It has become clearer that the Employee Retention Credit is a priority enforcement topic for the IRS. Like other priority enforcement topics, such as micro-captives and conservation easements, the IRS issued a stern warning to employers in October “to be wary of third parties who are advising them to claim” the ERC “when they may not qualify.” Thus, it is more important than ever for employers to revisit their ERC positions.
What Issues Might the IRS Focus On?
The IRS likely will focus on three general themes: eligibility, substantiation of the amounts claimed, and whether (if required) an amended income tax return was filed to correct any overstated wage deduction.
In particular, the IRS likely will focus on substantiating qualifications based on a partial suspension of business operations, which requires a taxpayer to demonstrate that a government order interrupted at least a portion of its business (but a complete shutdown of the business was not required). Additionally, the order must be more than a recommendation, and it must have negatively impacted their business by a more than nominal amount.
What Are the Possible Penalties?
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 Type of Documentation Is Required?
If an employer has claimed the ERC, they must have sufficient documentation to substantiate eligibility under either the gross receipts decline or government order tests, including how the orders negatively impacted their operations in a more than a nominal way. See Notice 2021-20, Q& A 70[SS2]. In ERC audits, the IRS has been known to request documentation for the quarters the ERC is claimed, such as: the work papers used to compute the ERC, payroll journals, the employees’ names, the amount of wages paid to each employee for which the ERC is claimed, evidence that the taxpayer experienced a significant decline in gross receipts, and application of any PPP loan forgiveness.
The IRS has also been known to request bank records, such as statements and canceled checks, and general books and records, such as the general ledger, accounts payable, and the trial balance. According to the IRS, documentation related to the ERC claim, including all records of employment tax, of an eligible employer should be retained “for at least four years after the date the tax becomes due or is paid, whichever comes later.” The IRS subsequently extended the statute (see below) suggesting documentation should be maintained for at least five years.
What Is the Statute of Limitations?
Generally, the IRS has three years from the date a return is filed to assess additional tax. However, in the case of a Form 941, which is 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. See IRC §6501(b)(2)[SS4]. 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.
For the third quarter of 2021, a special five-year statute of limitations applies instead of the general three-year rule. See IRC §3134(l)[SS5]. 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. See IRC §6501(c)(1)–(2).[SS6].
What if an ERC Claim Has Already Been Filed?
An employer or its adviser that might have taken an uncertain position or is in doubt if it has proper documentation should consult a tax professional to conduct a pre-audit assessment of the ERC claim. A pre-audit assessment should entail a review of the eligibility and credit amount claimed. It should also include a review of the existing documentation to evaluate if there is a need for additional documentation.
If the pre-audit assessment changes the amount of ERC available, an employer might want to consider filing an amended return. Generally, if an amended return is filed to reduce the amount of the ERC claimed and the IRS has not already notified the employer of audit, the employer can avoid the 20% accuracy penalty.
What Can an Employer Do?
The IRS warned that “[b]usinesses are encouraged to be cautious of advertised schemes and direct solicitations promising tax savings that are too good to be true” and that “improperly claiming the ERC could result in taxpayers being required to repay the credit along with penalties and interest.” Thus, similar to conservation easements and micro-captives, the IRS given its recent warning will more than likely be tougher on taxpayers that proceed with egregious ERC claims.
Accordingly, it is important to have a tax professional who understands the ERC program and who can perform a comprehensive study incorporating the pre-audit assessment into calculating the claim by understanding employer-specific facts and preparing proper contemporaneous documentation.
Now is the time for employers to reexamine their ERC claims and to proceed prudently in filing any new ERC claims. If the ERC claim is too good to be true, it might just be what the IRS is warning about.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Kristin Balding Gutting is a principal at FORVIS, LLP where she leads the firm’s Tax Controversy and Procedure Group.
Troy Taylor, CPA, is a tax managing director for FORVIS’ tax specialty practice.
Joshua Elliot is a national practice leader for FORVIS’ federal tax specialty services practice.
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