NATIONALLY RECOGNIZED FEDERAL LAWYERS
How long can the IRS audit ERC?
|IRS Audits of Employee Retention Credits
Overview of Employee Retention Credits
The Employee Retention Credit (ERC) was created by the Coronavirus Aid, Relief, and Economic Security (CARES) Act in March 2020 to help employers retain employees during the COVID-19 pandemic. The ERC provides a refundable tax credit against certain employment taxes equal to 50% of up to $10,000 in qualified wages paid to employees after March 12, 2020 and before January 1, 2021. The tax credit was initially available to employers whose operations were fully or partially suspended due to COVID-19 shutdown orders or whose gross receipts declined by more than 50% when compared to the same quarter in 2019.
The ERC was modified and extended by the Consolidated Appropriations Act in December 2020 and the American Rescue Plan Act in March 2021. Key changes included:
Increasing the credit rate to 70% of qualified wages
Expanding eligibility by lowering the required year-over-year gross receipts decline from 50% to 20%
Increasing the limit on per employee creditable wages from $10,000 for the year to $10,000 per quarter
Extending the ERC through December 31, 2021
Employers can receive advance payments of the ERC by reducing their federal employment tax deposits. If the credit exceeds the employer’s payroll tax liability, the IRS will refund the excess as an overpayment. Employers can also request advance payments from the IRS instead of reducing deposits.
IRS Audits of ERC Claims
The IRS has flagged the ERC as prone to abuse and plans to conduct audits of employers who claimed the credit. The IRS expects to start audits in 2023 after employers have filed returns for the 2021 tax year. Audits will likely focus on the following key requirements for ERC eligibility:
Qualified Wages
The ERC applies only to qualified wages paid to employees. Auditors will check that wages claimed for the credit meet the definition of qualified wages:
Paid to an employee who did not provide services during the period of credited wages due to COVID-related circumstances
Paid for the applicable quarter(s) in 2020 and/or 2021
Capped at $10,000 per employee for all quarters
Gross Receipts Reduction
To be eligible based on a decline in gross receipts, an employer must demonstrate a reduction in gross receipts by 20% or more in a calendar quarter compared to the same quarter in 2019. Auditors will verify employers’ gross receipts calculations and documentation.
Full or Partial Suspension of Operations
Employers whose operations were fully or partially suspended due to a COVID-19 government order are eligible for the ERC. Auditors will review the applicable government orders and validate that the employer was subject to mandates that suspended operations.
Affiliated Entities
For entities with multiple related businesses, eligibility must be determined by aggregating gross receipts and employees of all affiliated entities. Auditors will evaluate businesses’ organizational structures and determine if any related entities should have been included in ERC calculations.
Loan Forgiveness and Other Relief
Wages paid using Paycheck Protection Program (PPP) loan funds that are forgiven may not also be counted for the ERC. Auditors will check for overlap between PPP loan forgiveness amounts, ERC credits claimed, and wages paid during relevant periods.
Penalties for ERC Fraud
The IRS treats fraudulent claims of the ERC very seriously. If an employer is found to have intentionally claimed credits improperly, the IRS can seek several types of civil penalties and may also pursue criminal prosecution.
Civil Penalties
The IRS may assess the following civil tax penalties for fraudulent ERC claims:
Accuracy-Related Penalties
Section 6662: Adds a penalty of 20% of the underpayment of tax resulting from negligence or disregard of rules and regulations.
Section 6662A: Adds a penalty of 20% of underpayments related to any undisclosed noneconomic substance transactions.
Section 6663: Imposes a penalty of 75% of any underpayment that is attributable to fraud.
Erroneous Refund Penalties
Section 6676: Imposes a penalty of 20% on excessive refund claims.
Section 6701: Imposes a penalty on any person who aids or assists in fraudulent tax return claims, set as the greater of $1,000 or 100% of the improper refund claim.
Failure to Comply Penalties
Section 6708: Imposes a $10,000 per day penalty for failure to make required certifications or provide required information to claim tax benefits such as the ERC.
Criminal Prosecution
In the most severe cases of intentional ERC fraud and abuse, the IRS may refer cases to the Department of Justice for criminal prosecution. Potential criminal tax charges include:
Tax Evasion (26 U.S.C. § 7201): Punishable by up to 5 years in prison and fines up to $250,000. Requires willful attempt to evade or defeat tax.
False Statements (26 U.S.C. § 7206): Punishable by up to 3 years in prison and fines up to $250,000. Requires willful falsification, concealment, or covering up of material facts.
Fraud and False Statements (18 U.S.C. § 1001): Punishable by up to 5 years in prison and fines. Applies to willful and knowing concealment or false representations made in any matter within the jurisdiction of the federal government.
Theft of Government Funds (18 U.S.C. § 641): Punishable by up to 10 years in prison and fines. Covers embezzlement, theft, or improper conversion of government funds or property.
Conspiracy (18 U.S.C. § 371): Punishable by up to 5 years in prison and fines. Covers conspiring to commit an offense against or defraud the United States.
IRS Audit Process
If the IRS decides to audit an ERC claim, the process will typically involve the following steps:
- The IRS sends a notification letter informing the taxpayer they are being audited.
- The auditor requests documentation and information related to the issues under review.
- The taxpayer provides requested evidence supporting their credit claims.
- The auditor examines documentation and conducts additional research as needed.
- The auditor may interview relevant employees and request sworn statements.
- Audit adjustments are proposed based on review findings.
- The taxpayer can agree to adjustments or dispute them and provide additional documentation.
- A final determination letter is issued to the taxpayer.
- Any underpayment or penalty amounts must be paid.
- Taxpayers have appeal rights and can request a conference with the IRS Office of Appeals.
The statute of limitations gives the IRS a minimum of 3 years to initiate an audit after a return is filed. The timeline is extended to 6 years for substantial understatements of income. There is no limit in cases of tax fraud.
Audits can be wearying for taxpayers, but thoroughly documenting eligibility for ERCs in advance can help expedite the process. Supporting records like validated gross receipts reports, applicable shutdown orders, employee payroll records, and accounting for any COVID relief loans and grants received can demonstrate good faith in complying with credit requirements.
Being forthright and responding promptly to all information requests can help taxpayers demonstrate willingness to cooperate fully. For those who intentionally tried to defraud the ERC program, however, the audit may expose them to significant civil penalties and potential criminal prosecution.
Avoiding ERC Audits and Penalties
Taxpayers who claimed ERCs in good faith and with reasonable basis for meeting eligibility criteria are unlikely to face penalties. The IRS has indicated audits will primarily target potentially fraudulent claims.
The best way for employers to avoid ERC audits and potential penalties is to:
Maintain thorough documentation validating credit eligibility.
Report qualified wages and claimed credits accurately.
Respond promptly to any IRS inquiries.
Be transparent about your business operations and financial situation.
Consult qualified tax professionals when unsure if your business qualifies.
With some foresight and caution, legitimate taxpayers can claim the ERC without fear. The IRS is focused on punishing those who intentionally abuse this COVID relief program, not those working in good faith to retain employees during difficult times. Being proactive in record-keeping and transparency will demonstrate your intent to follow the rules.
Conclusion
The ERC provides substantial tax credits to support struggling employers and protect jobs during the pandemic. However, improper claims will be subject to strict scrutiny by the IRS. Audits are imminent, and severe civil penalties or criminal prosecution await those who knowingly claim fraudulent credits. Legitimate ERC claims that are well-documented have nothing to fear. With proper care and transparency, employers can take full advantage of the credit without anxiety about repercussions.