While the One Big Beautiful Bill Act made headlines for tax and spending cuts, it also contains significant changes to the federal government’s treatment of COVID era Employee Retention Tax Credit (ERC) claims — many of which are still pending with the IRS.
Taxpayers and ERC advisers need to understand these changes, and how they could impact pending claims and potential liability.
Congress designed the ERC to encourage businesses to retain employees during the COVID-19 pandemic. The CARES Act allowed certain employers to receive a tax credit for the first quarter of 2020 through the second quarter of 2021. The American Rescue Plan (ARPA), passed in March 2021, extended the ERC (with certain restrictions) through the fourth quarter of 2021. The ERC’s complexity, combined with widespread marketing by promoters, created a backlog of questionable claims that the IRS is still struggling to review. As of August 2024, the IRS had disallowed 28,000 claims with an estimated worth of approximately $5 billion and launched thousands of audits and hundreds of criminal investigations. However, according to the National Taxpayer Advocate, the IRS still had 597,000 unprocessed claims in its inventory as of April 2025, although it was unclear whether that number included claims submitted after January 31, 2024.
Section 70605 of the OBBBA addresses the ERC and gives the IRS additional tools and time to review ERC claims for the third and fourth quarters of 2021. For these two quarters, the OBBBA:
- Retroactively bars all ERC refund claims filed after January 31, 2024.
- Extends the time for the IRS to make tax assessments for six years after the claim date.
- Includes new penalties for ERC promoters who prepared claims without due diligence.
These provisions do not apply to ERC claims for 2020 or the first and second quarter of 2021, which the CARES Act, not the ARPA, authorized.
New ERC Provisions
Statutory Bar for Third and Fourth Quarter 2021 ERC Claims Filed After January 31, 2024
The OBBBA retroactively bars ERC claims for the third and fourth quarter of 2021 that were filed after January 31, 2024. This means that the IRS will automatically deny those claims if they are still pending and, potentially, institute audits or erroneous refund claim procedures for any ERC claims filed after January 31, 2024 that it already paid. Taxpayers with otherwise valid ERC claims might consider challenging the retroactive application of the January 31, 2024 deadline as violating constitutional due process principles. However, they face a high burden in bringing such a challenge because courts have upheld retroactive tax laws so long as the retroactive effect is justified by “a rational legislative purpose.” United States v. Carlton, 512 U.S. 26, 31 (1994).
Extension of Statute of Limitations for ERC Claims for the Third and Fourth Quarters of 2021
The OBBBA extends the statute of limitations for the IRS to review and make assessments with respect to ERC claims for the third and fourth quarters of 2021. Specifically, it extends the statute of limitations for the IRS to make assessments for any ERC claims related to the third and fourth quarters of 2021 to the later of 6 years (rather than 5 years under prior law) from the date the original Form 941 return was filed or treated as filed or the date on which the claim for credit or refund was made, most likely on a Form 941-X. This means that the IRS can audit pending ERC claims as late as January 31, 2030, for claims filed on the January 31, 2024, deadline. Again, this provision only applies to ERC claims for the third and fourth quarters of 2021.
Corresponding Extension of the Statute of Limitations to Claim Income Tax Refunds Resulting from ERC Denials
The OBBBA also addresses the income tax implications of ERC claim disallowances. Employee wages that form the basis of an ERC claim are ordinarily not deductible as business expenses on an employer’s income tax return because a taxpayer cannot deduct expenses if they have a right or reasonable expectation of repayment. Thus, taxpayers were required to reduce their wage expense on their income tax return by the amount of ERC claimed. As a result, under prior law, if the IRS denied an employer’s ERC claim, the employer may be in a worse position than if it had never claimed the credit in the first place because the time to claim a refund of the income taxes on account of the now increased amount of deductible wages might have expired. The OBBBA resolves this issue by extending the time for employers to seek an income tax refund to account for the increased wage expense deduction, notwithstanding the ordinary limitations period for refund claims in Internal Revenue Code section 6511.
New Promoter Penalty for Failure to Comply with Due Diligence Requirements
The OBBBA imposes a new $1,000 penalty against “any COVID-ERTC promoter” who assists with ERC refund claims for the third and fourth quarters of 2021 and fails to comply with the due diligence requirements imposed by the IRS. The penalty applies to each due diligence failure — one ERC claim theoretically could have multiple due diligence failures and a promoter may have hundreds or even thousands of ERC claims each with multiple failures. The OBBBA also defines a “COVID-ERTC promoter” to mean persons (including promoter firms) for whom ERC related fees make up at least 20% to 50% of their taxable income with the exact percentage based on the amount of the promoter’s taxable income and whether they charged fees based on the value of their clients’ ERC claims.
The OBBBA doesn’t specify what due diligence standards promoters must follow. Instead, it provides that the due diligence requirements must be “similar” to those imposed under Internal Revenue Code section 6695(g) and directs the IRS to issue regulations. Section 6695(g) imposes a penalty on preparers who fail to comply with the due diligence requirements with respect to certain other credits including the Earned Income Tax Credit. Treasury Regulation section 1.6695-2 generally requires tax preparers to complete a due diligence worksheet to be filed with the return, not rely on information that the preparer knows or has reason to know is incorrect, and to retain records related to the credits, including any information provided by the taxpayer.
Since taxpayers have already filed all ERC claims, it is unclear what due diligence requirements the IRS seeks to impose on promoters retroactively – especially when due diligence worksheets were almost certainly not filed with most ERC claims since no such requirement previously existed. At a minimum, promoters who assisted with ERC claims, and those that continue to assist with third and fourth quarter 2021 claims, should ensure that they are retaining appropriate records and performing due diligence.
Expansion of Penalty for Erroneous Refund Claims to Employment Tax Credits
The OBBBA extends the 20% penalty for erroneous refund claims under Internal Revenue Code section 6676 to claims for refunds of employment taxes like ERC claims. Previously this provision only applied to income taxes, but the large number of questionable ERC claims likely motivated Congress to expand the penalty going forward.
While this provision applies to refund claims after the date of enactment of the OBBBA and will therefore not apply to pending ERC claims, employers should be aware that this penalty applies to claims for refunds of employment taxes. That includes the research and development credit, the work opportunity credit and other employment tax credits enacted in the future.
Conclusion
The ERC landscape has been marked by uncertainty, delays, and administrative challenges from the outset. The changes enacted by the OBBBA shift that terrain again, giving the IRS more time to address pending claims and additional authority to assess penalties. Staying abreast of the IRS regulations and guidance that will implement these changes will be critical for taxpayers with unprocessed claims and for COVID-ERTC promoters.
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