There have been a lot of questions this year about the Employee Retention Credit (ERC), specifically about IRS audits related to the ERC. The ERC is a refundable tax credit for certain eligible businesses and tax-exempt organizations that had employees and were affected during the COVID-19 pandemic. With this credit came a large number of improper ERC claims and the IRS significantly increased its enforcement of the claims. As a result, thousands of businesses are receiving audit notices and disallowance letters. Receiving a disallowance letter does not necessarily mean the matter is over, but businesses need to understand what and how they should respond.
An ERC disallowance letter is the official IRS notice denying all or part of an ERC claim. The primary notices are Letter 105-C (full denial) and Letter 106-C (partial denial), which states the specific reasons for rejection, appeal rights, and the two-year legal deadline to challenge the decision. If you receive a disallowance letter, the first thing to do is not panic and to realize you may still have options and appeal rights.
There are many reasons why the ERC claim may be disallowed, one of them being insufficient documentation such as missing payroll records. Eligibility issues are another reason for disallowance. These could be issues related to incorrect calculation of qualified wages or there was no suspension of operations. Another reason may be promoter-related problems. These could be boilerplate eligibility analyses or providing inadequate supporting files.
Regardless of why your business received the disallowance letter, the letter itself will include the reason, tax periods involved, your response deadline, and appeal rights. As with any IRS audit notice, make sure to gather all appropriate documents, including payroll records, quarterly tax returns, and gross receipt calculations. You may also need to gather government orders affecting operations, internal records documenting business disruptions, ERC calculation worksheets, and any correspondence with ERC consultants or preparers.
If you request an appeal, your explanation and documents will be reviewed before being sent to the IRS Independent Office of Appeals. The next step depends on whether it is agreed that your explanation and documents support a change to the disallowance. If the IRS agrees that your response supports a change to the amount of ERC you’re allowed, your claim will be processed without sending the case to Appeals.
If the IRS believes your response does not support the ERC you claimed, they will forward your case to Appeals for their office to decide if the disallowance is correct. The IRS will send Letter 86-C to let you know your case has moved to Appeals and they will independently decide if the IRS should allow your claim in whole or in part, or if the disallowance is proper.
The ERC credit is complicated and receiving a disallowance letter is not uncommon. While the disallowance letter is serious, remember that it is not always the final word. Businesses that respond quickly, understand their rights, provide strong documentation, and work with an experienced tax attorney or professional often have better outcomes.
Allison Soares is a partner and tax attorney at Vanst Law LLP. It doesn’t matter the issue: audits, collections, appeals, international disclosures, grumpy people— Allison enjoys fixing problems. In addition to her legal work, she has worked in accounting and utilizes that knowledge to her advantage while handling cases involving EDD audits from San Francisco to San Diego.
