Even though the COVID-19 pandemic is now largely in the past, many business owners continue to grapple with the challenges it created—particularly with respect to the government’s response to the crisis. Among the most significant of these responses was the Employee Retention Credit (ERC), a critical lifeline offered to many businesses that were forced to totally or partially suspend operations in response to the pandemic and responsive government orders. However, the ERC qualification rules were often complex and subject to varying interpretations, and the program itself was plagued with administrative delays, a massive backlog of claims, and widespread concerns about fraud, leading to an Internal Revenue Service (IRS) moratorium on processing new claims. Years later, as the IRS navigates its enforcement efforts, courts continue to interpret the nuanced qualification requirements for a successful ERC claim. Last month, a federal court denied the government’s motion to dismiss an employer’s ERC refund suit, potentially handing a significant procedural victory to employers who are still awaiting these crucial refunds. For businesses struggling to prove they experienced a qualifying partial suspension due to government orders during COVID-19, this ruling is worth a close and careful examination.
The Genesis and Evolution of the Employee Retention Credit
The Employee Retention Credit (ERC) was initially established as part of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, signed into law on March 27, 2020. Its primary objective was to incentivize employers to keep employees on their payrolls during the unprecedented economic disruptions caused by the COVID-19 pandemic. The program offered a refundable tax credit against certain employment taxes for eligible employers.
Initially, for 2020, the credit amounted to 50% of qualified wages, up to $10,000 per employee per year, meaning a maximum credit of $5,000 per employee. Eligibility was broadly defined for employers who either experienced a full or partial suspension of operations due to a government order limiting commerce, travel, or group meetings, or experienced a significant decline in gross receipts (a 50% drop compared to the same calendar quarter in 2019).
The program underwent significant modifications and expansions through subsequent legislation. The Consolidated Appropriations Act, 2021, enacted in December 2020, extended the ERC through June 30, 2021, and enhanced the credit for the first two quarters of 2021. For these quarters, the credit increased to 70% of qualified wages, up to $10,000 per employee per quarter, raising the potential maximum credit to $7,000 per employee per quarter, or $14,000 for the first half of 2021. The significant decline in gross receipts threshold was also lowered to a 20% reduction compared to the same quarter in 2019 (or the immediately preceding quarter). The American Rescue Plan Act (ARPA), enacted in March 2021, further extended the ERC through December 31, 2021, maintaining the enhanced 70% credit and $10,000 per quarter wage limit for the third and fourth quarters of 2021, although a later Infrastructure Investment and Jobs Act retroactively ended the credit for most employers on September 30, 2021.
Despite its vital role, the ERC program was characterized by considerable complexity. The IRS issued extensive guidance through notices (e.g., Notice 2021-20, Notice 2021-49) and FAQs, but interpreting the rules, especially those pertaining to "partial suspension" due to government orders, remained a significant challenge for many businesses and their advisors. This complexity, combined with the substantial financial incentive, unfortunately also led to a surge in aggressive marketing by third-party promoters, often making misleading claims and encouraging ineligible businesses to apply. This widespread abuse ultimately prompted the IRS to declare a moratorium on processing new ERC claims in September 2023, citing concerns about fraudulent applications and a desire to protect taxpayers from scams. At the time of the moratorium, the IRS had a backlog of hundreds of thousands of claims, some dating back years, and estimated that a significant portion of claims might be ineligible.
Tri-State Memorial Hospital v. United States: The Crux of the Legal Challenge
The recent federal court decision emerged from the case of Tri-State Memorial Hospital v. United States, a lawsuit filed by an employer seeking an ERC refund that had been pending with the government for an extended period. The central legal question in this case revolved around whether the plaintiff, Tri-State Memorial Hospital, had been forced to partially suspend its operations due to a government order, a prerequisite for claiming the ERC.
The hospital’s claim stemmed from operational disruptions experienced during the first three quarters of 2021. They contended that a Washington state order, which imposed specific COVID-related restrictions on healthcare facilities, directly necessitated a partial suspension of their services. The hospital detailed multiple factors supporting their claim:
- Cancellation of Non-Urgent Procedures: A significant volume of elective surgeries and non-urgent medical procedures had to be postponed or canceled to preserve capacity for COVID-19 patients and to comply with public health directives.
- Repurposing of Facilities: Portions of the hospital were reconfigured or dedicated solely to COVID-19 patient care, diverting resources from their usual functions.
- Implementation of Isolation Procedures: Strict isolation protocols for COVID-19 patients required extensive changes to patient flow, staffing assignments, and the use of personal protective equipment (PPE), impacting efficiency and capacity.
- Reduced Capacity: Overall patient capacity was effectively reduced due to social distancing requirements, isolation needs, and staffing constraints.
- Diversion of Staff: Medical personnel were redirected from their regular duties to perform COVID-19 vaccinations, testing, and manage specific COVID-19 protocols, straining existing resources.
Based on these disruptions, Tri-State Memorial Hospital calculated that its revenue was $4.6 million less than anticipated, directly attributable to the impacts of the government order. Consequently, they filed for an ERC refund. After the government failed to process their refund claim for 16 months—an unacceptably long delay for many businesses struggling with cash flow—the hospital took legal action, filing suit against the United States. In response, the government filed a motion to dismiss the case, arguing that the hospital’s claims did not meet the legal standard for an ERC refund.
Government’s Arguments: A Narrow Interpretation
The government’s motion to dismiss was predicated on a strict interpretation of the ERC qualification rules, particularly concerning the concepts of "partial suspension" and "causation." Their arguments aimed to significantly narrow the scope of eligibility, making it more challenging for employers to qualify.
First, the government contended that the term "partial suspension" should be interpreted narrowly. They argued that for a business to qualify, the suspension had to amount to the closure of a significant portion of the business. Furthermore, they asserted that the disruptions experienced must extend beyond the basic economic disturbances felt by virtually every business during the COVID era. This argument implied that general slowdowns or difficulties, without a clear and substantial shutdown of a distinct part of operations, would not meet the "partial suspension" criterion. The IRS, in its previous guidance (Notice 2021-20), had mentioned a "more than nominal" standard, suggesting that if 10% or more of a business’s operations were suspended, it could qualify. However, the government’s argument in this case appeared to push for a higher, more stringent threshold than merely "more than nominal."
Second, the government vigorously argued against the causation link presented by the hospital. They claimed that the disruptions the plaintiff experienced were not "due to" a government order. Instead, they posited that it was the COVID virus itself, with its inherent health risks and societal impact, that caused the disruption. Essentially, the government argued for a more stringent "proximate causation" standard, meaning that the government order had to be the direct, immediate, and sole cause of the disruption for the employer to qualify under the ERC. This interpretation would exclude situations where the virus’s presence led to government orders, which then led to operational changes.
The Court’s Decision: A Broader View of Eligibility
The federal court, in its ruling on the motion to dismiss, sided with the plaintiffs on both critical questions, allowing their case to proceed. This decision represents a significant setback for the government’s attempts to narrow ERC eligibility and provides crucial interpretive clarity for employers.
On the issue of "partial suspension," the court rejected the government’s narrow interpretation. It ruled that, based on the plain meaning of the term, a partial suspension constitutes a temporary delay, interruption, or termination of an employer’s business. While the court agreed that the suspension had to be "more than nominal," it critically clarified the application of this standard. The court acknowledged that the IRS had previously suggested a 10% standard for satisfying the "more-than-nominal" threshold in Notice 2021-20. However, the court explicitly found that this 10% threshold is not a bright-line test, meaning it is not the sole or definitive metric. Instead, the court determined that the 10% threshold is merely one way to prove that the disruption was more than nominal. This ruling suggests that other forms of evidence demonstrating a significant, albeit not necessarily 10%, impact on operations could also satisfy the "more than nominal" requirement. This flexibility is vital for businesses whose operational changes might not neatly fit a percentage calculation but undeniably represented a substantial disruption.
With respect to the element of causation, the court also found in favor of the plaintiffs, determining that a "but for" standard should apply. This interpretation, relying on established Supreme Court precedent, means that the employer did not have to prove that the government order was the sole or primary cause of the partial suspension. Instead, the employer only needed to demonstrate that the partial suspension would not have occurred but for the government order. This is a significantly lower bar than the government’s proposed "proximate causation" standard. Crucially, the court also rejected the government’s argument that it was the virus, not the government order, that caused the disruption. The court accepted the plaintiff’s assertion that they implemented the protocols and experienced the disruptions because of the government’s order, not merely because of the presence of the virus itself. This distinction is paramount, as many businesses altered operations in response to mandates that were themselves a reaction to the pandemic.
Broader Implications and Future Outlook
The Tri-State Memorial Hospital ruling carries substantial implications for the ongoing landscape of ERC claims and litigation, offering a potential beacon of hope for thousands of businesses.
Firstly, it provides much-needed clarity on the interpretation of "partial suspension." The decision unequivocally states that employers are not required to show that a significant portion of their business was shut down entirely to qualify as a partial suspension for ERC purposes. An ERC claim may legitimately be based on a temporary disruption or interruption of a more-than-nominal part of the business, provided it was a direct consequence of a government order. This interpretation could open the door for many businesses, particularly those in healthcare, retail, and hospitality, that adapted their operations rather than completely closing, to successfully pursue their claims. These businesses often faced capacity restrictions, mandated operational changes, or supply chain disruptions directly tied to government mandates.
Secondly, the adoption of the "but for" causation standard significantly eases the burden of proof for employers. By rejecting the government’s more stringent "proximate causation" argument, the court acknowledges the complex interplay between the pandemic, government mandates, and business operations. This broader causation standard recognizes that many operational changes were a direct, compelled response to orders, even if the underlying reason for those orders was the virus itself. This is a critical distinction that could benefit a wide array of employers who struggled to meet a higher causation bar.
The ruling comes at a time when the IRS is heavily focused on combating ERC fraud and addressing a massive backlog of claims. While the IRS has initiated a voluntary disclosure program and a withdrawal process for questionable claims, it has also maintained a strict stance on eligibility criteria. This judicial decision, however, represents a pushback against potentially overly restrictive interpretations by the agency. It could influence future IRS guidance or, if appealed and upheld, set a significant precedent for other federal courts hearing similar ERC cases. It may also embolden more employers to file lawsuits if their legitimate refund claims are denied or delayed based on interpretations that this court has now rejected.
It is crucial, however, to contextualize this victory. The Tri-State ruling was a decision resolving a motion to dismiss—not a final judgment on the merits of the case. When ruling on a motion to dismiss, the court accepts well-pleaded allegations as true and interprets facts as favorably to the plaintiffs as reasonably possible. This means the hospital has cleared a significant procedural hurdle, allowing its case to move forward to discovery and potentially a trial. Now, the plaintiffs in this case will be tasked with returning to court and proving their case with concrete evidence, demonstrating the factual basis for their claimed partial suspension and its causal link to the government order. The government, for its part, still has avenues for appeal or to vigorously defend the case on its facts.
Nonetheless, this ruling sends a clear signal to both the IRS and the business community. For employers with pending ERC claims, especially those grappling with "partial suspension" criteria, this decision offers renewed hope and a stronger legal footing. It underscores the importance of a detailed, fact-based approach to documenting how government orders specifically impacted business operations. Given the billions of dollars in potential refunds still held by the IRS, and the ongoing legal and administrative complexities of the ERC program, businesses are well-advised to consult with qualified tax and legal professionals to assess their eligibility and navigate this evolving landscape. The Tri-State Memorial Hospital decision marks a pivotal moment, affirming that the judiciary will ensure a fair and reasonable interpretation of the critical relief measures enacted during one of the most challenging periods in recent economic history.
