Industry the December 2023 issue

IRS Cracks Down on Employee Retention Credit

COVID-based claims are under scrutiny, and it’s not as simple as it may seem.
By Scott Sinder, Caitlin Tharp Posted on December 1, 2023

Robocalls and television ads promise up to $26,000 per employee for businesses that were affected by COVID-19. Perhaps your firm or one of your key clients claimed the ERC based on one of these ads or after consulting with a tax professional. While you (or your client) may not have anticipated it, you (or they) are now in the IRS’s sights.

The IRS just took the extraordinary step of announcing an immediate moratorium on processing new ERC claims in order “to protect against fraud and revenue loss.” The IRS designated the credit on its Dirty Dozen list of tax scams, and the situation has even reached the IRS commissioner’s attention. Commissioner Danny Werfel explained that “[w]hile the credit has provided a financial lifeline to millions of businesses, there are promoters misleading people and businesses into thinking they can claim these credits.” To target dubious claims, the IRS has referred thousands of ERC claims for audit.

Congress enacted the ERC to support businesses hit hard during the pandemic. To be eligible for the ERC, the employer must have experienced either a significant decline in gross receipts or a full or partial suspension of the employer’s operations due to COVID-19 governmental orders. Most of the eligibility disputes with the IRS involve employers whose claims ride on meeting the partial suspension test. Most businesses were adversely impacted by COVID-19-related government action, but does that mean they are all eligible for the ERC?

Qualification under the partial suspension test hinges on a facts-and-circumstances analysis of how one or more COVID-19 governmental orders affected the employer’s operations. If, for example, some of your firm’s operations were suspended due to COVID-19, the difficult question is whether the suspension was material enough to qualify as a partial suspension.

ERC claimants need to be armed with information that substantiates their eligibility when the IRS comes knocking.

IRS guidance creates a safe harbor for the partial suspension test if more than a nominal portion of the business’s operations were suspended. A “more than nominal portion” is defined as a portion of the business constituting more than 10% of either the revenues or employee hours of service of the entire business. There remain, however, numerous open questions on how that safe harbor applies and what a “portion” of a business is. In addition, the employer must identify a specific governmental order that was in effect that caused the suspension of operations for the entire period for which the employer claimed the ERC. With the IRS aggressively targeting fraud and underlying rules that are fact-bound and ambiguous, the conditions are ripe for a glut of contentious disputes.

Notwithstanding all of this complexity, there are firms advertising they can determine ERC eligibility in minutes. The IRS has warned taxpayers about the risks of using ERC “mills”—third-party promoters that use marketing ploys to charge heavy, upfront contingency fees with the promise of helping businesses compute and claim the credit. These “mills” have every incentive to claim the maximum possible ERC for every employer who comes to them, even if the business is not ultimately eligible. In response, the IRS commissioner has urged businesses to “seek out a trusted tax professional who actually understands the complex ERC rules” to advise them as to ERC eligibility.

Maybe you were careful and made your ERC claim only after consulting with a reputable advisor. This might mean that you will ultimately get the refund, but it may not save you from an audit—the IRS cannot readily separate questionable ERC claims from those based on professional advice. As it often does, the IRS is taking a one-size-fits-all approach and has further slowed down processing of ERC claims received prior to the moratorium start date so that it can engage in “detailed compliance reviews.”

Because the forms for claiming the ERC are typically inadequate for the IRS to judge the validity of the claim, the IRS will have to open an audit and request more information. ERC claimants need to be armed with information that substantiates their eligibility when the IRS comes knocking. The IRS frequently begins an audit with an initial interview at which the employer will need to explain to the IRS how and why it qualified for the credit. With the typical 30-day response window for IRS information requests, an employer will have little time to develop its argument for eligibility, gather documentation, and sharpen that narrative for the IRS. This is a reason to engage a tax professional before commencement of the audit.

Even when the IRS has paid out a taxpayer’s ERC claim, the taxpayer is not necessarily in the clear. The IRS can sue taxpayers to recover what it later deems to be an erroneous refund. If the IRS denies an ERC claim before paying it, the employer is simply left without the claimed amount (and may be out fees the employer paid to mills or advisors). If, however, the IRS denies the ERC claim after it has paid the refund, the employer must pay back the credit along with penalties and interest. The IRS currently charges interest in these circumstances at an 8% rate.

ERC promoters advertise that the ERC is simple. It is not. ERC claimants should seek professional advice to understand and mitigate their risk from an ERC claim.

Scott Sinder Chief Legal Officer, The Council; Partner, Steptoe Read More

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