The Employee Retention Credit (ERC) has served as a crucial support for numerous businesses, offering financial assistance in times of adversity. Nevertheless, along with the advantages of the ERC tax credit, arises the obligation to adhere to the ERC laws enacted by Congress. This includes navigating the myriad of Internal Revenue Service (IRS) guidance issued to implement the legislative mandates. In this comprehensive guide, we will explore what ERC audits entail, how to prepare for them, and the potential penalties companies may face.
What is an ERC Audit?
An ERC audit is an examination carried out by the IRS to verify a company’s eligibility and compliance with the Employee Retention Credit program. The IRS ERC audit program is a result of the agency’s dedication to ensuring tax credit programs are not abused or exploited. This specialized program is designed to scrutinize companies’ claims for ERC tax credits, with a particular focus on accuracy and adherence to program rules. The program employs a mix of random and targeted audits to ensure that both a broad spectrum of businesses and those with higher ERC audit risk are thoroughly examined.
The IRS recently announced that it has trained 300 employees to handle ERC audits, signifying the increasing focus on this tax credit. Businesses that have claimed the ERC on their payroll tax returns are facing heightened scrutiny. If your business is chosen for an ERC audit, the IRS will send an audit notice to your last known address. To avoid missing these notices, it’s crucial to keep your address information up to date with the IRS. Failure to update your address may lead to missed audit notifications and the disallowance of the credit without your knowledge. The audit notice will specify the type of audit, the issues under examination, and the subsequent steps to be taken. There are three main types of ERC audits: correspondence, desk, and field audits.
- Correspondence Audit: In a correspondence audit, the auditing process primarily occurs through the exchange of documents and letters via mail. Typically, the IRS will request specific documents or information related to your Employee Retention Credit claim. You’ll be required to provide accurate and complete supporting documentation to substantiate your eligibility and the credit amount you’re claiming. The IRS will review these documents carefully and may correspond with you to seek clarifications or additional information if necessary. Correspondence audits are often considered less invasive than other audit types, making them a relatively less intimidating option for businesses undergoing ERC audits.
- Desk Audit: A desk audit is a more interactive process compared to a correspondence audit. Business owners, or their representatives, typically arrange phone meetings or video conferences with IRS auditors. During these discussions, you’ll go over the documents you’ve provided and address any questions or concerns raised by the auditor. The auditor will assess the information presented and may request further clarification or additional documentation. This type of audit allows for a direct line of communication with the auditor, enabling you to explain your ERC calculations and provide context for any discrepancies or questions they may have. Desk audits offer a level of flexibility and can be conducted remotely, making them a convenient option for businesses.
- Field Audit: A field audit is the most extensive and intrusive of the three ERC audit types. In this case, an IRS auditor will physically visit your place of business to conduct an on-site examination. However, it’s important to note that field audits for ERC claims are mostly rare and are typically reserved for more complex or high-value cases. During a field audit, the auditor will examine not only your financial records and documentation but also the overall operations of your business to verify the accuracy of your ERC claim. While field audits may be more time-consuming and invasive, they can also provide a more comprehensive assessment of your eligibility and credit calculations.
How to Prepare for an ERC Audit
Preparation is paramount when facing an ERC tax credit audit. Companies must be ready to provide documentation, back up their claims, and ensure compliance with IRS regulations. Here’s a breakdown of the key steps and considerations for effective preparation:
- Gather Documentation: Collect and organize all relevant documents, including payroll records, financial statements, tax returns, and any other documents supporting ERC claims.
- Review Eligibility: Carefully review the eligibility criteria for the ERC program. Ensure that your company meets all the necessary requirements.
- Compliance Check: Conduct an internal compliance check to verify that you have followed the ERC statutory framework and IRS guidance when claiming the ERC tax credits.
- Expert Guidance: Immediatley seek assistance from tax professionals or legal experts, such as Bennett Thrasher, to navigate the complex ERC rules and IRS audit administrative procedures effectively.
During an audit, you’ll need to substantiate your claim for the credit. The burden of proof for the ERC initially lies with the taxpayer. While solid record-keeping practices can make this process smoother, ERC audits may present unique challenges. Here are the kind of records you might need to provide:
1. Proof of Eligibility for the Credit: Depending on the basis for your ERC claim, you’ll need to provide specific documents:
- For revenue reduction claims, sales or revenue records on a federal income tax basis from the relevant quarters and comparison quarters.
- For suspended operations claims, details of the government orders and how they impacted your business operations.
- For recovery start-up businesses, evidence of your business’s start date and compliance with revenue thresholds.
2. Proof of Qualifying Wages: You may need to demonstrate that you’ve claimed the credit only on Qualified Wages, which may involve providing:
- Detailed employee by employee credit calculation worksheets supporting ERC amounts on Forms 941 and 941-X.
- Clarification on which wages were paid with Paycheck Protection Program (PPP) loans.
- Information about your full-time employee count in 2019.
3. Additional Payroll Details: The audit may extend to examining general payroll records and wage-related information such as time sheets, payroll reports, and bank account statements.
ERC Audit Penalties
Non-compliance with the ERC can lead to severe penalties for companies. These penalties can significantly impact a business’s financial stability and reputation. Here are some potential punishments to be aware of:
- Repayment of Credits: If it is determined that a company wrongly claimed ERC tax credits, they may be required to repay the credits with interest.
- Penalties: Failure to pass an audit may also result in penalties. Negligence in complying with tax laws can incur an accuracy-related penalty, typically amounting to 20% of the underreported tax. In cases of fraud, the penalty rises to 75% of the tax owed.
- Criminal Charges: The IRS has the authority to bring criminal tax fraud charges on those individuals or corporations willfully trying to defraud the government through false tax credits, potentially leading to fines and imprisonment.
- Loss of Future Benefits: Non-compliance in an ERC audit can also result in losing access to future benefits, tax credits, or government contracts.
Not Yet Under IRS ERC Audit?
For companies not yet under an IRS exam process and are concerned about the eligibility of their ERC claim, or those who suspect an erroneous or overstated ERC claim, the IRS has provided 2 pathways to avoid penalty assessments and future compliance action. The first is a voluntarily withdraw option for unpaid ERC refund claims. The second, the IRS has announced that it will soon introduce a settlement program to repay ERC claims previously received. Advisory from a tax professional or legal expect, such as Bennett Thrasher, should be sought to navigate these programs effectively.
Conclusion
Facing an ERC audit can be a challenging experience for any company. However, with proper preparation and compliance, the risk of facing penalties can be significantly reduced. It is crucial for businesses to avoid prior assumptions of their ERC claim, understand the intricacies of the ERC tax credit audit process, gather supporting documentation, and seek expert guidance when necessary.
The key takeaways from this guide are that ERC audits are a vital part of IRS oversight to protect tax revenue and ensure businesses receive their due credits. If selected for an IRS exam, companies should prepare diligently, review eligibility criteria, and compare compliance with ERC legislation, IRS notices, revenue procedures and other guidance to assess potential credit disallowance and penalties that could harm their financial health and reputation. Always remember that thorough preparation is the best defense against the uncertainties of an ERC audit.
For more information on surviving an ERC audit, contact Tim Watt, partner of Tax, or James Pickett, Director of Tax Controversy at Bennett Thrasher.
