What is the penalty for ERC audit?

What is the Penalty for an ERC Audit?

The Employee Retention Credit (ERC) has been a valuable lifeline for many businesses during the pandemic. However, the IRS is now cracking down on potential abuse of this tax credit through increased audits. If your business claimed the ERC, you may be wondering – what are the penalties if I get audited and the IRS reduces or denies the credit?

The stakes can be high. Penalties range from 20% to 75% of the disallowed credit amount. In extreme cases of fraud, business owners could even face jail time and hundreds of thousands in fines. Let’s break down exactly what you need to know.

Civil Tax Penalties

If the IRS determines you claimed too much ERC, the most common penalty is a 20% accuracy-related penalty. This means if your credit is reduced by $10,000, you’ll owe $2,000 on top of repaying the excess credit.

Things get more serious if the IRS asserts you committed civil tax fraud. The penalty then jumps to a whopping 75% of the disallowed amount[1]. So in the example above, your penalty would be $7,500 instead of $2,000.

The IRS has a high bar for proving civil tax fraud. They must show you intentionally tried to evade taxes you knew you owed. But they will look for red flags like:

• Claiming the ERC despite clearly not meeting eligibility requirements
• Using sham companies or false employee names to multiply the credit
• Fabricating documentation to support a larger credit

The stakes go up if the IRS can prove you knew your ERC claim was bogus. So accurately claiming what you’re entitled to is critical.

Criminal Tax Penalties

In the most extreme cases, the IRS may pursue criminal prosecution. This is very rare but can happen if they believe you deliberately tried to defraud the government.

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Potential criminal penalties include[2]:

• Up to $100,000 in fines for individuals ($500,000 for corporations)
• Up to 5 years in prison

Going to jail for taxes seems unthinkable. But it has happened to business owners who engaged in outright fraud. So don’t take the ERC lightly.

Failure-to-Deposit Penalty

Another possible penalty is the failure-to-deposit penalty. This applies if you initially claimed the ERC as a refundable credit but are later denied. The disallowed ERC then becomes an underpayment of payroll taxes.

The penalty is 2% to 15% of the underpaid amount, depending on how late you pay it. The IRS may waive this penalty if you can show reasonable cause for the underpayment.

Statute of Limitations

One important question is how long you can be on the hook for ERC penalties. The IRS typically has 3 years from when you filed the return to assess accuracy and fraud penalties[3].

However, there is no statute of limitations on criminal prosecution for tax fraud. The IRS can pursue criminal charges at any time if they believe you deliberately tried to evade taxes.

Defending Yourself in an ERC Audit

The best defense is being able to document your eligibility for the ERC you claimed. Keep detailed records showing:

• You experienced the required revenue decline in 2020 and/or 2021
• Employees for whom you claimed the credit were retained but not working
• Wages paid to those employees during ERC-eligible periods

It’s also crucial to respond promptly to any IRS inquiry about your ERC claims. If you get an audit notice, contact a tax professional right away. An experienced CPA or tax attorney can help make the best case to avoid penalties.

If the audit does reduce your eligible ERC, consider amending your return before the IRS formally asserts penalties. This can sometimes help avoid accuracy penalties, though not fraud penalties[4].

Beware of Shady ERC Help

With lucrative tax credits like the ERC, scammers inevitably come out of the woodwork. The IRS has already identified numerous schemes to wrongly obtain these credits[5].

Some signs a so-called ERC “expert” may be selling you on an improper strategy:

• Claiming you’re eligible for credits far exceeding your payroll spending
• Using sham companies or false employees to multiply the credit
• Advising you to fabricate documentation
• Charging exorbitant contingency fees based on the credit amount

Stick to reputable CPAs and tax pros with legitimate strategies for maximizing credits under the law. The “too good to be true” offer is likely just that.