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"The IRS to Scrutinize ERC Claims: Are Businesses Ready?"

July 3, 2023

Kevin Sweeney's article, “The IRS to Scrutinize ERC Claims: Are Businesses Ready?” in CPA Now


Reprinted with permission from CPA Now, the blog of the Pennsylvania Institute of Certified Public Accountants.

The Employee Retention Credit (ERC) is a refundable tax credit against certain employment taxes that was originally authorized by the CARES Act of 2020 to entice small and medium-size businesses to retain employees through the pandemic. To qualify, businesses generally had to establish that they had a significant decline in gross receipts for a particular quarter; had business operations fully or partially suspended due to a COVID-related governmental order; or qualify as a recovery startup business, in addition to other factors and certain limitations.

Recently, the IRS has begun to take a closer look at ERC claims, and it does not appear to like what it is seeing. In IRS press releases IR-2022-183 and IR-2023-40, the IRS warned businesses about third-party ERC advisers who, it says, are taking improper positions related to taxpayer eligibility and credit computations. Additionally, the IRS highlighted fraudulent ERC promotions in its 2023 “Dirty Dozen” list and noted its plan to step up enforcement in this area. It has been reported that the IRS is training 300 revenue and special agents to civilly examine and criminally investigate ERC claims and that federal grand juries have already returned over 10 criminal indictments.

Given the IRS scrutiny and growing enforcement activity in this area, business owners who claimed the ERC may be at a heightened risk of civil audit or, in particularly egregious cases, criminal investigation. Consequently, businesses and their accountants must be ready to defend legitimate claims should the IRS comes knocking and prepared to identify and possibly remediate improper and fraudulent claims before they are discovered.  

Risk of Criminal Prosecution

Although U.S. tax laws operate on a system of “voluntary compliance,” the IRS and Department of Justice (DOJ) routinely seek to deter the commission of tax crimes by making examples of egregiously noncompliant taxpayers through criminal prosecutions that seek lengthy prison sentences. When that taxpayer is a business, the government generally targets the principals and employees who contributed to the noncompliance. Before decisions concerning how to remediate and/or defend ERC-related compliance issues are made, it is critically important to assess where a particular matter may fall on the spectrum of potential civil versus criminal tax exposure. Below are a few ERC-related circumstances that could tilt a matter toward criminal exposure:

  • Businesses with ERC claims that are based on false or manipulated payroll or financial records.
  • Businesses with ERC claims that are based on opinions that contain false, misleading, or manipulated facts.
  • Businesses that had reason to know that their ERC positions were not valid.
  • Businesses that worked with a third-party adviser already under criminal investigation or subject to an IRS promoter examination.

To the extent that any of the above circumstances are present or other circumstances exist that could cause the IRS to suspect fraudulent conduct, the best practice is to proactively engage an attorney with ERC and criminal tax experience – either alone or with the assistance of an accountant under a Kovel arrangement – to develop the facts in detail, to analyze the potential exposure, and to advise those involved of their options. This will allow for a thorough factual inquiry while still protecting sensitive communications under the umbrella of attorney-client privilege. If criminal exposure is determined to be significant, the IRS Voluntary Disclosure Program should be considered. Based on the program’s current guidelines, this approach may not provide much penalty relief, but it does offer an opportunity to avoid the more severe consequences of a criminal prosecution and possible prison time. 

Civil ERC Issues

In most cases, the risk of criminal exposure will be nonexistent or minimal. Still, given the rising intensity of the IRS’s investigations into ERC claims, businesses should proactively consider having a trusted tax professional with knowledge of the ERC statutes and IRS guidance review a claim to ensure they were indeed eligible and that the credit was properly computed. While not as critical in cases where fraud is not an issue, it is still prudent to conduct this review under the direction of an attorney so that negative findings remain cloaked in attorney-client privilege. 

When conducting a review, tax professionals should pay particular attention to typical areas of confusion, including the affiliation, aggregation, and full-time employee calculation rules (which are similar to, but not the same as, those applicable to Paycheck Protection Program loan eligibility), and the partial suspension requirement, which is a subjective standard open to reasonable interpretation. Additionally, to the extent a business claimed the ERC on amended employment tax returns, it should ensure that amended income tax returns were also filed to reduce deductible wage expenses commensurate with those filings.

To the extent a nonfraudulent error or improper position is found, a business should consider having its accountant file amended tax return(s) to correct the errors. Although the business will need to repay the financial benefit of the erroneous tax credit plus interest, this approach will give it a better chance of avoiding penalties.

Where no clear errors or improper positions are found, businesses and their accountants should still take proactive steps to organize themselves to defend the ERC in a potential civil examination. At the least, they should attempt to identify areas of likely IRS scrutiny and consider creating or perfecting a file with all relevant substantiating documentation such as the following:

  • Payroll journals
  • Lists of employees and owners
  • Health plan expenses
  • Wage amounts per employee
  • Original and amended tax returns
  • Government orders
  • Work papers concerning ERC-related computations
  • Wage allocations across the ERC and any Paycheck Protection Program loan forgiveness

The best defenses to IRS inquiries concerning ERC require proactivity. By analyzing ERC claims now, identifying issues, and either remediating or organizing support for these claims, businesses and their CPAs can favorably position themselves for the coming wave of IRS enforcement in this area.