Employee Retention Credit (ERC): OBBBA Disallowance, Audit Defense, and Practitioner Guide

The Employee Retention Credit (ERC) was one of the largest COVID-19 relief programs in U.S. history. It was also one of the most aggressively promoted by third-party firms that filed claims for employers with little or no eligibility analysis. The IRS received millions of ERC claims, identified widespread fraud and ineligibility, and has since suspended routine processing, issued hundreds of thousands of disallowance letters, and referred hundreds of cases to Criminal Investigation. The One Big Beautiful Bill Act (OBBBA), enacted in 2025, materially changed the legal landscape by extending the audit statute of limitations, disallowing a class of late-filed claims by statute, and expanding penalties against promoters.

This guide is written for enrolled agents, CPAs, and tax attorneys who have clients with existing ERC claims. It covers the statutory background, OBBBA changes, eligibility criteria for defensibility review, the IRS enforcement environment, the Voluntary Disclosure Program, promoter and practitioner liability, and a practical checklist for conducting a client file review. All statutory citations, procedural details, and regulatory guidance must be verified at IRS.gov before being relied on in any specific client matter. This guide does not constitute legal or tax advice.

IRS Fact Sheet FS-2025-07 (issued October 2025) provides current IRS guidance on ERC claim review and ineligibility factors. Practitioners should treat FS-2025-07 and the current IRS.gov ERC guidance page as the authoritative sources for IRS positions referenced throughout this guide.

Section 1: ERC Background and Credit Period

The Employee Retention Credit was enacted as part of the Coronavirus Aid, Relief, and Economic Security (CARES) Act. For the 2020 tax year, the statutory basis is IRC 2301 (CARES Act). For 2021, the credit was extended and significantly modified by subsequent legislation, including the Consolidated Appropriations Act, 2021 and the American Rescue Plan Act of 2021; the primary statutory basis for the 2021 ERC is IRC 3134.

The credit rewarded eligible employers who retained employees on their payrolls during periods of COVID-19-related disruption. Eligible employers claimed the credit against their share of Social Security taxes on Form 941, the Employer's Quarterly Federal Tax Return, or filed amended Forms 941-X to claim the credit retroactively after the original return had been filed.

Credit Period by Quarter

The ERC credit period ran from Q2 2020 through Q3 2021 for most eligible employers. Q4 2021 was available only to Recovery Startup Businesses, a distinct eligibility category with its own qualification requirements (hedge specifics to IRS.gov and IRC 3134). The credit period is now fully closed. No new qualifying periods exist, and the current practitioner issue is reviewing and defending claims that have already been filed.

The Scale of the Problem

The IRS received millions of ERC claims, a significant portion of which were filed by promoter firms charging contingency fees. Many of those promoters applied eligibility criteria incorrectly, relied on legal theories the IRS has since rejected (most notably the supply chain disruption theory applied without a primary government order suspension), or filed claims for employers with no supportable basis for eligibility at all. The result is a large population of employers who received ERC proceeds for claims that may not withstand audit scrutiny. Practitioners who advised on or prepared original ERC claims, and practitioners who are now engaged by clients who received those claims from promoters, are on the front line of resolving this problem.

Section 2: OBBBA ERC Provisions (Section 70605)

The One Big Beautiful Bill Act, enacted in 2025, included significant ERC-specific provisions in Section 70605. This is recently enacted legislation that is subject to ongoing regulatory interpretation. Verify all OBBBA ERC provisions and any implementing IRS guidance at IRS.gov before advising clients.

Extended Audit Statute of Limitations

OBBBA Section 70605 extended the IRS's authority to audit ERC claims to 6 years from the later of the original filing date or the due date of the Form 941 for the quarter in which the ERC was claimed. Under the standard rule in IRC 6501, the IRS generally has 3 years to assess tax. The OBBBA 6-year period is a substantial extension that significantly expands the window during which clients who claimed ERC remain exposed to examination.

The precise mechanics of how the 6-year OBBBA period interacts with the standard 3-year SOL rules (including whether the extension applies only to the ERC portion of the return, how it applies to Form 941-X amended returns, and how it is calculated for quarters with different original filing dates) should be verified at IRS.gov and under the current text of IRC 6501, as amended by OBBBA. Do not advise clients that their ERC claims are beyond audit reach based on the standard 3-year period without confirming whether the OBBBA extension applies.

Statutory Disallowance of Q3 and Q4 2021 Claims Filed After January 31, 2024

OBBBA Section 70605 disallows ERC claims for Q3 2021 and Q4 2021 wages if those claims were filed after January 31, 2024. This is a statutory disallowance, not a discretionary penalty. Claims filed after that date for those quarters are denied regardless of whether the employer would otherwise have qualified. The IRS does not have discretion to allow a Q3 or Q4 2021 claim filed after January 31, 2024 under this provision.

Practitioners whose clients filed Q3 or Q4 2021 ERC claims after January 31, 2024 should advise those clients that the claims are disallowed by statute, explain the implication for any pending refund requests or credits already received, and review the VDP at IRS.gov for potential resolution options. Confirm at IRS.gov whether any case-specific exceptions exist under the current implementing guidance.

Expanded Promoter Penalties Under IRC 6700 and IRC 6701

OBBBA expanded the application of IRC 6700, which imposes penalties on promoters of abusive tax shelters, to cover ERC promoters. OBBBA also expanded IRC 6701, which penalizes aiding in the understatement of tax liability, to reach ERC promoter conduct. The specific penalty amounts, the definitions of covered conduct, and the procedural rules applicable to these expanded penalties are set forth in the OBBBA and in IRS.gov guidance. Hedge all specific penalty figures and conduct definitions to those sources.

Section 3: Who Is Affected -- Conducting the File Review

The first step in the practitioner response to the OBBBA environment is identifying which clients have ERC exposure. This is a broader population than it may initially appear, because many clients received ERC through promoter-prepared amended returns without their primary tax practitioner's involvement.

Clients Who Are Affected

• Employers who claimed ERC on an original Form 941 for any quarter from Q2 2020 through Q3 2021 (or Q4 2021 for Recovery Startup Businesses).
• Employers who filed Form 941-X to claim ERC retroactively after the original return was filed for those quarters.
• Employers who received ERC proceeds in the form of a refund check from the IRS or a credit applied against payroll taxes due, whether they received those proceeds directly or through a promoter arrangement.
• Employers who have a pending ERC claim that has not yet been processed by the IRS (given the IRS's processing pause on many ERC claims).

What Practitioners Should Review

For each affected client, the file review should address:

• The eligibility analysis used at the time of filing: Which test did the claim rely on -- the government order test or the gross receipts test? Was the analysis documented? Was it prepared by the practitioner or by a third-party promoter?
• The supporting documentation retained: Are copies of the relevant government orders, gross receipts records, payroll documentation, and credit calculation workpapers available?
• Whether the claim was prepared by a promoter: If a third-party promoter prepared and filed the claim on a contingency fee basis, the practitioner should treat the eligibility analysis as unverified until independently reviewed.
• Whether the claim was for Q3 or Q4 2021 and filed after January 31, 2024: If so, the claim is disallowed by OBBBA statute regardless of other factors.

Red Flags for Ineligible Claims

The following indicators suggest a claim may not survive audit scrutiny:

• No operational suspension: The employer had no significant interruption to its operations during the claimed period. The business continued substantially as normal throughout the COVID-19 period.
• Gross receipts decline below the applicable threshold: The employer's gross receipts did not decline by the percentage required for the specific quarter claimed. The applicable thresholds vary by quarter and year; verify the correct threshold for each claimed quarter at IRS.gov. Do not rely on a uniform percentage applied across all quarters.
• Wages paid to majority owners' family members: The IRS has issued guidance disqualifying wages paid to majority owners and their family members from ERC eligibility in certain circumstances. Verify the specific IRS position at IRS.gov and FS-2025-07.
• Supply chain disruption theory without a primary government order: The claim relied solely on supply chain disruptions as the basis for a government order suspension, without identifying a specific qualifying government order that directly suspended the employer's operations. The IRS has largely rejected this theory when used in isolation. See FS-2025-07 and current IRS.gov guidance.

Section 4: ERC Eligibility Criteria -- Defensibility Review

Since the credit period is closed, the eligibility criteria are now most relevant for evaluating whether an existing claim is defensible in audit. The two primary eligibility tests are described below. All percentage thresholds, employer size definitions, and quarterly calculation mechanics should be verified at IRS.gov and under FS-2025-07 for each specific quarter.

Test 1: Government Order Test

Under the government order test, an employer's operations must have been fully or partially suspended by a qualifying government order related to COVID-19. For a claim to be defensible under this test, the practitioner's file review should confirm:

• A qualifying order existed: The order was issued by a federal, state, or local government authority with the requisite jurisdiction.
• The order was COVID-19 related: The order must have been issued in response to the COVID-19 pandemic, not as a result of unrelated regulatory activity.
• The order suspended operations: The order must have caused a full or partial suspension of the employer's operations. A partial suspension must be more than nominal; a government recommendation (as opposed to a mandatory order) generally does not qualify. Hedge the "more than nominal" standard and what constitutes a qualifying partial suspension to IRS.gov and FS-2025-07.
• Documentation is retained: Copies of the specific orders relied upon, the dates they were in effect, and a written analysis tying each order to specific operational suspensions at this employer's business.

Test 2: Gross Receipts Test

Under the gross receipts test, an employer qualifies for ERC in a quarter if gross receipts in that quarter declined by a significant percentage compared to the corresponding quarter in 2019. The applicable percentage threshold varies by quarter and year. This guide does not state specific percentage thresholds because the thresholds differ between 2020 and 2021 quarters, and stating a single figure risks applying the wrong threshold to a claim. Verify the exact threshold for each specific quarter at IRS.gov before conducting any eligibility review or advising a client.

For defensibility, the file review should confirm that quarterly gross receipts records for both the claim quarter and the corresponding 2019 quarter are retained and that the percentage decline was calculated correctly using gross receipts as defined under applicable IRS guidance.

Qualified Wages

The definition of qualified wages, and the maximum credit per employee, varied between 2020 and 2021, and the wages eligible for the credit also depended on employer size. Large employers (above a threshold headcount, which varied by year -- hedge to IRS.gov) could only claim the credit for wages paid to employees who were not providing services during the suspension or decline period. Small employers could claim the credit for all qualified wages, including wages paid to employees who continued working. Verify the large/small employer thresholds applicable to each specific quarter at IRS.gov.

Wages used to support PPP loan forgiveness cannot also be claimed for ERC. This no-double-counting rule applies to wages claimed on the same Form 941 or 941-X; review client records to confirm there was no overlap between PPP forgiveness wage calculations and ERC wage claims.

Recovery Startup Businesses (Q4 2021 Only)

Recovery Startup Businesses had access to the ERC in Q4 2021 under a separate category with distinct qualification requirements (generally, employers who began operations after February 15, 2020 and had gross receipts below a specified annual threshold). Hedge all Recovery Startup Business criteria, including the gross receipts limit and the startup date requirement, to IRC 3134 and IRS.gov. For Q4 2021 claims, confirm the employer in fact met the Recovery Startup Business criteria if that was the basis for the claim.

Section 5: IRS Enforcement, CP320B Notices, and Audit Response

The IRS ERC enforcement program represents one of the largest coordinated tax compliance campaigns in recent history. Practitioners must understand both the administrative disallowance process and the criminal referral risk when advising clients on how to respond.

The CP320B Notice

CP320B is the IRS correspondence notice issued when an ERC claim is under examination or has been disallowed. The notice will state the specific quarter and amount at issue, the basis for the IRS's position, and the deadline for the employer's response. Response deadlines are typically 30 to 60 days from the notice date, but practitioners must confirm the exact deadline stated on the specific notice received. Missing the response deadline may forfeit the right to provide documentation or protest the disallowance.

Response Options on Receipt of CP320B

• Agree with the disallowance: If a review of the underlying eligibility analysis confirms the claim was not supportable, the employer may agree with the IRS's position. In this situation, evaluate whether the employer should repay any amounts received, whether the VDP provides a more favorable resolution path, and whether there are penalty abatement arguments available.
• Submit a protest letter with supporting documentation: If the eligibility analysis is solid and the documentation supports the claim, prepare a written protest within the notice deadline. The protest should identify the specific quarter, the eligibility test relied upon, and attach all supporting documentation. See also our IRS audit reconsideration practitioner guide for context on structuring protest submissions and responding to examination findings.
• Request IRS Appeals: If the practitioner's protest is denied at the examination level, the employer generally has the right to request independent review by the IRS Independent Office of Appeals. For the Appeals process and how to invoke statutory rights related to IRS collection actions that may follow a disallowance, see our Collection Due Process (CDP) hearing practitioner guide. Hedge current Appeals procedures and the specific right to conference for ERC cases to current IRS.gov guidance, as procedures may differ from standard deficiency Appeals.

IRS ERC Review Program

The IRS paused routine processing of many ERC claims beginning in 2023 due to concerns about fraud and ineligibility. The IRS has since issued disallowance letters based on risk-scoring factors and is conducting targeted audits of claims it has identified as high-risk. FS-2025-07, issued October 2025, describes the IRS's current approach to ERC claim review and identifies the categories of claims the IRS considers ineligible. Practitioners should review FS-2025-07 in full when assessing any client's ERC exposure.

Criminal Investigation Risk

IRS Criminal Investigation has hundreds of open criminal investigations related to ERC fraud. The primary targets include employers who submitted claims with fabricated employee counts, fictitious payroll records, promoter networks that mass-filed claims for ineligible employers, and cases involving large dollar amounts with no legitimate factual basis for eligibility. Clients whose claims were prepared by third-party promoters and who received very large ERC refunds without a documented, supportable eligibility analysis have the highest criminal exposure risk. If a client's situation presents indicators of intentional fraud (not just an eligibility mistake), practitioners should consider referring the client to qualified criminal defense counsel before any substantive response is made to the IRS.

Section 6: The ERC Voluntary Disclosure Program

The IRS previously offered an ERC Voluntary Disclosure Program (VDP) designed to allow employers who received ERC for ineligible claims to come forward, repay the amounts received, and resolve their exposure with reduced penalties compared to what an audit would produce. The VDP has been an evolving program; terms, eligibility criteria, and availability have changed since the program was first introduced.

Who May Benefit from the VDP

Employers who may benefit from the VDP include those who received ERC for claims that do not meet the applicable eligibility tests upon review, and who prefer to resolve their exposure proactively rather than waiting for an IRS audit or disallowance notice. The VDP is generally designed for situations where the employer did not intentionally commit fraud; employers whose situations present indicators of intentional fraud should seek criminal defense counsel before considering VDP enrollment.

For clients with Q3 or Q4 2021 claims filed after January 31, 2024 (which are statutorily disallowed under OBBBA Section 70605), the VDP is one of the primary resolution paths to review, but its applicability and any special terms for OBBBA-disallowed claims should be confirmed at IRS.gov.

VDP Interaction with OBBBA

OBBBA's enactment may have affected VDP availability, terms, or procedures. The post-OBBBA VDP status and the interaction between the statutory Q3/Q4 2021 disallowance and the VDP framework should be verified at IRS.gov before any VDP guidance is given to a client.

Section 7: Promoter and Practitioner Liability

One of the most important distinctions in the post-OBBBA ERC environment is between practitioners who provided competent, documented eligibility analysis and promoters who mass-filed claims without any individualized eligibility review. This distinction is not just a matter of professional ethics; it has direct legal consequences for penalty exposure.

IRC 6700: Promoter Penalties

IRC 6700 imposes penalties on persons who organize or participate in the sale of abusive tax shelters, including by making or furnishing a statement about allowability of a tax benefit that the person knows or has reason to know is false or fraudulent. OBBBA expanded IRC 6700 to cover ERC promoters. The specific penalty amounts and the definitions of covered promoter conduct under the OBBBA expansion should be verified at IRS.gov and in the current OBBBA text. The IRS has been active in identifying and pursuing IRC 6700 penalties against ERC promoters, including pursuing injunctions against firms that continued to market ineligible ERC claims.

IRC 6701: Aiding in Understatement

IRC 6701 penalizes any person who aids, assists, procures, or advises with respect to the preparation or presentation of a document (including a tax return or claim for refund) knowing that it will be used in connection with a material matter arising under the Internal Revenue Code, if the document will result in an understatement of another person's tax liability. OBBBA expanded IRC 6701 to ERC-related conduct. Hedge specific amounts and definitions to IRS.gov.

The Practitioner Distinction

Authorized practitioners who conducted a thorough, documented eligibility analysis and provided advice in good faith are not in the same legal position as promoters who mass-filed claims without individualized review. The key distinction is whether the practitioner conducted a real eligibility analysis for the specific employer, documented that analysis, and retained the supporting documentation. A practitioner who can produce:

• A written eligibility analysis identifying which test was relied on and why it was satisfied for this employer;
• Copies of the specific government orders relied upon (for government order test claims), or quarterly gross receipts records showing the applicable percentage decline (for gross receipts test claims);
• Payroll records and the qualified wages calculation for each quarter claimed;
• Documentation of the employer size determination and the PPP non-overlap analysis;

is in a materially stronger position than one who prepared ERC claims based on representations from the client or a promoter without independent verification.

Disclosure Requirements for Promoter Arrangements

If a client's ERC claim was filed through a promoter arrangement that may constitute a reportable transaction or a listed transaction, IRC 6111 and IRC 6112 disclosure obligations may apply. Hedge the applicability of these disclosure rules to current IRS.gov guidance and the specific facts of the arrangement. Not all ERC promoter arrangements trigger IRC 6111/6112 disclosure, but practitioners should evaluate whether disclosure was required and, if so, whether it was made.

Practitioner Self-Protection

The central protective measure for practitioners in the post-OBBBA environment is documentation. Maintain complete records of the eligibility analysis prepared for each client who claimed ERC, including:

• Copies of government orders relied upon and a written analysis of how each order affected this employer's specific operations;
• Gross receipts records showing the applicable quarterly comparison;
• Payroll records and qualified wages documentation;
• The employer size determination and any supporting headcount records;
• Written confirmation that wages claimed for ERC were not also used for PPP loan forgiveness.

Section 8: Practitioner Checklist for ERC File Review

Use this checklist as a structured starting point for reviewing ERC files for every client who claimed the credit. Adapt the steps to the specific facts of each client's situation.

Step 1: Identify All Clients Who Claimed ERC

• Search client records for any Form 941 or Form 941-X that claimed the Employee Retention Credit for Q2 2020 through Q4 2021.
• Include clients who may have used a promoter to file ERC claims separately from their primary tax practitioner.
• For each client, note the quarters claimed, the amounts, and whether the IRS has issued any notices or correspondence regarding those claims.

Step 2: Address Q3 and Q4 2021 Claims Filed After January 31, 2024

• Identify any Q3 2021 or Q4 2021 claims filed after January 31, 2024.
• Advise those clients that these claims are disallowed by statute under OBBBA Section 70605, regardless of underlying eligibility.
• Review current IRS.gov guidance on the VDP and any other resolution options for statutorily disallowed claims.
• If the client has already received a refund for a Q3 or Q4 2021 claim filed after January 31, 2024, address the repayment and penalty implications with the client immediately.

Step 3: Review the Eligibility Analysis for All Other Claims

• Identify the eligibility test relied on for each quarter claimed (government order test or gross receipts test).
• For the government order test: confirm which specific orders were relied on, that the orders were in effect during the claimed period, and that documentation of the operational suspension is retained.
• For the gross receipts test: confirm the correct comparison quarters and the applicable percentage threshold for each specific quarter (verify at IRS.gov -- thresholds vary by quarter and year).
• Confirm the qualified wages calculation, the employer size determination, and the PPP non-overlap analysis.
• If the claim was prepared by a third-party promoter, treat the eligibility analysis as unverified and conduct an independent review of each element.

Step 4: Respond to IRS Notices and Audits

• Upon receipt of a CP320B or other ERC examination or disallowance notice, immediately calendar the response deadline stated on the notice.
• Gather all eligibility documentation: government orders, gross receipts records, payroll documentation, credit calculation workpapers.
• Prepare a written protest if the claim was eligible and documentation supports the position. Structure the protest around the specific quarter, the specific eligibility test, and the specific documentation. Reference our IRS audit reconsideration guide for protest structure and submission logistics.
• Request Appeals if the protest is denied at the examination level. Track all response deadlines independently; do not rely on IRS confirmations of receipt to establish that the deadline has been met.

Step 5: Evaluate Resolution Options for Ineligible Claims

• If the eligibility review reveals a claim that was not supportable, evaluate the VDP as a potential resolution option. Verify current VDP availability and terms at IRS.gov before any recommendation is made.
• Advise the client of the audit risk under the extended 6-year OBBBA SOL.
• Consider whether penalty abatement options (reasonable cause, first-time penalty abatement) apply to the client's situation.
• If the client has a large ERC repayment obligation that they cannot satisfy, note that bankruptcy may be considered but that employment taxes (including the employer's share of payroll taxes that underlie some ERC adjustments) are generally priority debts under 11 U.S.C. 507(a)(8) and are not dischargeable in bankruptcy under IRC 523 in certain circumstances. See our bankruptcy and tax debt practitioner guide for the non-dischargeability rules. Consult bankruptcy counsel for case-specific analysis before advising any client that a tax debt related to ERC recapture can be discharged.

Step 6: Document the Review in the Client File

• Create a written record of the file review conducted for each client, including the eligibility analysis reviewed, the documentation confirmed, the conclusions reached, and the advice given.
• Retain all supporting documentation (government orders, gross receipts records, payroll records, credit calculation workpapers) for the duration of the OBBBA 6-year SOL period and beyond.
• If the eligibility analysis was prepared by a third-party promoter and the claim appears ineligible, document that conclusion and the basis for it, and retain that documentation as part of the practitioner's own file.

Frequently Asked Questions

The following questions address the most common practitioner issues in the post-OBBBA ERC environment. All answers should be verified against current IRS.gov guidance and the current OBBBA text before being relied on in any specific client matter.