Employers beware: IRS to scrutinize aggressive Employee Retention Credit (ERC) claims

April 5, 2023

Recent IRS notices signal significant enforcement action regarding the ERC

On March 20, the IRS opened its annual “Dirty Dozen” list of identified tax scams for 2023, with an additional warning about Employee Retention Credit (ERC) claims. The yearly list is aimed at raising awareness to protect honest taxpayers from aggressive promoters and con artists.

This notice addressing concerns regarding the ERC is the latest of several notices and warnings centered on increased IRS scrutiny of potentially abusive or fraudulent ERC claims. In an October 19, 2022 notice, the IRS warned employers to beware of third parties promoting improper ERC claims. On November 7, 2022, a COVID Tax Tip made the same warning to employers. Then on March 7, 2023, the IRS issued a renewed warning on Employee Retention Claims, and the IRS Office of Professional Responsibility issued an alert to tax professionals regarding Professional Responsibility and the Employee Retention Credit. And now - the first tax scam on the 2023 Dirty Dozen list.

The IRS is clearly aware of issues with respect to potentially abusive or fraudulent ERC claims and has indicated that it will take action to stop the potential abuse.

ERC background / Why this is an issue

ERC basics

The ERC was introduced in March 2020, as part of the Coronavirus Aid, Relief, and Economic Security (CARES) Act. The Act targeted businesses that continued paying employees while closed, or while they were experiencing significant declines in gross receipts. For most businesses, the credit applies to wages paid between March 13, 2020, and Sept. 30, 2021. Generally, only recovery startup businesses can claim the ERC for wages paid after Sept. 30, 2021.

The credit is tied to payroll and is calculated quarterly. Businesses that claimed the ERC contemporaneously with their payroll tax returns could reduce the required deposits of payroll taxes by the amount of the credit.

Businesses that did not claim the credit when filing their original returns can file amended tax returns. The usual rules apply, which means that businesses typically must file Form 941-X within three years of filing or two years from the date they paid the tax, whichever is later.

To be eligible for the ERC, employers must meet one of the following conditions:

  1. The Suspension of Operations Test - They sustained a full or partial suspension of operations due to orders from an appropriate governmental authority limiting commerce, travel, or group meetings due to COVID-19 during 2020 or the first three quarters of 2021 – this is a very subjective test
  2. The Gross Receipts Test - The business experienced a significant decline in gross receipts during 2020, or a decline in gross receipts during the first three quarters of 2021 – this is a very objective test
  3. The Recovery Startup Test - The employer qualified as a recovery startup business for the third or fourth quarters of 2021 – this is also a very objective test

A “recovery startup business is an employer (i) that began carrying on any trade or business after February 15, 2020, (ii) for which the average annual gross receipts of the employer (as determined under rules similar to the rules under section 448(c)(3) of the Code) for the 3-taxable-year period ending with the taxable year that precedes the calendar quarter for which the credit is determined does not exceed $1,000,000, and (iii) that is not otherwise an eligible employer due to a full or partial suspension of operations or a decline in gross receipts.”

ERC claims: What is the issue?

The prospect of an abundance of free money was tempting for fraudulent claims. In its 2022 summary, the Treasury Inspector General for Tax Administration reported concerns, including that “the IRS does not have processes to verify a recovery startup business or effective controls to deny the Employee Retention Credit for nonrecovery startup businesses.” In fact, by March 10, 2022, the IRS had identified 11,096 suspicious returns claiming more than $2 trillion in credits.

As a result of a straightforward process for the preparation of an ERC claim, and an apparent lack of IRS processes and controls regarding the claims, there were many unscrupulous promoters of false ERC claims. These ERC “mills” began advertising inaccurate information regarding ERC claims promising huge refunds, and relentlessly soliciting ERC claims engagements with businesses via regular mail, emails, and social media.

Often these ERC mills would ignore the more objective gross receipts test when suggesting eligibility for the ERC, and instead assert that the employer was eligible under the more subjective suspension of operations test. Many of the stated arguments to support the position that eligibility was based on the suspension of operations take a broad interpretation of that test - and attempt to take undue advantage of the subjectivity of the test.

In the notice regarding inclusion in the Dirty Dozen list, Danny Werfel, the new IRS commissioner, said this about the ERC solicitations: "The aggressive marketing of these credits is deeply troubling and a major concern for the IRS. Businesses need to think twice before filing a claim for these credits. While 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. There are extremely specific guidelines around these pandemic-era credits; they are not available to just anyone. People should remember the IRS is actively auditing and conducting criminal investigations related to these false claims. We urge honest taxpayers not to be caught up in these schemes."

Signs that an ERC solicitation claim may be problematic

Here are a few red flags if you receive a solicitation for an ERC claim:

  • Solicitations making promises without any knowledge of your financials or payroll information, or whether you reported applicable wages to obtain PPP loan forgiveness.
  • Offers to file when your business does not even file payroll tax returns.
  • Refund amounts that are more than the total payroll.
  • Eligibility determinations made without regard for affiliated or commonly controlled entities or the number and relationship of employees; and
  • Fees based on a percentage of the refund. In some cases, the fees have been as high as 40%. Although high fees may not necessarily indicate that the promoter is an ERC mill, it is advisable to exercise care when working with tax professionals that base fees on expected refunds since that could create an incentive to artificially inflate the amount of the refund.

What to consider if you receive an ERC claim solicitation, including potential penalties

If you receive a solicitation for preparation of an ERC claim that seems like it may be too good to be true, and is generally based on an assertion that you are eligible for the ERC under the suspension of operations test, you should consider the red flags listed above and ask the ERC promoter the following questions – based on IRS guidance regarding the ERC:

  1. Did they identify a specific governmental order that limited the business’ commerce, travel, or group meetings due to COVID-19? It is not enough to focus on the impact to the business - identification of the governmental order is a necessary first step in the analysis. 
  2. Did they determine whether the effect on the business was more than nominal?
  3. Did they analyze whether employees of the business were able to work comparably through telework?

Also, if you think the ERC promoter is unscrupulous and may be acting illegally, consider reporting the ERC promoter to the IRS using Form 14242, Report Suspected Abusive Tax Promotions, or Preparers.

Finally, consider the prospect of an IRS audit of an ERC claim. The statute of limitations for audits of Form 941 is slightly different than the regular rules. In the case of a Form 941, filed quarterly, the statute of limitations starts on April 15 of the following calendar year if the return is filed on or before April 15. For example, if all quarterly returns for 2020 are filed on or before each quarter’s filing due date, then the general three-year statute for all quarters begins running on April 15, 2021. Also, for the third quarter of 2021, a special five-year statute of limitations applies instead of the general three-year rule. Furthermore, given the IRS’ warning, there is no time limit for the IRS to assess in the case of a false or fraudulent return filed with the intent to evade tax, or in the case of a willful attempt to evade taxes by the employer or by the preparer, which likely includes the preparer of the ERC calculation used to claim the ERC on the return. 

The potential penalties in the event of an ERC audit can be significant. If an employer is audited, and the amount of the ERC is reduced, the penalties could range from a 20% accuracy-related penalty to a 75% penalty if the IRS asserts civil fraud by the employer. In an egregious case, the IRS could assert criminal fraud, resulting in penalties and potential imprisonment.

What Herbein will do

As quality tax professionals we will follow and comply with the Professional Responsibility and the Employee Retention Credit notice issued by the IRS OPR, and therefore we will exercise due diligence if we receive requests to prepare and file payroll tax returns to claim ERC refunds; fully disclose to clients the tax situation with respect to the ERC claim; and be reasonable in our reliance on client-provided information and on advice provided by another tax professional (such as a third-party ERC consultant).

If we are engaged to prepare the applicable amended income tax returns to reduce the wage expense deduction for the amount of the ERC refund when the ERC claim was prepared by another tax professional, we will agree to prepare the applicable amended returns and will advise the client if we believe the ERC claim was overstated and that additional tax and penalties could apply. We may also advise the client to file a complaint with the IRS using Form 14242, Report Suspected Abusive Tax Promotions, or Preparers.

We will act on behalf of our clients to take advantage of all tax savings opportunities lawfully and effectively without incurring undue additional tax and penalties.

If you have additional questions or concerns, please reach out to your Herbein team member through the form below.

Article prepared by Barry D. Groebel