q/A-10, the IRS defines what constitutes an “order” for the purpose of the ERC. Beyond the Notice, the IRS has taken the position in other contexts that certain pronouncements by federal agencies, including orders from the Centers for Disease Control (“CDC”), do not meet the definition of “orders from an appropriate governmental authority” for the purpose of the ERC.
Further, the IRS outlined is position in GLAM 2023-007, issued on November 3, 2023, that Occupational Safety and Health Administration (“OSHA”) communications are generally not considered “orders” for the purpose of the ERC. The IRS analysis related to OSHA guidance is more nuanced, with the IRS acknowledging that an employer who violates OSHA’s existing standards may be subject to a governmental order to the extent that OSHA issues a citation and order to the employer related to such violation. Beyond that, the IRS's position is that OSHA communications and guidance are not “orders” because they do not place mandatory obligations upon employers.
Protective Claim vs. Disclosed Position
In each of the three areas described above, the potential disagreement with the IRS's position on these interpretive issues would be sufficient to support a protective claim under certain circumstances. However, an employer might also consider simply filing a timely Form 941-X claiming the credit, accompanied by a disclosure statement explaining the interpretive issues.
Example Language for Explanation of Protective Claim on Line 43 of the Form 941-X
This return is being filed as a protective claim for a refund. This return is intended to amend the originally filed Form 941 to reflect the Employee Retention Credit and the Qualified Wages used to calculate this credit, consistent with section 2301 of the CARES Act, as amended by sections 206 and 207 of the Taxpayer Certainty and Disaster Relief Act, and Internal Revenue Code section 3134, enacted as part of the American Rescue Plan Act and amended by the Infrastructure Investment and Jobs Act. As of the date of this filing, the Employer has not completed its determination of whether it was an eligible employer that paid qualified wages during the ____ quarter of 202_. The Employer is filing this Form 941-X as a protective claim to ensure that this claim, once perfected by the filing of a subsequent Form 941-X, will be treated as timely filed for the tax year 202_.
Amending Employer’s Income Tax Returns
When an employer claims the benefits of the ERC and receives the credit funds, the taxpayer has received a payroll tax credit that is determined based on the payment of qualified wages to employees. The IRS stated in Notice 2021-20 that the principles of Code section 280C apply to require the employer to amend its income tax return for the periods during which the credit was claimed. Such an amendment will, in effect, reduce the wage expense that the employer claims as a deductible expense, with the result that the employer’s net income for the year in question will increase by the amount of the credit.
The employer will thus amend its federal (and in some cases state) income tax return in order to reduce the wage expense by the amount of the credit received. In general, the income tax return for 2020 must be amended by April 15, 2024; to put this another way, further amendments to the 2020 income tax return will be time-barred after April 15, 2024. Similarly, changes to the 2021 federal income tax return will be barred after April 15, 2025.
In the event an employer amends its income tax return for either 2020 or 2021, the position taken on the amended return (the wage expense reduction) will be “irrevocable” after April 15, 2024, and April 15, 2025, respective deadlines.
Although the employer’s obligation to file the amended income tax return arises upon its receipt of the ERC refund, the IRS can still review the payment of the refund and ultimately disallow the ERC on audit. In that event, the employer will experience the “whipsaw” of losing the ERC but also losing the wage expense that would have been taken if the employer had not initially received the ERC.
Because of this uncertainty, an employer should consider filing a protective claim for income tax refund to essentially reverse the wage expense disallowance under Code section 280C in the event that the IRS later disallows and recoups the refund.
Example Language for Explanation of Protective Claim on Part II of Form 1140-X
This return is being filed as a protective claim for a refund. This return reflects the change to the amount of the Total deductions shown in Part I, Line 2, above. The Taxpayer previously filed a Form 1120-X, Amended U.S. Corporation Income Tax Return, on [DATE], reflecting a reduction in the amount of the deduction for Salaries and Wages taken on Line 13 of the originally filed Form 1120, U.S. Corporation Income Tax Return. The Form 1120-X filed on [DATE] reflected the adjustment required under section 280C of the Internal Revenue Code that arose as a result of the Taxpayer claiming the Employee Retention Credit for the tax periods [PERIODS].
In the event that the IRS disallows any claim for the Employee Retention Credit reflected in the Forms 941-X filed for [PERIODS], the Taxpayer will file an amended Form 1120-X to reinstate the full deduction for Salaries and Wages taken on Line 13 of the originally filed Form 1120.