May 15, 2023
Employers may be subject to government refund suits for employee retention credits even after the normal three-year statute of limitations expires
While the general three-year statute of limitations on assessment will expire on April 15, 2024, for 2020 employee retention credit claims (and April 15, 2025, for 2021 claims), the IRS has an additional two years from issuance of any refund to seek its repayment in court, even if the general three-year statute of limitations has expired.
Employee retention credit
The employee retention credit is a refundable federal employment tax credit that was first enacted as part of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) in 2020 and was repeatedly modified and extended. Under current law, the credit is available for qualified wages paid by eligible employers between March 13, 2020, and September 30, 2021.
Many employers claimed and continue to claim the credit by amending Forms 941, Employer's QUARTERLY Federal Tax Return, and requesting refunds. While many of those refund claims already have been paid, others are still pending. The backlog not only results from the high volume of refund claims and COVID-related processing disruptions but also IRS concerns about the legitimacy of many of the refund claims.1 Indeed, aggressive promotion of the employee retention credit was at the top of the IRS's "Dirty Dozen" list of tax scams for 2023.
Statute of limitations
General statute of limitations for FICA taxes and federal income tax withholding
Most tax practitioners are familiar with the general three-year statute of limitations under IRC Section 6501, which applies to the assessment of tax by the IRS. The same three-year period generally applies to FICA taxes (composed of Social Security, Medicare and Additional Medicare taxes) and federal income tax withholding, which are generally reported on a Form 941, subject to a special rule under IRC Section 6501(b)(2) and IRC Section 6513(c) for when the three-year period begins. Under that special rule, for any Form 941 filed by April 15 of the following calendar year, the three-year statute of limitations begins on April 15. For example, the statute of limitations for all four Forms 941 filed for 2020 generally would expire on April 15, 2024, and the statute of limitations for all four Forms 941 filed for 2021 generally would expire on April 15, 2025.
Five-year statute of limitations for the third quarter of 2021 and related "Greenbook" proposal
A special five-year statute of limitations applies to IRS assessments for the third quarter of 2021. This single-quarter anomaly arose from the manner in which the employee retention credit evolved over time. As originally enacted under the CARES Act, the credit would have expired at the end of 2020. The Taxpayer Certainty and Disaster Tax Relief Act of 2020, however, significantly enhanced and extended the credit through the first half of 2021. The American Rescue Plan Act of 2021 modified the credit further and extended it through the end of 2021. It also extended the statute of limitations for IRS assessments to five years for employee retention credit claims for the second half of 2021. The Infrastructure Investment and Jobs Act, however, retroactively repealed the credit as of the end of the third quarter of 2021. The five-year statute of limitations on assessment for the third quarter of 2021, much like the retroactive repeal of the credit for the fourth quarter of 2021, could reflect growing skepticism of the legitimacy of employee retention credits in the second half of 2021.
The Treasury Department's 2024 "Greenbook" (officially, "General Explanations of the Administration's Fiscal Year 2024 Revenue Proposals"), which was published on March 9, 2023, includes a proposal to apply the five-year statute of limitations on employee retention credit tax assessments to all the quarters for which the credit was available. The rationale for this proposal includes the following explanation:
[T]he majority of dollars of ERTC claims were made on amended returns, often with a substantial delay relative to the quarter of the underlying activity that generated the credit. As the current-law three-year limitations period applicable to … the CARES Act ERTC does not restart when an amended return is filed, a three-year assessment period makes it difficult for the IRS to audit the amended returns and timely assess any tax, if warranted.
It is presently unclear whether this proposal will be enacted. In the meantime, the anomalous five-year statute of limitations (which, recall, applies only to tax assessments by the IRS and not to refund claims by taxpayers) applies only for the third quarter of 2021.
Civil action for recovery of erroneous refunds
Despite all the attention the employee retention credit has received, there has been very little discussion of IRC Section 7405(b), which allows the government to bring a civil action to recover any portion of a tax imposed by the Internal Revenue Code that was erroneously refunded. To prevail in an action under IRC Section 7405(b), the government must prove that (1) a refund was made to a taxpayer, (2) the refund was erroneously issued, and (3) the lawsuit to recover the erroneously issued refund was timely filed.2 Such actions are broadly used to recoup refunds that were "erroneously" issued. This error might, for example, be a clerical error, or alternatively, an error as to the taxpayer's legal entitlement to the refund.3 Under IRC Sections 7405(d) and 6532(b), the statute of limitations for bringing such an action is generally two years from the making of the refund but extends to five years for fraud or misrepresentation of a material fact. (Similarly, a taxpayer can bring a refund suit under IRC Section 6532(a), beginning six months from the date of filing a refund claim and ending two years from the IRS's disallowance of the claim.)
It is too early to tell whether or to what extent the government will use its IRC Section 7405(b) authority in the context of employee retention credit claims. Until the statute of limitations expires under IRC Section 7405(d) and IRC Section 6532(b), employers should be aware that the government may use the erroneous refund provisions to seek repayment of employee retention credits the IRS has paid them, even if the general three-year statute of limitations on assessment has expired for the Forms 941 to which the credits relate. The following chart summarizes the statutes of limitations under current law, assuming there has been no fraud or misrepresentation of any material facts:
The fact that the IRS pays an employer's claim for the employee retention credit does not mean that the IRS agrees the employer is actually entitled to it. Only after the relevant statutes of limitations have expired can the employer take comfort in knowing that its refund claim will not be challenged by the government. This lingering uncertainty presents challenges with respect to income tax returns on which IRC Section 280C disallows an amount equal to the dollar amount of the credit from the taxpayer's compensation deduction for the same tax year. Depending on when the employee retention credit refund is received, taxpayers may want to consider filing a protective claim for income tax refund to allow the IRC Section 280C disallowance to be reversed in the event the refund is later recouped as erroneous. Finally, there may be implications for an employer's internal financial planning as well as its external financial statement reporting.
Published by NTD’s Tax Technical Knowledge Services group; Andrea Ben-Yosef, legal editor
1 In an April 27, 2023, hearing before the House Ways & Means Committee, in response to questions concerning employee retention credit refund claims, IRS Commissioner Daniel Werfel testified: "One of the reasons why there's a backlog is that we do get a lot of fraudulent or ineligible applications that clog the system. And, so, we're working to try to ferret those out as effectively as we can."
2 U.S. v. Brokemond, 304 Fed. Appx. 765 (11th Cir. 2008).
3 See, e.g., O'Gilvie v. U.S., 117 S. Ct. 452 (1996).