Case: ERC Today LLC et al. v. John McInelly et al., No. 2:24-cv-03178 (D. Ariz.)
In an April 2025 order, the US District Court for the District of Arizona denied a motion for a preliminary injunction filed by two tax preparation firms. The firms sought to halt the Internal Revenue Service’s (IRS) use of an automated “risk assessment model” that the IRS used to evaluate and disallow claims for the Employee Retention Credit (ERC), seeking to restore individualized review of ERC claims.
BACKGROUND ON THE ERC
The ERC was enacted in 2020 as part of the Coronavirus Aid, Relief, and Economic Security (CARES) Act to provide financial relief to businesses affected by COVID-19 by incentivizing employers to retain employees and rehire displaced workers. The ERC allowed employers that experienced significant disruptions due to government orders or a substantial decline in gross receipts to claim a tax credit equal to a percentage of qualified wages paid to employees. Millions of employers have filed amended employment tax returns (Form 941-X) claiming the credit for periods in 2020 and 2021. Since the enactment of the CARES Act, the IRS has issued roughly $250 billion in ERC.
THE IRS’S MORATORIUM AND AUTOMATED RISK ASSESSMENT MODEL
In September 2023, the IRS instituted a moratorium on processing ERC claims to review its procedures, reduce the backlog of claims, and identify potential fraud. Before the moratorium, all ERC claims received individualized review. During the moratorium, the IRS developed an automated “risk assessment model” to facilitate the processing of claims. This model, which is alternatively known as “risking,” utilizes taxpayer-submitted data and publicly available information to predict the likelihood that a taxpayer’s claim is valid or invalid. Claims deemed to be “high risk” by the system are excluded from review by an IRS employee and instead are designated for immediate disallowance. In August 2024, the IRS lifted its ERC processing moratorium and began issuing thousands of disallowance notices to taxpayers. Notwithstanding these actions, the number of pending ERC claims remained above one million as of November 2024.
THE COURT CHALLENGE TO THE IRS’S “RISKING” MODEL
In their motion for a preliminary injunction, filed January 7, 2025, the plaintiffs (the tax preparation firms) sought a court order compelling the IRS to, among other things, stop the use of “risking” and restore individualized employee review of ERC claims. The plaintiffs claimed to be injured by the “risking” model because they were unable to collect contingency fees from clients when claims were disallowed.
In support of their motion, the plaintiffs pointed to having received on behalf of their clients many boilerplate rejections immediately following the end of the moratorium. The plaintiffs alleged that these summary disallowances were arbitrary and capricious, thus violating the Administrative Procedure Act (APA), because the “risking” model precluded the IRS from acquiring information necessary to properly evaluate the claims.[1] The plaintiffs also contended that the disallowances reflected a shift in IRS policy to disfavor ERC, with the result being that several legitimate claims were being unfairly disallowed. The plaintiffs argued that this apparent shift violated Congress’s intent in enacting legislation providing for ERC.
On April 7, 2025, the court denied the motion, finding that the plaintiffs failed to meet the high bar for injunctive relief at this stage of the litigation.[2] The court said that the record of the case at this juncture did not support the plaintiffs’ contention that the increase in claim disallowances after August 2024 was because of the IRS denying valid claims. However, the court pointed to a concession by the IRS that its use of the “risking” model may be resulting in the disallowance of legitimate claims. The court suggested at several points in its order that the plaintiffs (or the employers they support) could bring forth evidence demonstrating that the “risking” model was unduly denying benefits to deserving taxpayers.
Practice Point: This case highlights that the IRS has been adopting novel mechanisms to address its backlog of pending ERC claims, which given current resource constraints, it may seek to employ them in other contexts, including those involving income tax refunds. The “risking” model in particular, while purporting to expedite the review of certain supposedly “high-risk” claims, may be having the collateral consequence of denying benefits to eligible employers. Taxpayers with potentially meritorious claims can (and should) be prepared to administratively appeal or even litigate disallowed claims, which they can do by filing a complaint in the US district court with jurisdiction or in the US Court of Federal Claims. For more on appealing and litigating ERC claims, click here.
[1] The plaintiffs also alleged that the IRS exceeded its statutory authority by disallowing their clients’ ERC claims without providing them a right to be heard or a direct right to appeal in an independent forum. The plaintiffs argued that the IRS violated the Due Process Clause of the US Constitution’s Fifth Amendment by depriving their clients of ERC without adequate review of these clients’ claims.
[2] More specifically, the court found that the plaintiffs did not establish that they had standing to seek the requested relief, or that the United States (through the actions of the IRS) had waived sovereign immunity as to the plaintiffs’ APA claims. The court also concluded that the plaintiffs did not show that their due process claim was likely to succeed on the merits such that a preliminary injunction was an appropriate remedy.
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