IRC 3134: Employee Retention Credit Eligibility, Claims, and Audits

IRC 3134 is the Internal Revenue Code section that created the 2021 Employee Retention Credit, a refundable payroll tax credit worth 70% of qualified wages up to $10,000 per employee per quarter, for a maximum of $7,000 per employee per eligible quarter. It covers wages paid after June 30, 2021, and before October 1, 2021, for most employers, and through December 31, 2021, for recovery startup businesses. The window to file new claims closed on April 15, 2025, but over 597,000 previously filed claims were still in the IRS pipeline in early 2025, and the rules still govern audits, disallowances, and the income tax adjustments many employers owe.1IRS Taxpayer Advocate Service. The ERC Claim Period Has Closed

What Quarters Section 3134 Actually Covers

The American Rescue Plan Act of 2021 added Section 3134 to the Internal Revenue Code. It applies to qualified wages paid after June 30, 2021, and before October 1, 2021, which for most employers means only the third quarter of 2021.2Office of the Law Revision Counsel. 26 USC 3134 – Employee Retention Credit for Employers Subject to Closure Due to COVID-19 Recovery startup businesses get the fourth quarter too.

The credit for 2020 and the first two quarters of 2021 sits under a different statute — Section 2301 of the CARES Act, as extended by the Consolidated Appropriations Act. IRC 3134 replaced that framework starting Q3 2021 with largely identical rules. The Infrastructure Investment and Jobs Act then retroactively terminated the Q4 2021 credit for everyone except recovery startups.3Internal Revenue Service. Employee Retention Credit – 2020 vs 2021 Comparison Chart If your issue involves 2020 wages or the first half of 2021, Section 3134 is not your statute, and the 2020 filing deadline was earlier: April 15, 2024.

Who Qualified

An employer had to be carrying on a trade or business during the quarter and meet one of three eligibility tests.2Office of the Law Revision Counsel. 26 USC 3134 – Employee Retention Credit for Employers Subject to Closure Due to COVID-19

  • Full or partial suspension of operations during the quarter because a federal, state, or local government order limited commerce, travel, or group meetings due to COVID-19. The order had to have more than a nominal effect on the business.
  • Gross receipts for the quarter below 80% of gross receipts for the same quarter in 2019. The 20% decline threshold was more generous than the 50% threshold that had applied in 2020. An employer not in business during 2019 could use the corresponding 2020 quarter as the baseline.
  • Recovery startup status: operations began after February 15, 2020, and average annual gross receipts were $1 million or less. This path did not require either a suspension or a receipts decline.

How the Credit Is Calculated

The credit equals 70% of qualified wages paid to each employee during the eligible quarter, capped at $10,000 in wages per employee per quarter. That produces a maximum of $7,000 per employee per quarter. Qualified wages include gross pay plus the employer’s share of health plan costs.2Office of the Law Revision Counsel. 26 USC 3134 – Employee Retention Credit for Employers Subject to Closure Due to COVID-19

The credit first offsets the employer’s share of payroll taxes for the quarter. Any excess is refundable, paid out by the IRS. Businesses did not need payroll tax liability large enough to absorb the credit for it to have value.

The 500-Employee Split

What counts as a qualified wage depends on the average number of full-time employees the business had in 2019.

  • 500 or fewer full-time employees in 2019: all wages paid during the eligible quarter count, whether the employee was working or not.
  • More than 500 full-time employees: only wages paid for time employees were not providing services count. Wages for hours actually worked generate no credit.

A separate carve-out applies to a “severely financially distressed employer” — one whose quarterly gross receipts were less than 10% of the same quarter in 2019. For that employer, all wages qualified regardless of size.

The Recovery Startup Cap

Recovery startups took a lower ceiling in exchange for their easier eligibility path. Their credit is capped at $50,000 per quarter across all employees, not calculated per employee. A qualifying recovery startup could therefore claim up to $100,000 total across Q3 and Q4 of 2021.2Office of the Law Revision Counsel. 26 USC 3134 – Employee Retention Credit for Employers Subject to Closure Due to COVID-19 Average annual gross receipts over the three-year period ending before the quarter had to stay at or below $1 million.

Wages That Don’t Qualify

Even for an eligible employer, several categories of payroll get excluded.

Wages paid to certain relatives of the business owner don’t count. Under IRS Notice 2021-49, if the employee is related to someone who owns more than 50% of the business, the wages are excluded. The disqualifying relationships include children, siblings, parents, nieces, nephews, aunts, uncles, and in-laws.4Internal Revenue Service. Notice 2021-49 – Guidance on the Employee Retention Credit Under Section 3134 This has a bigger reach than it appears. A majority owner’s own wages are excluded if the owner has any living relative in those categories, which is almost everyone. The owner’s spouse is also excluded. Only when the majority owner has no living relatives in those categories do the owner’s and spouse’s wages qualify. Most owner-operators cannot claim the credit on their own compensation.

The same wages also cannot be double-counted across federal programs. Wages paid with forgiven Paycheck Protection Program loan proceeds must be pulled out of the ERC calculation. Wages already claimed for the Work Opportunity Tax Credit, the paid family leave credit under Sections 3131 and 3132, or other employment-based credits cannot count again for IRC 3134. Each payroll dollar goes to one program only.

The Wage Deduction Reduction

This is the piece employers most often miss, and it creates real income tax exposure. Claiming the ERC reduces the wage expense you can deduct on your income tax return for the year the qualified wages were paid.5Internal Revenue Service. Frequently Asked Questions About the Employee Retention Credit Claim $50,000 in ERC, and your 2021 wage deduction drops by $50,000. Taxable income rises accordingly.

The adjustment belongs on the 2021 return, not the year you filed Form 941-X or received the refund. Employers who claimed the credit retroactively generally need to file an amended income tax return — Form 1120-X for C-corporations, Form 1065-X for partnerships, or Form 1040-X for sole proprietors — to reflect the reduced deduction. Skipping this step can trigger penalties and interest calculated from the original due date of the 2021 return. Employers who resolved incorrect claims through the IRS Voluntary Disclosure Program were relieved of this amendment requirement, but that program closed on November 22, 2024.6Internal Revenue Service. Employee Retention Credit – Voluntary Disclosure Program

Where Filed Claims Stand Now

New Form 941-X claims for any 2021 quarter had to be submitted by April 15, 2025. After that, the credit cannot be claimed for the first time.5Internal Revenue Service. Frequently Asked Questions About the Employee Retention Credit

If you already filed, your claim is in the IRS backlog. The IRS imposed a moratorium on processing new ERC claims in September 2023 over fraud concerns. Processing resumed, but as of early April 2025 over 597,000 claims remained unresolved, and the National Taxpayer Advocate projected clearing the inventory could take through the end of calendar year 2025.1IRS Taxpayer Advocate Service. The ERC Claim Period Has Closed Approved claims are paid by refund check or applied to the tax account.

If the IRS Disallows Your Claim

The IRS uses Letter 105-C to notify an employer that an ERC claim has been denied. The letter is not the end of the process.7Internal Revenue Service. Understanding Letter 105-C, Disallowance of the Employee Retention Credit

The letter asks for a response within 30 days, but the operative deadline is two years from the date on the disallowance letter. Within that two-year window you can request review by the IRS Independent Office of Appeals, or file suit in U.S. District Court or the U.S. Court of Federal Claims. Requesting an appeal does not extend the two-year period for filing suit.

The response should carry the documentation that proves eligibility: payroll records, copies of the specific government orders that affected operations with the dates and restrictions they imposed, and financial statements showing gross receipts if the claim rested on the revenue decline test. If new information persuades the IRS, the claim can be allowed without going to Appeals. If not, the case is forwarded to Appeals for independent review.

Withdrawing a Claim That Hasn’t Paid Out

Employers who now believe their claim was filed in error — often after being pushed into filing by aggressive promoters — can ask the IRS to withdraw it. A completed withdrawal treats the Form 941-X as if it were never filed, with no penalties or interest.8Internal Revenue Service. Withdraw an Employee Retention Credit (ERC) Claim Withdrawal is available only if all of the following are true:

  • The claim was filed on Form 941-X or an equivalent adjusted return.
  • The adjusted return was filed solely to claim the ERC, with no other corrections.
  • You want to withdraw the entire credit, not reduce it.
  • The IRS has not paid the claim, or you received a refund check but haven’t cashed or deposited it.

Employers whose claims have already been processed and the refund cashed cannot use the withdrawal path. The Voluntary Disclosure Program was the designated route for those situations, and it closed on November 22, 2024. Employers past both deadlines who suspect their claims were wrong should consult a tax professional about filing a corrected return or preparing for examination.

The Five-Year Audit Window and What to Keep

ERC claims carry an extended assessment period. Legislation lengthened the IRS’s window to review and disallow ERC credits to five years, well beyond the three-year statute of limitations that applies to most tax returns. Recent legislation, including ERC compliance provisions in the One Big Beautiful Bill, added enforcement tools for investigating questionable claims and penalizing promoters.9Internal Revenue Service. IRS Frequently Asked Questions Address Employee Retention Credits Under ERC Compliance Provisions of the One Big Beautiful Bill

Records should be kept for at least five years from the Form 941-X filing date. If an examination finds the credit was incorrect, the employer owes back the credit plus interest, and potentially penalties if the claim lacked a reasonable basis.

What the file should contain depends on the eligibility path taken. For a government-order claim, keep the specific federal, state, or local orders that restricted the business, along with evidence of the actual operational impact: internal communications, reduced schedules, records of closed facilities. For a gross receipts claim, keep quarterly financial statements or tax returns that show 2021 receipts alongside the 2019 baseline, demonstrating the drop below 80%. Payroll records should show which wages and health plan costs were assigned to the ERC and confirm those same dollars were not counted toward forgiven PPP loans or other credits. Employers with more than 500 employees also need records identifying which employees were not providing services during the claimed periods.