The Employee Retention Credit (ERC) and Audit Risks

The IRS recently published their annual “Dirty Dozen”, a list of common scams that taxpayers may encounter. Number one on this list is the Employee Retention Credit (ERC). The Coronavirus Aid, Relief, and Economic Security Act (CARES Act), enacted on March 27, 2020, provided for an employee retention tax credit. As a refresher, from the IRS website:

“The ERC is a refundable tax credit for businesses that continued to pay employees while shut down due to the COVID-19 pandemic or had significant declines in gross receipts from March 13, 2020 to December. 31, 2021. Eligible employers can claim the ERC on an original or adjusted employment tax return for a period within those dates.”

The IRS continues, “An employer is eligible for the ERC if it:

  • Sustained a full or partial suspension of operations limiting commerce, travel, or group meetings due to COVID-19 and orders from an appropriate governmental authority or
  • Experienced a significant decline in gross receipts during 2020 or a decline in gross receipts during the first three quarters of 2021.”

This article is not intended to go through the intricacies of the ERC, such as how the decline in gross receipts is calculated or listing of every governmental order that suspended business operations (and remember that these governmental orders must be domestic, not from a foreign country that caused factories to be shut down, as an example). Rather, we wanted to focus on the ongoing IRS audit activities, and some cautionary advice.

While this credit is completely legitimate (if eligible requirements are met), please keep these points in mind:

  • Be wary of solicitations from any companies promising guaranteed eligibility in obtaining the full credit amounts of $5,000, and $10,000 per employee per quarter in 2020, and 2021, respectively.
  • Note what fee structure they have in place. Companies that base their fees based on a percentage of the credits received, or similar type of contingent fees, have a vested interest to maximize these amounts, whether eligibility exists or not.
  • Note what fee structure they have in place. Companies that base their fees based on a percentage of the credits received, or similar type of contingent fees, have a vested interest to maximize these amounts, whether eligibility exists or not.
  • Have your trusted advisors, such as your accountants or attorneys examine the engagement letters. Critical items to understand include, but are not limited to:
    • Who will be evaluating and documenting the eligibility requirements?
    • Who will be preparing the calculations as well as the amended tax returns?
    • What sort of responsibility and audit support will these companies provide in the event of an IRS audit? 
      • The general statute of limitations for an audit or amending a return is three years after filing. The 2021 returns were expanded to five years for an audit only.
    • How many years will they provide audit support?
    • What is their refund policy in the event of adverse audit findings?
  • Were you informed that if you received the credits for 2020/2021, your tax returns for these same years must be amended to reflect the reduction in payroll expenses “reimbursed” by these credits?
    • In the event of an audit, let’s say that eligibility didn’t exist, and these monies must be repaid. Under the expanded five-year statute of limitations, there is a possibility that the window of time to go back and amend the business tax returns is closed (the three-year rule). As an example, say you receive the ERC for $1 million for 2021. You would need to go back and amend your 2021 tax returns to add back $1 million in payroll expenses. Assuming a 40% blended tax rate, you would have to pay $400,000 in taxes for 2021 (plus any interest for underpaid taxes). In five years, an audit determines that eligibility wasn’t met, and the $1 million must be paid back with penalties and interest. Because the three-year time frame of amending your business tax returns is now closed, you can’t go back to recover the $400,000 in taxes. In essence, you are “out” $400,000, plus penalties and interest, plus the fees paid to the company who prepared the ERC to begin with. And in our opinion, once the IRS is examining your ERC claims, what would prevent them from commencing audits on your business tax returns.
  • The IRS has noted that there are now over 300 employment tax examiners that have been specifically trained on these credits. The training course is over 56 hours and includes the use of a 72-page, comprehensive training guide.
  • Ensure that you have proper documentation. Have detailed reasons on why your business(es) are eligible for the credit, including financial statements and payroll records, backup on all credit calculations, and copies of all domestic governmental orders if using the suspension of business operations for eligibility.

We are seeing solicitations from these companies daily. One even notes in their brochure that the chances of being audited by the IRS are minimal, as the IRS is very “backed-up” and they don’t have the resources necessary to commence audits on a timely basis. These “ERC credit mills” continue to aggressively market to businesses. If you feel that your business has been negatively affected or harmed by these companies, the IRS is advocating that IRS Form 3949-A be filed. This is an information referral to report alleged tax law violations by an individual, a business, or both, and can be used for whistleblowers to report tax-related illegal activities related to ERC claims, amongst other violations.

For any questions on how this impacts you or your business, please click here to contact us.

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