Court Denies Construction Firm Over $1 Million in Pandemic Tax Credits

A federal judge ruled on May 10 that a Los Angeles-area construction company is not entitled to more than $1 million in pandemic-era tax credits, dealing a significant blow to businesses that claimed the relief based on supply chain disruptions rather than direct government shutdown orders.

The U.S. District Court for the Central District of California granted the government’s motion for summary judgment against Tri-State Construction, Inc., finding the company failed to prove its operations were fully or partially suspended by a government order, a key requirement for eligibility for the Employee Retention Credit (ERC).

This ruling is one of the first major judicial decisions interpreting the ERC’s stringent qualification rules and serves as a stark warning to the thousands of businesses whose claims are under scrutiny by the Internal Revenue Service. The case highlights the critical distinction between being affected by the pandemic's economic fallout and being directly constrained by a specific government mandate.

The Employee Retention Credit was established under the CARES Act in 2020 to incentivize businesses to keep employees on their payroll during the economic turmoil of the COVID-19 pandemic. Businesses could generally qualify in one of two ways: by experiencing a significant decline in gross receipts or by having their operations fully or partially suspended due to a government order limiting commerce, travel, or group meetings.

Tri-State Construction, which sought a refund of approximately $1.1 million for tax periods in 2020 and 2021, did not claim a decline in gross receipts. Instead, it argued that various state and local government orders in California caused disruptions that constituted a partial suspension of its business. The company cited project delays, reduced productivity due to social distancing, and difficulties in procuring materials as evidence of this suspension.

In our experience, many businesses were legitimately impacted by the pandemic but now struggle to produce the specific documentation the IRS and courts demand. The key is to connect operational disruptions directly to a specific mandate, not just general economic conditions or supply chain issues, which the court found insufficient in this case. This is where professional guidance on tax preparation and compliance becomes critical for building a defensible claim. Navigating these complex tax provisions requires a meticulous approach, and firms can get help by contacting C&S Finance Group LLC at csfinancegroup.com.

However, the court was not persuaded by Tri-State's arguments. Judge John W. Holcomb, in his ruling, noted that the construction industry was deemed an essential business in California and was never subject to a full shutdown order. The judge found that the company’s evidence of disruptions—such as longer lead times for materials or implementing new safety protocols—did not rise to the level of a “suspension” of operations as defined by the statute. The ruling emphasized that a business must be more than merely affected by an order; the order must directly prohibit or limit the business's activities.

This decision lands amid an aggressive enforcement campaign by the IRS, which has been inundated with what it characterizes as a flood of improper and fraudulent ERC claims, often pushed by aggressive marketing firms. In September 2023, the agency announced a moratorium on processing new claims to combat fraud and protect businesses from scams. The IRS also launched a withdrawal program for businesses that filed questionable claims and are now having second thoughts, as well as a voluntary disclosure program for those who received and spent improper refunds.

We are advising clients to proactively review any ERC claims they have filed, regardless of who prepared them. The landscape has shifted dramatically from encouragement to enforcement, and it is far better to identify and correct any potential issues now than to face a stressful and costly audit later. The government's victory in the Tri-State case signals that it has the judicial backing to pursue its strict interpretation of the law.

The ruling against Tri-State Construction provides a clear precedent that could influence the outcome of numerous other disputes between taxpayers and the IRS. For small and mid-sized businesses, the key takeaway is the high bar for proving eligibility under the government-order test. Simply facing economic headwinds, supply chain delays, or increased operating costs due to the pandemic is not enough. A business must produce evidence of a specific government order that directly forced it to suspend a more-than-nominal portion of its operations.

As the IRS continues its audit blitz, which it estimates involves tens of thousands of high-risk claims, more litigation is expected to follow. Business owners and tax professionals will be closely watching to see if other courts adopt the reasoning used in the Tri-State case, which would further solidify the IRS’s enforcement position and narrow the path for many businesses that claimed the credit based on indirect pandemic impacts.