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The Employee Retention Credit was meant to keep workers on payroll during the worst of the pandemic. Five years later, it has become one of the most contested provisions in the Internal Revenue Code. The IRS has processed hundreds of thousands of disallowances. Refund lawsuits are piling up. And practitioners advising legitimate claimants are running out of administrative options.
Three developments deserve close attention right now. The first is the federal district court ruling in Tri-State Memorial Hospital v. United States. The second is the IRS's October 2025 overhaul of its Post-Appeals Mediation program. The third, just decided, is First Source Employee Management, Inc. v. United States (N.D. Ohio June 11, 2026), which sharpens what taxpayers can and cannot ask a federal court to do. Read together, they sharpen the strategic choices facing taxpayers whose ERC claims have stalled at Appeals.
What Tri-State Memorial actually says
Tri-State Memorial Hospital, an Eastern Washington provider, sued the United States in the U.S. District Court for the Eastern District of Washington to recover roughly $11.5 million in ERC refunds the IRS had denied. The government moved to dismiss. The court denied that motion, holding that the hospital had plausibly alleged a partial suspension of operations caused by a governmental order.
That is a procedural ruling, not a judgment on the merits. But it matters for three reasons.
First, the court allowed the partial-suspension theory to move forward in a fact pattern the IRS has aggressively challenged. Hospitals were classified as essential, never ordered to close, and continued operating throughout 2020 and 2021. The IRS has used those facts to deny ERC claims wholesale. The court was not persuaded that essential-business status defeats a partial-suspension claim at the pleading stage.
Second, the case keeps pressure on the IRS's "more than nominal" standard from
Third, even a motion-to-dismiss denial shifts settlement leverage. The government now faces discovery, fact development and the prospect of bad facts becoming bad law in the Ninth Circuit.
A note of caution: This is one district court ruling on a motion to dismiss. It is not precedent outside the Eastern District of Washington, and the ultimate merits remain open. Practitioners should not overread it. They should, however, use it.
The good news at Appeals
Let's start with the good news. Appeals is not merely aware of Tri-State. We have encountered officers who bring it up first. It is making a difference at the conference table. That matters, because Appeals leverage is built one citation at a time.
The not-so-good news: First Source
Now the not-so-good news. First Source Employee Management, Inc. v. United States, Case No. 1:24-cv-02209-CEF (N.D. Ohio, June 11, 2026), is another taxpayer, here a professional employer organization, that brought a refund suit and stacked Administrative Procedure Act-style counts on top of it. First Source sought to enjoin enforcement of IRS Notice 2021-20 and to vacate the Notice. The amount at stake is roughly $20.2 million in unpaid 2021 ERC refunds.
The court is not going for APA shortcuts.
The court dismissed the injunctive and vacatur counts on jurisdictional grounds, concluding the plaintiff did not adequately allege standing for forward-looking relief. The refund claim itself survived. The collateral attack on the Notice did not.
That ruling matters for three reasons.
First, it confirms a pattern. Federal district courts are willing to hear ERC refund claims. They are not willing to be turned into a vehicle for striking down Notice 2021-20 in the abstract. Taxpayers who load up complaints with APA counts are losing those counts early, even when the underlying refund case proceeds.
Second, it narrows the litigation playbook. If the refund claim is the only count likely to survive a 12(b)(1) or 12(b)(6) motion, then substantiation, the eligibility narrative and payroll tax mechanics are not background details. They are the case. For PEOs and other third-party payors filing aggregate Forms 941 and Schedule R, the client-by-client documentation and allocation must be airtight.
Third, it reinforces what Tri-State already signaled. The path to challenging the IRS's "more than nominal" standard runs through the merits of an actual refund claim, not through a free-standing APA attack. Courts will test the Notice when it is applied to a taxpayer's facts. They will not entertain a pre-enforcement vacatur on a thin standing record.
Why most ERC disputes still die at Appeals
Refund litigation is expensive, slow and not available to every client. Most ERC fights are still resolved, or not resolved, inside the IRS Independent Office of Appeals. That is where the bottleneck lives.
Appeals officers handling ERC cases are working from a narrow playbook. The hazards-of-litigation analysis is constrained when the underlying IRS position is institutional rather than case-specific. Taxpayers report Appeals conferences that feel less like negotiation and more like position restatement.
When Appeals is unwilling or unable to move, the next administrative step is Post-Appeals Mediation. And PAM, until recently, had limited appeal.
The 2025 PAM pilot changes the calculus
On Oct. 1, 2025, the IRS Independent Office of Appeals launched a pilot program restructuring how PAM cases are staffed. Under interim guidance dated Sept. 11, 2025, mediation cases in the pilot are assigned to a new Appeals team with no prior involvement in the underlying matter.
That single change addresses the most persistent criticism of PAM: that the mediator and the reviewing Appeals personnel were too close to the original Appeals determination to offer a meaningful fresh look. For ERC cases in particular, where Appeals has often applied IRS-wide positions with little room to maneuver, an unconnected team has at least the opportunity to evaluate hazards differently.
The basic PAM framework under
What is new is the reason to use it. For ERC taxpayers facing a stalled Appeals process, PAM under the pilot is no longer a formality. It is a genuine second look by personnel who did not author the disallowance.
You should verify current pilot eligibility and procedural requirements against the most recent IRM and Appeals guidance before initiating a request, as the pilot's parameters may evolve.
How to think about strategy for ERC clients now
For taxpayers with legitimate, well-documented ERC claims that have been denied or stalled, the path forward is no longer binary. Practitioners have a more nuanced set of choices than they did a year ago.
Document the partial-suspension theory carefully. Tri-State survived dismissal because the hospital pleaded specific governmental orders and specific operational impacts. Generic references to "the pandemic" or "state restrictions" will not carry the weight. Identify the order, identify the affected operation and quantify the disruption with contemporaneous evidence.
Build the refund claim as if it is the only claim that will survive. After First Source, that assumption is the safer working hypothesis. Substantiation, the eligibility narrative and the payroll tax mechanics are central. For PEOs and other third-party payors, that means clean Schedule R allocations, client-level eligibility files and a clear chain from the governmental order to the wages claimed.
Do not load the complaint with APA counts you cannot defend. Injunctive and vacatur counts aimed at Notice 2021-20 are drawing early dismissals. If you plead them, plead the standing facts to support forward-looking relief. If the standing record is not there, lead with the refund claim and let the merits do the work.
Reassess PAM where Appeals has stalled. The 2025 pilot meaningfully changes who reviews the case. For clients who declined PAM previously because they viewed it as duplicative of Appeals, the calculus has shifted.
Reserve litigation for the right cases. Refund suits in district court or the Court of Federal Claims remain available after full payment of any disputed amount or where the IRS has issued a notice of disallowance and the six-month or two-year clocks under Section 6532 are managed correctly. Tri-State, First Source and similar cases will continue to develop the law. Not every client should be the test case, but for taxpayers with strong facts and the resources to litigate, the docket is moving.
Manage expectations honestly. Even with a more credible PAM process and favorable early rulings in Tri-State and parallel cases, the IRS's institutional posture on the ERC has not softened. Settlements are likely to remain partial. Accepting an imperfect resolution may still be the right outcome for a client who needs finality.
Final word
Tri-State Memorial is not a green light. It is a narrow procedural ruling in a single district. First Source is not a setback for legitimate refund claims. It is a reminder that the refund claim is the claim, and APA shortcuts are not a substitute for the work. The 2025 PAM pilot is not a guarantee of resolution. It is a structural improvement to a process that had lost taxpayer confidence.
Together, they give practitioners advising ERC claimants something they did not have a year ago: a credible administrative alternative when Appeals is at impasse, and a litigation track that is no longer purely theoretical, so long as the case is built around substantiation, eligibility and payroll tax mechanics rather than a collateral attack on the Notice.
The work for practitioners is to match the client to the right track, document the facts that matter, plead the refund claim as if it is the only one that will survive early motion practice, and stop treating an unfavorable Appeals determination as the end of the road.
