This article was originally published in Law360 on April 17, 2023, and is republished with permission.
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For most businesses, turning the calendar to 2023 meant putting the pandemic and any of its tax-related effects further in the rearview mirror.
One notable exception, however, is the employee retention credit, or ERC, which Congress first created as part of the March 2020 Coronavirus Aid, Relief and Economic Security Act.
Given the substantial benefits available under the ERC — and its complexity — a cottage industry of third-party ERC advisers has sprung up, often charging substantial upfront or contingent fees to assist employers with claiming the credit.
The issue of improperly claimed ERCs has become so acute that the Internal Revenue Service took the step of issuing News Release 2022-183[1] late last year, which sought to warn employers to be “wary of third parties who are advising them to claim the [ERC] when they may not qualify” and reissuing that warning as recently as March 7 in News Release 2023-40.[2]
Many of these advisers were, in the IRS’ view, “taking improper positions related to taxpayer eligibility for and computation of the credit” and failing to inform taxpayers of all the collateral consequences of taking the ERC.
On March 20, the IRS also added promoters improperly claiming the ERC as a new entry to its annual dirty dozen list of tax scams in News Release 2023-49.[3]
The IRS has trained auditors in its Small Business/Self-Employed Division to examine ERC claims, and its Criminal Investigation Division is looking to prosecute promoters of fraudulent claims.
Congress, for its part, has extended the civil-audit limitations period for the ERC to five years — instead of the typical three — to address the ERC’s abuse.
By way of background, the ERC is a refundable tax credit for businesses that continued paying employees while under a full or partial suspension of operations due to a governmental order in response to COVID-19 or that suffered a significant decline in gross receipts from March 13, 2020, to Dec. 31, 2021.
The ERC was quite generous — allowing up to $5,000 per employee in 2020 or $7,000 per employee per quarter for the first three quarters of 2021.
And, although the ERC is no longer available for current wages, the deadline to amend a payroll tax return for 2020 and 2021 is long. The ERC remains available to a taxpayer on an amended return up to three years after the original filing deadline.
The devil, as always, is in the details, and the ERC is no exception to that old saw, particularly because the IRS has issued limited guidance for the credit.
Taxpayers, for example, must be aware of these key requirements when determining whether they qualify for an ERC:
- Proving a significant decline in gross receipts or a full or partial suspension of operations;
- Identifying a qualifying governmental shutdown order related to COVID-19;
- Computing and documenting the taxpayer’s average number of full-time employees in 2019, to ensure that the employer is not a large employer subject to certain limitations;
- Computing qualified wages and qualified health-plan expenses; and
- Analyzing the taxpayer’s wage allocation across the ERC and any Paycheck Protection Program loan forgiveness.
One problematic issue featured in News Releases 2022-183 and 2023-40 has been the employer’s obligation to amend a previously filed income tax return deducting qualified wages if it subsequently amended its employment tax return to claim the ERC.
The employer must amend its income tax return in that scenario or else it will overstate the proper amount of its wage deduction for income tax purposes.
Most third-party servicers do not take the critical step of amending a previously filed income tax return — or advise their clients to do so.
The taxpayer, as always, remains ultimately responsible for the information reported on its returns, and it can be subject to penalties and interest for improperly reporting the amount of its wage deduction on its income tax return after claiming the ERC, for example.
A further complicating factor associated with the scenario outlined in the news releases could be the mismatch in limitations periods in the event of an IRS audit of the ERC.
The IRS currently has up to five years to audit ERC claims; businesses have three years to amend a return.
Given the longer limitations period for the IRS to audit ERC claims, it is possible that an ERC disallowed by the IRS in years four or five of the IRS’ limitations period for audits will result in a taxpayer repaying the credit — with associated penalties and interest — without the opportunity to amend tax returns to reclaim wage deductions on an income tax return that were eliminated originally when claiming the ERC.
If Congress fails to address this mismatch in limitations periods, this could be a harsh result for audited taxpayers, particularly those who unwittingly trusted an ERC adviser who took improper positions related to the taxpayer’s eligibility to claim the credit.
Key Takeaways
For Employers Who Are Still Considering Claiming the Credit
Heed the warnings in the IRS’ recent news releases, and beware of vendors who claim that the ERC is easy money or who make broad statements about the availability of the credit to any employer.
Only recovery startup businesses are eligible to claim the ERC in the fourth quarter of 2021, and employers cannot claim the ERC for wages reported as payroll costs on an application for loan forgiveness under the Payroll Protection Program.
The IRS has noted that shady promoters often overlook or fail to mention these important limitations on the ERC’s availability.
The ERC remains a powerful and valuable tool, but employers should take extra precaution to ensure that they are receiving competent advice. Red flags include engagement letters with ERC vendors that disclaim any responsibility or liability for the vendor or ERC vendors who refuse to sign a return as a tax preparer.
Promises that seem too good to be true probably are, and, as outlined above, improperly claiming the ERC could turn out to be quite expensive.
The IRS, furthermore, encourages employers who encounter an abusive ERC vendor to report the vendor by completing Form 14242 or to send information to the IRS Whistleblower Office.
For Employers Who Might Have Erroneously Claimed the Credit
The IRS is considering a voluntary-disclosure program for those who might have fallen victim to an ERC mill.
No further details have been released on such a program at this point.
For Tax Preparers Reviewing an Improperly Claimed ERC
Improperly claimed ERCs also create issues for tax preparers who find themselves amending old returns to account for ERC claims that they did not prepare.
Some tax preparers have reported receiving pressure from clients to overlook erroneous ERC calculations.
The IRS has noted in connection with the ERC that the tax preparer must follow Circular 230’s requirements of due diligence in the practitioner’s advice and in preparing and filing returns, full disclosure to a client of its tax situation, and reasonable reliance on client-provided information and on any advice provided by another tax professional.
Specifically, the agency has advised tax practitioners that, if they have
reason to believe that a client’s excessive ERC claim is owing to the client’s reliance on erroneous or improper advice from another practitioner, tax return preparer, or other third-party, the practitioner should, consistent with Circular 230 and the [IRS’] guidance … advise the client of the overstated claim and any additional tax and penalties that could apply and, if requested, competently assist the client in correcting or mitigating the problem.
Conclusion
We are in the early innings of the IRS’ enforcement efforts related to the ERC, and, with the IRS receiving $80 billion of additional funding in the Inflation Reduction Act of 2022 — $45.6 billion of which was earmarked for enforcement activities — we are likely to see much more enforcement activity around the ERC as the IRS works its way through the backlog of employment tax returns.
