Employee Retention Credit Applications Attract Heightened IRS Scrutiny
By now, every business owner has heard of the Employee Retention Credits (“ERC”). The ERC program was created by the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) to help struggling businesses with payroll obligations during the COVID-19 pandemic by allowing refundable tax credits against employer taxes. As a general rule, ERC claims can be made for the period from March 13, 2020, through the third quarter of 2021 (ERC for the 4th quarter may be claimed only by a “recovery start-up business” that started after February 15, 2020). Thus, with respect to 2020 calendar quarters, employers have until April 15, 2024, and with respect to 2021 calendar quarters, employers have until April 15, 2025, to claim ERC by filing an amended payroll tax return on Form 941X. In order to apply for ERC, an employer must meet certain eligibility requirements and could qualify under either the gross receipts test or the suspension of operations test.
While Congress intended for the ERC program to provide relief to struggling businesses, the program became an easy target for aggressive third-party promoters who misled and lured taxpayers by causing them to improperly claim ERC while charging excessive fees as a percentage of ERC refunds. Due to an easy application process, lack of enforcement efforts by the IRS, and lack of detailed guidance with respect to ERC eligibility, ERC became subject to widespread fraud and abuse due to many false or inflated ERC claims. Thus, while the Congressional Budget Office initially budgeted approximately $85 billion dollars for the ERC, the Treasury Inspector General report states that as of March 10, 2022, the IRS’s fraud filters identified 11,096 returns with more than $2 trillion in credit claims, and the IRS reports that more than 2.5 million claims have been submitted. ERC has also affected the M&A community as buyers became increasingly concerned about ERC abuse and audit risks with respect to their business acquisitions, which contributed to increased transaction costs with due diligence, insurance, and other efforts spent on review and negotiation related to ERC audit exposure.
In recent months, the IRS has zeroed in on erroneous ERC claims and added ERC to the IRS’s 2023 “Dirty Dozen” list of tax-related schemes. According to Carolyn Schenck, the IRS national fraud counsel, the IRS is considering all of its enforcement options with respect to dubious ERC claims, including criminal and civil penalties against third parties promoting ERC-related schemes. As of April 20, the IRS was conducting 122 criminal investigations involving more than $1.2 billion of potentially fraudulent ERC claims according to a member of the House Ways and Means Committee. The IRS has started to offer additional legal clarifying guidance around ERC rules and held a webinar on July 25, 2023, providing information regarding ERC eligibility, compliance, and tips on identifying and reporting fraud.
Below is a summary of the recent IRS guidance:
- On June 30, 2023, the IRS issued General Legal Advice Memorandum, AM 2023-005, providing additional clarification on ERC eligibility pursuant to supply chain disruption under the suspension of operations test. The IRS has previously provided in Notice 2021-20 that an employer may be considered to have a full or partial suspension of operations if the employer’s suppliers are unable to make deliveries of critical goods or materials pursuant to a governmental shut-down order. However, in AM 2023-005, the IRS used five different examples to demonstrate the limited application of the supply-chain disruption claim. To the extent an employer could not substantiate that its supply-chain disruption was due to a governmental order, or could continue its operations and offer a variety of products to its customers despite some shortage of certain products, an employer was not an eligible employer for ERC purposes.
- On July 24, 2023, the Treasury Department and the IRS released final regulations under Sections 3111, 3131, 3132, 3134, and 3221 of the Internal Revenue Code, D. 9978, allowing to treat erroneous refunds of pandemic-related employment credits (i.e., ERC, paid sick leave, or paid family leave) as tax underpayments subject to assessment and administrative collection procedures. The final regulations replace temporary regulations, T.D. 9953, which came out in September of 2021.
- On July 26, 2023, the IRS issued a news release, IR-2023-135, warning businesses and other taxpayers of misleading marketing by ERC promoters, scams, and potential fraud within the ERC program. The news release discusses warning signs of aggressive ERC marketing, which include large upfront fees required by third-party promoters, aggressive claims from the promoter that the business qualifies before any discussion of the businesses’ factual situation, leaving out key details or not explaining eligibility requirements, and other warning signs. The news release also discussed simple steps that taxpayers can take to protect themselves from making improper ERC claims by working with a trusted tax professional and requesting and reviewing details of ERC computations. Taxpayers may also report ERC abuse on Form 14242, Report Suspected Abusive Tax Promotions or Preparers.
On July 31, 2023, the IRS released new FAQs to provide additional guidance related to ERC eligibility, claims, scams, and recordkeeping. In these FAQs, the IRS further discussed certain ERC eligibility rules, the process for claiming ERC, what to do with an improperly claimed credit, how the ERC impacts an employer’s income tax return, provides a list of warning signs related to ERC scams, suggestions for how taxpayers may protect themselves from scam promoters, and outlines recordkeeping requirements.
As a general rule, there is a higher propensity for fraud under the suspension of operations claim. Unlike the gross receipts test which is based on a mechanical calculation, the suspension of operations test is highly subjective, is based on facts and circumstances, and lacks a significant amount of clarifying guidance from the IRS. In many instances, promoters tend to rely on the suspension of operations test by using certain provisions of IRS Notice 2021-20. For example, Notice 2021-20 provides that if an employer’s business operations continue, but the operations are subject to significant modification due to a governmental order, such a modification of operations is considered to be a partial suspension of business operations if the modification required by the governmental order has more than a nominal effect on the business operations. The general rule provides that a governmental order that results in a reduction in an employer’s ability to provide goods or services in the normal course of the employer’s business of not less than 10% will be deemed to have more than a nominal effect on the employer’s business operations. However, the IRS failed to provide clear guidance and specific parameters by which the 10% reduction can be measured. Promoters were able to capitalize on the lack of clear guidance by creating misleading data sets and calculations and convincing taxpayers of their eligibility for ERC based on weak or nonexistent eligibility factors.
It is also important that taxpayers recognize their compliance obligations with respect to ERC claims. An employer may claim ERC only with respect to qualified wages, which do not include wages used for the Paycheck Protection Program loan forgiveness or for other tax benefits such as the credit for Sick and Family Leave Wages under the Families First Coronavirus Response Act or the Work Opportunity Tax Credit. In addition, employers who obtained ERC refunds must reduce the deduction for wages on their business income tax returns by filing an amended income tax return. Note that the statute of limitations with respect to a specific ERC claim and a federal income tax return may vary, which may also have an adverse impact on the taxpayer whose ERC claim was subsequently rejected on audit.
Given the increasing IRS scrutiny of ERC claims, it is important that taxpayers stay vigilant of ERC fraud and discuss their ERC eligibility or concerns about prior claims with trusted tax advisors.
For more information, please contact Asel Lindsey (firstname.lastname@example.org or 210-554-5298), Michael Cumming (email@example.com or 248-203-0740), or your local Dykema relationship attorney.
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