Managing Attorney at Brotman Law.
In March 2020, Congress passed the Coronavirus Aid, Relief and Economic Security Act (CARES Act) to provide over $2 trillion of economic assistance for individuals, businesses and industries during the pandemic. Two main components of the CARES Act were the Paycheck Protection Program (loans sponsored by the U.S. Small Business Association), and the Employee Retention Credit (a tax credit designed to help keep people employed).
The ERC offered businesses thousands of dollars per employee if they could demonstrate that they were seriously affected by a government order. Though the credit was intended to help keep businesses afloat, it has become, as a New York Times article put it earlier this year, “a magnet for fraud, creating a cottage industry of firms that market themselves as tax credit specialists who can help clients — even those who don’t qualify for the money — reap huge refunds from the I.R.S.”
This September, the IRS announced a moratorium on processing new ERC claims until at least the end of the year due to increased fraud concerns. The agency reported that it is investigating hundreds of criminal cases and referring thousands of ERC claims for audit. Third-party companies making inaccurate or fraudulent claims, known as “ERC mills,” are especially susceptible to scrutiny.
I’ve seen a lot of misinformation about the IRS’ crackdown on ERC fraud. As a tax attorney with years of experience protecting businesses from tax problems, I want to set the record straight. Here is the most important information you need to know about ERC compliance as a business owner.
A Business Owner’s Guide To The ERC
The first thing you should know is that if your business is eligible for the ERC, don’t let the IRS moratorium scare you off. You should still apply for the credit, keeping in mind that your application won’t be processed before the end of the year. If you aren’t eligible for the credit, don’t apply. The IRS put ERC claims at the top of its Dirty Dozen tax scams for 2023, and it’s putting its full weight behind pursuing fraudulent claims.
But if you did apply for the ERC, you need to prepare for IRS scrutiny and protect your business in case of an IRS audit. Even if you have a legitimate claim, you could be forced to pay back the credit, with severe penalties.
You can qualify for the credit in two ways: based on a drop in gross receipts from the second quarter of 2020 to the third quarter of 2021, or based on what I call the operational impact test. This test is defined by the question: Was your business more than nominally impacted by a government order? I use a four-part analysis to determine the answer:
1. There must have been a government order.
2. There must have been an impact on the business.
3. That impact had to be more than nominal.
4. There must have been a causation link between the order and the impact on the business.
At-Risk Business Categories
In my experience, if your business fits a certain profile, you may be more vulnerable to IRS scrutiny:
• ERC mill users: If you responded to an advertisement and engaged an ERC mill to submit a claim for you, even if your claim is valid, your business has high potential to be near the top of the list for IRS audits. The IRS has issued several warnings about companies who charge large contingency fees in exchange for filing the credit and is examining returns for evidence of fraud.
• Businesses in Republican-led states and rural areas: If your business is located in a rural area or a state that was led by a Republican administration during the pandemic, you likely didn’t experience as many government orders or regulations as densely populated areas or Democratic-led states. Because of this, your Employee Retention Credit claim could be weaker and the IRS may give your application more attention.
• Certain industry categories: Your tax returns contain a North American Industry Classification System (NAICS) code, which the IRS uses to segment taxpayers that it wishes to audit. Some industries, such as those related to professional services; consulting; real estate; retail or manufacturing reliant on domestic versus international supply chains may be more at risk of audit. If your business is the type that typically allows employees to work remotely, this may also put you in a high-risk category.
• Growing businesses: If your business experienced revenue growth or increased its employee count during the quarters you claimed ERC, you should be prepared for closer IRS examination. Businesses that experienced success during the pandemic may have a weaker argument than those that were more than nominally impacted.
Two Steps To Protect Your Business
The stakes of an IRS audit are high, and it’s in your best interest to be proactive. I recommend taking these two actions to prepare for a potential audit:
1. Seek professional guidance from a tax attorney.
Build a case to substantiate and corroborate your ERC claim, preferably working with a tax attorney who specializes in these types of IRS audits and penalties. While CPAs are experts in tax compliance, they don’t normally handle payroll tax returns and don’t have the necessary legal expertise to navigate the intricacies of the ERC. In comparison, tax attorneys are trained in advocacy and strategy and make arguments behalf of their clients to the IRS when they get audited.
2. Document impact thoroughly.
The ERC is based on a quarter-by-quarter analysis. For each quarter you claimed the credit, meticulously document the impact the pandemic had on your business. This documentation could include financial reports, written testimonies from employees, emails or any other relevant evidence. If you had supply chain issues in Q3 of 2020, for example, record in detail the materials you couldn’t acquire, why they were essential to your business and how your business suffered without them. If your ERC claim is larger in size ($500,000 or more), you may want to consider having a tax opinion drafted to support your claim.
The IRS’ crackdown on ERC claims could have devastating effects on your business, even if you followed all the rules. Take the time now to prepare for a rainy day because it could start raining all too soon.
The information provided here is not investment, tax, or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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