Diligence is often one of the longest—and most expensive—parts of merger and acquisitions work. On the buyer’s side, a team dives deep into their target’s financial past to unearth any risky activity.
These days, lawyers and accountants are discovering a new skeleton in targets’ closets: the employee retention credit.
Signed into law by former President Donald Trump as part of the CARES Act in 2020, the ERC is a refundable credit meant to encourage small businesses to keep their employees on payroll during Covid-19 lockdowns. But the IRS quickly faced a pileup of hundreds of thousands of unprocessed claims, as well as the meteoric rise of scammers on social media, email, and broadcast media encouraging businesses to claim tens of thousands of dollars per employee when they didn’t qualify.
ERC fraud became such a problem that this year the IRS put it on its “Dirty Dozen” list of tax scams and prioritized the credit as a red flag for audits. The IRS confirmed to Bloomberg Tax a recent report stating that the agency has opened 122 investigations totaling $1.2 billion in credit claims as of April 30.
That has created the need for hundreds of hours more due diligence work for tax practitioners working on M&A transactions so a buyer isn’t susceptible to an IRS audit or steep penalties. Anxiety and hesitance about these credits have spurred disagreements between parties, questions about a company’s value and ultimately prolonged deals—compounded by insurance companies’ reluctance to underwrite the credit.
“With this employee retention credit, I just know as soon as I see it, I’m extremely concerned,” Laurent Campo, partner at Potomac Law Group’s M&A practice, told Bloomberg Tax.
Part of the problem is that taxpayers have, indeed, been duped by scammers. They truly believe they qualify for large government refunds, to the point of spurning their accountants or lawyers because the professional refused to file incorrect ERC claims.
But many tax professionals are also not well-versed in the minutiae of the ERC. Some advertisements encourage businesses to question or reject the advice of CPAs on the credit.
Practitioners say because of the liabilities associated with the ERC, service providers must learn the ins and outs of the credit’s program to protect their clients from immediate and future consequences of a faulty claim.
“This should be part of the due diligence process for each deal that goes on right now,” said Derek Adams, partner at Potomac Law Group. “Because it’s not just paying back the money. That’s a risk, paying back the money, but it’s also interest potentially, which is currently 7 or 9% depending on how much the IRS determines the underpayment was.”
Disagreements About Facts and Circumstances
At the crux of many disagreements over the ERC in a transaction is whether a small business qualified using the government order test—one of two criteria used to determine if a business was significantly impacted by pandemic-era lockdowns.
Businesses qualify for the credit if they have a substantial decline in gross receipts—known as the gross receipts test—or endured a full or partial suspension of operations due to a government ordered shutdown.
IRS Notice 2021-20 laid out specific examples of what is considered a full or partial suspension of business operations following a government ordered shutdown.
But Gabe Rubio, partner with BDO USA’s Business Incentives Group, said the guidance leaves room for debate. He added he’s seen deals where the tax practitioner on the target’s side has been adamant the entity passed the government test using evidence that didn’t necessarily gel with IRS guidance.
And where there’s a claim on facts and circumstances without “substantial authority” there’s risk that the IRS won’t agree with an assessment, he continued.
Adams echoed Rubio, telling Bloomberg Tax whether an entity passes the government order test can be subjective.
“The answer under that test is not a yes or a no. It’s a ‘how strong is your argument?’” Adams said.
Booking
Another issue is that many companies record ERC refunds they received from the IRS on their books improperly, skewing the business’s financial health or worth to a buyer.
Jenn McCabe, partner at Armanino, LLP, said she’s seen companies book the refund as income instead of as a credit to non-operating or other income. She said that was the situation in one deal she worked on, where a small dance studio was looking to sell to a private equity firm. The mistake affected the “whole valuation” of the deal, she said.
“It’s a problem for the buyer because the seller has recorded it as an increase to revenue,” McCabe said.
“They hadn’t done it on purpose,” McCabe said, referring to the dance studio, “but that whole thing had to be redone.”
ERC Eats Up Time
McCabe said three deals she’s consulted on have been prolonged by a month due to disputes over the employee retention credit.
Adding to the time suck are negotiations for indemnification of the credit, because it’s not eligible for representation and warranty insurance. A buyer seeks a representation and warranty policy in an M&A transaction to ensure that if there’s a breach in a contract’s negotiated representations and warranties, they’re not on the hook for a large bill.
Insurance companies are catching on to the risk associated with the ERC and many have made it part of their standard exclusions, Campo said.
“In the last 18 months, what we’ve been seeing is just a blanket statement that every single insurance company came back and said that their standard exclusion covers ERC,” Campo said.
There is an option for the buyer to get tax insurance—a policy to reduce risk from an audit or dispute—for the credit, but tax insurers are also wary.
Mark McTigue, managing director and tax insurance specialist at Marsh, said his company is aware that some advisers in the ERC market are “considered a bit aggressive.”
“We are highly selective when we work with any client on insuring the employee retention credit. That being said, we have insured the employee retention credit for several clients that took very strong positions,” McTigue said.
When the buy and sell sides can’t agree on how to move forward with the employee retention credit and they can’t insure the refund, the parties often decide to put the ERC in escrow or an indemnity.
“From a diligence perspective, there are ways to negotiate around any of the either identified risk within diligence or a perception that there could be risk at a future date,” said Nicole Szczepanek, tax partner and corporate tax vertical leader at Baker Tilly US.
Szczepanek said the more specific the language is in the indemnification clause tied to the ERC, the better. This way, there is no question about the dollar value of the perceived risk associated with the credit and who bears the responsibility in the case of an IRS audit.
Businesses can be audited by the IRS up to five years after they claim the employee retention credit. Adams predicted the problems are only beginning for businesses who’re acquiring targets with an ERC claim.
“I mean, without a doubt, there will be litigation following transactions when the IRS comes along and says, ‘Oh, by the way, you owe us 3 million bucks back.’”
“It’s a great credit if you qualify—really great credit if you qualify—but you need to go into it with your eyes open and know what you’re looking at.”
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