What to Expect If the IRS Audits Your Employee Retention Tax Credit
The employee retention tax credit was offered to businesses that kept employees on the payroll during the COVID pandemic. The credit was extremely valuable — up to $10,000 per eligible employee in 2020 and up to $20,000 per eligible employee for 2021, and the 2021 maximum credit was even higher for qualifying new businesses.
This credit was a boon to employers who paid employees even though their revenue was down or their operations were suspended. But unfortunately, many people claimed the credit erroneously. Due to this fact, the IRS is auditing payroll tax returns with this credit at very high rates.
Have you been notified about an ERC audit? Worried about an ERC audit? Thinking about claiming the credit retroactively but concerned about your audit risk? Then, you're in the right place. This guide provides an overview of the ERC audit process as well as an explanation of red flags and what to do if you claimed the credit incorrectly. To get help now, use TaxCure to find a local tax pro in your area.
What to Expect From an ERC Audit
The ERC audit process is generally similar to any other IRS audit. If the IRS selects your payroll tax return for an ERC audit, it will send you a notification. Then, you will be required to provide documents that support your right to claim this credit.
In most cases, ERC audits are conducted through the mail with some telephone consultations. This is called a correspondence audit. In some cases, however, the auditor may request that you come to their office (desk audit) or that you meet at your place of business (field audit).
Once you provide the supporting documents, the auditor will review them and determine if you were eligible for the ERC. If there are any uncertainties, the auditor may request additional information. If the documents prove that you were eligible for the credit, the auditor will close out the audit and issue a no-change report. Otherwise, they will adjust your return and send you a proposed assessment.
At this point, you can appeal the audit results. During the appeal, you will be allowed to present additional information or arguments about interpreting the tax code. The review team may adjust your return or stick with the auditor's findings. At that point, the proposed taxes are formally assessed. Depending on the situation, you may still have the right to appeal, or you may just have to pay the taxes.
Supporting Documents for ERC Audits
An ERC audit usually starts with the IRS sending you an information document request (IRD). The IRD will outline the documents you need to provide and let you know how to contact the auditor for clarification. The exact supporting documents vary based on the situation, but in general, you should be prepared to back up the following:
- How you qualified for the ERC.
- The wages paid to employees.
- Additional details as related to your situation.
You will use different documents to back up each of these elements. Here are more details.
Proof of Eligibility for the ERC
First, let's look at the qualification criteria. Businesses were eligible for the ERC based on 1) a reduction in revenue, 2) a suspension of operations, or 3) being a recovery start-up business.
If you claimed the credit based on a reduction in revenue, you will need to show that your revenue for the quarter you claimed the credit was lower than the revenue for the comparison quarter. For example, you could only claim the credit in 2020 if your revenue was at least 50% or less of your revenue in the same quarter of 2019. So you'll need income documents from both quarters.
Businesses that claimed the credit based on a suspension in operations will need to prove that their operations were suspended. To back up this claim, you may need to find statements from the Health Department, media stories about business closures, or announcements from government websites.
If you claimed the credit based on being a recovery start-up business, you will need to prove your eligibility by showing when you opened your doors and by proving that you're under the revenue threshold. Recovery start-up businesses are any businesses that were opened after February 15, 2020. You also must have less than $1 million in gross receipts over the three years before claiming the credit.
Wages Paid to Employees
Second, you will have to substantiate the wages that you paid to employees. This is a fairly standard part of a payroll tax return audit. You may need to provide copies of time cards or bank statements showing that the paychecks were cashed.
The auditor may also ask if you are related to any of your employees. You are not allowed to claim the ERC for relatives of the company's owners. This includes spouses, children, parents, grandparents, siblings, step-siblings, nieces/nephews, aunts/uncles, and the spouses of any of these relatives.
Additional Details Related to Your Situation
Finally, what additional details will the auditor ask about? Well, if you claimed a paycheck protection program (PPP) loan, you will have to prove that you didn't claim the credit on any wages paid with that loan. PPP loans required detailed paperwork, or businesses set up separate accounts to disperse those funds. You can use that paperwork or account statements to back up your claims.
You may also have to show how the ERC affected the wage deduction claimed on your business tax return. Normally, you can claim all of your wage expenses (which includes wages paid and payroll taxes) as a deduction on your tax return, but if you claimed the ERC, you were supposed to reduce this deduction by the amount of the credit.
Who's at Risk of an ERC Audit?
The IRS may audit anyone who submitted an Employer's Federal Tax Return with an employee retention credit. You may be at additional risk if any of the following apply:
- An ERC mill amended your employer tax return.
- The wages reported on your payroll return were significantly higher than the wages reported on previous years' returns.
- Your business tax returns from 2020 show more income than in 2019, but you still claimed the credit.
These factors don't necessarily mean that you're ineligible for the credit, it just means that the IRS may give the situation a second look.
What's an ERC Mill?
An ERC mill is a company that just churns out ERC credits. These companies do a lot of marketing to try to reach business owners about these credits. Some are ethical, and they really help businesses claim credits that they missed when COVID was happening. Others, however, are notorious for pushing businesses to claim credits they aren't eligible to claim.
At the time of writing, this is still happening. It's still possible to amend most COVID-era payroll tax returns, and thus, these mills are still out there looking for clients. The IRS has issued warnings about using these companies to claim the ERC.
Red Flags of ERC Mills
Thinking about claiming the employee retention credit? Worried that the company you're hiring is an ERC mill? Then, look for these red flags:
- The company's ads make inaccurate claims about eligibility. If you're unsure, consult the IRS's website or reach out to a local tax professional.
- The reps say that you'll automatically qualify. No one can make this claim until they know more about your unique situation.
- The rep uses aggressive sales tactics to get you to sign up quickly. An honest tax professional will let you know about deadlines, but they won't try to rush you.
- They don't ask for any documentation to support your eligibility. Because the eligibility rules are so complex, this is a huge red flag.
- The company's fee is based on a percentage of the tax credit. This isn't necessarily illegal, but it's a sign that you're not working with an experienced CPA. CPAs can only charge contingency fees in select situations which do not include amended returns.
If you already filed and you believe that you may have worked with an unscrupulous company, you should consider contacting a tax professional for guidance on what to do. You can also report the company by filing Form 14242 (Report Suspected Abusive Tax Promotions or Preparers).
ERC Voluntary Disclosure
Normally, if you don't file required returns or if you fail to report all of your income, you may be able to "come clean" through the IRS's voluntary disclosure program. There is one pathway for people who just didn't file or report all income, and there's another program for people who may have committed criminal tax fraud.
To protect yourself, you should always consult with a tax attorney before using either of these programs. As of now, the only disclosure option for misclaimed ERCs is the standard program. There is no specific voluntary disclosure program for this credit — however, there is some talk in the media that one may be created.
If the auditor disallows your credit, you will owe a tax liability, and the auditor may also add penalties to your account. There is an accuracy-related penalty of 20% of the unreported tax and a fraud penalty for 75% of the unreported tax.
For example, let's say that you claimed an ERC penalty, and it reduced your tax bill by $40,000. If the auditor assesses an accuracy penalty, the penalty will be $8,000 — that's 20% of the unreported tax. If the IRS decides that you committed fraud, the penalty could be $30,000.
There's a lot at stake with an ERC audit. Not only could you lose the penalty, but you might also incur very significant fees. A tax professional with extensive audit, payroll tax, or ERC experience can help you navigate the situation.
Can You Appeal an ERC Audit Decision Made by the IRS?
If you disagree with the results of your audit, you need to dispute the audit in writing. You can do this yourself, or you can hire an enrolled agent, CPA, or tax attorney to help you. If the audit increases your tax liability by $25,000 or less, you can file Form 12203 (Request for Appeals Review).
In both cases, you should explain why you disagree. You should also provide any documents that support your case. If you've gotten to this stage in the ERC audit process on your own, you may want to enlist help now. Failing an audit appeal can make the tax liability final.
If you miss the appeals window, you may still be eligible to request an audit reconsideration. This gives you a chance to present more details about your position.
Statute of Limitations for Audits on Tax Returns With ERCs
The IRS has five years to audit employer tax returns filed in Q3 or Q4 of 2021. The agency only has three years to audit most payroll tax returns, including returns with employee retention credits filed in 2020 or the first two quarters of 2021. However, there is chatter that this may be changed, and the statute may be extended for these quarters as well.
The statute of limitations on payroll tax returns starts in April of the year after they are filed. That means that the IRS has until April 15, 2024, to audit payroll tax returns filed in 2020. It has until April 15, 2025, to audit payroll tax returns from the first two quarters of 2021, and it has until April 15, 2027, to audit payroll tax returns with ERCs from the last two quarters of 2021.
Potential Complications With Late ERC Audits
If you face a late ERC audit (ie, an audit that occurs after the usual three-year statute of limitations), you will be unable to adjust your business tax return for a refund if you fail the audit.
That's a lot to understand. So, here's a breakdown.
First, let's look at what happens if you fail an ERC audit in the usual three-year time frame. Say that the IRS auditor determines that you are ineligible for a $50,000 ERC. You will owe that amount plus any interest and penalties to the IRS, but as a slight consolation, you will be able to claim a deduction on your business tax return.
If you filed your business tax return correctly, you should not have included that $50,000 credit in your wage expense. However, once you lose the credit, you can amend your wage expense and add the $50,000 back onto it. This will reduce your taxable profits and put a refund in your pocket.
Now, here's the potential problem. You only have three years to amend a tax return to get a refund. So, if the IRS audits your ERC four or five years after you file and you won't be able to amend your business return if you fail the audit. This means that failing the audit will cost you more in the long run than it would have if happened in the three-year window.
Analysts speculate that the IRS may issue a special ruling to deal with this potential refund loss for businesses. But at the time of writing, this is how the situation stands.
Get Help With an ERC Audit
Want help with an ERC audit? Need a second opinion before claiming this credit? Then, you should reach out to a local tax professional. A local tax professional such as an enrolled agent, CPA, or tax attorney can provide you with the ethical guidance you need when amending returns or claiming credits. They can also help you get through an ERC audit.
To find a local pro, use TaxCure to search for someone in your area today.