The Employee Retention Credit (ERC)
The ERC is a refundable tax credit designed for businesses who continued paying 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 taxpayers can claim the ERC on an original or amended employment tax return for a period within those dates.
ERC Eligibility Requirements
To be eligible for the ERC, employers must have:
- sustained a full or partial suspension of operations due to orders from an appropriate governmental authority limiting commerce, travel, or group meetings due to COVID-19 during 2020 or the first three quarters of 2021,
- experienced a significant decline in gross receipts during 2020 or a decline in gross receipts during the first three quarters of 2021 or
- qualified as a recovery startup business for the third or fourth quarters of 2021.
IRS Warning – Beware of ERC Refund Schemes
The Internal Revenue Service recently warned employers to be wary of third parties who are advising them to claim the Employee Retention Credit when they may not qualify. Some third parties are taking improper positions related to taxpayer eligibility for and computation of the credit.
These third parties often charge large upfront fees or a fee that is contingent on the amount of the refund and may not inform taxpayers that wage deductions claimed on the business’ federal income tax return must be reduced by the amount of the credit.
In connection with its recent warning, the IRS is preparing for a major compliance enforcement effort of ERC refund claims. Recently, the IRS Small Business/Self-Employed Division has begun training 300 examiners to examine ERC refund claims.
Last month, the Commissioner of this IRS Division, told tax practitioners that the IRS is encouraging taxpayers to take advantage of the credit, but that the IRS is “monitoring the situation very closely.” She said the warning signs of these schemes include large upfront fees, advertised solicitations and suggestions that businesses have nothing to lose by submitting these claims. As of February 14, 2023, the IRS Criminal Investigation division has initiated 44 investigations into ERC fraud that include aggressive ERC promoters and enablers. Eleven individuals have been charged to date.
In its examination of questionable ERC claims, the IRS likely will focus on three areas; eligibility, substantiation of the amount claimed and whether an amended income tax return was filed to correct any overstated wage deduction.
A particular focus of the IRS will be on substantiating qualifications based on a partial suspension of business operations, which requires a taxpayer to demonstrate that a government order interrupted at least a portion of its business operations. Additionally, the order must be more than a recommendation and the shutdown order must have impacted business operations by a more than nominal amount.
Potential Consequences of IRS Enforcement Action
If the refund claim is still pending and hasn’t been paid, the IRS could deny the payment of part or all of the refund. If the refund has already been paid, the IRS could seek repayment of part or all of the refunded amount, a potentially devastating consequence as the refund will likely have been spent already.
In addition to being denied a pending refund claim or having to repay previously refunded amounts, penalties could range from a 20% accuracy-related penalty to a 75% penalty if the IRS asserts civil fraud by the employer.
A Lengthy Period for IRS Compliance Enforcement
Generally, the IRS has three years from the date a return is filed to assess additional tax. However, in the case of an ERC claim filed on Forms 941 or 941-X, the three-year statute of limitations starts on April 15 of the following calendar year. Therefore, the quarterly 941 or 941-X returns for 2021 can be examined and additional taxes and penalties assessed by the IRS any time prior April 15, 2025.
Additionally, beginning with the third quarter of 2021, a special five-year statute of limitations applies instead of the general three-year rule, which means the IRS has until April 15, 2027 to assess additional taxes and penalties for ERC claims relating to the last two quarters of 2021.
Advice for Employers
The IRS has advised businesses to be cautious of advertised schemes and direct solicitations promising tax savings that are too good to be true. Taxpayers are always responsible for the information reported on their tax returns. Improperly claiming the ERC could result in being required to repay the refund along with penalties and interest. Taxpayers should have their substantiation documentation for the ERC prepared and ready to submit in the event they are asked to provide it to the IRS.
We’re Here to Help
Bennett Thrasher has expertise in handling IRS Employee Retention Credit tax issues with the IRS. For more information, please contact Tim Watt, Tax Partner, or James Pickett, Director of Tax Controversy, by calling 770.396.2200.