Employee Retention Credit Fines and Penalties
What to Expect If You Fail an ERC Audit
You may have heard that the IRS is focusing on ERC (employee retention credit) audits, and it's true. Due to many fraudulent claims and the rise of unscrupulous companies whose sole mission is to urge businesses to claim this credit whether they qualify or not, the IRS is narrowing on in returns with employee retention tax credits. The agency has named ERC fraud one of its dirty dozen tax scams, and it's ready to crack down on false claims.
So what happens if the IRS audits your ERC and disallows it? Then, you will lose the credit, but you may also face penalties and interest on your account. Here's an overview so that you know what to expect. Or contact a tax professional for help today.
When you claim a tax credit you aren't entitled to, you understate your tax on the return. If the understatement is significant, the IRS may apply an accuracy-related penalty that is 20% of the understatement.
For example, say that an auditor removes the ERC from your return and this increases your tax due by $50,000. Then, the accuracy-related penalty will be $10,000 (which is 20% of the $50,000 in tax that you didn't include on the return).
Usually, you'll only incur this penalty if the auditor believes one of the following is true:
- You were negligent about following the IRS's rules — For example, if an ERC mill convinced you to take the credit, and you didn't do any due diligence about your eligibility.
- You intentionally disregarded the rules — This applies when you knew about the rule, but you decided to break it anyway.
- You understated your tax liability by more than $5,000 or at least 10% — Because the ERC was worth $10,000 per employee in 2020 and $10,000 per employee per quarter in 2021, it's pretty easy to get up to this level of understatement.
If you just made a small error or if the auditor makes minor adjustments to your payroll tax return, you usually don't have to worry about these penalties.
Penalties for ERC Fraud
The penalties are much higher if the auditor believes that fraud was at play. In this case, you can receive a fraud penalty for 75% of the underpaid tax. Let's say that you understated your tax due by $50,000 from ERC credits. Then, the auditor disallows the credits and assesses a fraud penalty.
The fraud penalty will be $37,500. So, what's the difference between fraud and a mistake? How does an auditor determine if you committed fraud or just acted negligently? Here are some of the defining elements of fraud:
- You purposefully didn't keep records about your ERC claims or you destroyed your information.
- You lied to the auditor during the audit.
- You had two sets of books — one that shows your eligibility for an ERC claim and one with the real numbers.
- You used fake Social Security Numbers to claim the ERC for fake employees.
If you're worried about facing fraud penalties, get help before going through an ERC audit. If you haven't been selected for an audit but know that you made false claims on your return, contact a tax professional to talk about the options for voluntary disclosure.
Fines and Consequences of Criminal ERC Fraud
Usually, the IRS only applies civil penalties when fraud is involved. But in select cases, the agency may recommend criminal charges. Annually, there are only about 2,000 criminal tax convictions per year — when you consider that there are over 250 million income tax returns plus millions of other returns filed every year, this number is very low.
However, if fraud were involved, you could face tax evasion charges. This carries a penalty of up to $100,000 in fines and up to five years in prison.
In some cases, when the auditor reviews your payroll tax returns, they may decide to assess a failure-to-deposit penalty. Although this penalty can add up, it's not as significant as the other penalties. This penalty applies when you make late payroll tax deposits.
Most employers are required to make these deposits by the 15th of the month following the month where they paid wages. If the auditor disallows your ERC credit, that means that you should have owed more and thus should have deposited more.
Due to this, the auditor may decide to retroactively assess a failure-to-deposit penalty. This is 10% for deposits that are 15 or more days late. It increases to 15% if you don't pay within 10 days of the IRS issuing a demand for payment.
Trust Fund Recovery Penalties From ERC Audits
The Trust Fund Recovery Penalty is one of the IRS's harshest penalties. It applies in situations where employers take Social Security, Medicare, and income tax from their employee's paychecks, but they don't send the funds to the government.
If you claimed an ERC credit, you likely thought that you didn't need to deposit these funds, and if the credit was claimed correctly, you are right. However, if the IRS decides that you claimed the credit to avoid paying your trust fund taxes, it may decide to levy this penalty.
The TFRP is 100% of the unpaid tax, but it only applies to the trust fund taxes, aka the taxes withheld from your employees' paychecks. It doesn't include the employer's matching portion of Social Security and Medicare taxes. The truly scary thing about this penalty is that the IRS can assess it to anyone that seems responsible for not making the payment. That includes employees as well as business owners.
What to Do About ERC Penalties?
As explained above, the penalties can quickly inflate your balance due. Say that you're running your business, not expecting an additional tax bill. Then, out of nowhere, the IRS audits your payroll tax return, disallows $100,000 in credits, and assesses $20,000 in penalties. Now, you have an unexpected bill for $120,000.
To try to get some relief, you should request penalty abatement. Usually, the IRS will remove penalties if it's the first time you've incurred them. The agency will also remove penalties if you had reasonable cause for incurring them. For instance, they'll remove a late penalty if you filed late due to a serious illness.
With audit penalties, the situation can be a bit more complex. But it's always worth requesting that the IRS at least consider removing your penalties. A tax professional can help you figure out the best steps forward.
ERC Statute of Limitations
How long do you have to worry? How long can the IRS take to audit ERC credits? Well, the ERC audit period is five years for credits claimed in the last two quarters of 2021, and it's three years for credits claimed in 2020 or the first part of 2021. However, the timer doesn't start the day you file. Instead, it starts on April 15th of the year after you file.
This means that the IRS can audit your 2020 ERC credits until April 15, 2024. It can audit ERC credits from the beginning of 2021 until April 15, 2025. It can audit remaining ERC claims until April 15, 2025. There is some speculation that the government may extend the statute of deadline for all ERCs to five years.
That said, these limits only apply to honestly filed returns. If you fraudulently claimed the ERC, the IRS has an unlimited amount of time to go after you.
What If a Dishonest Preparer Caused Your Mistakes?
In a lot of cases, business owners claimed the ERC due to the urging of an ERC mill. This refers to companies that popped up just to "help" businesses claim this credit. These companies are infamous for coercing businesses to claim credits they don't deserve. They often charge high upfront fees or fees based on the amount of the refund.
Unfortunately, you are still responsible for the contents of your return. Even if you pay someone to do the return for you, it's your return, and you're expected to ensure that they complete it accurately. However, this is easier said than done, especially when you're dealing with a new part of the tax code.
If an ERC mill convinced you to claim a credit you shouldn't have claimed, then you should talk with your auditor about that. Legally, you're still responsible, but you may be able to convince them to remove penalties due to the bad guidance you received from your tax preparer.
Additionally, you should report the company by filing Form 14242 (Report Suspected Abusive Tax Promotions or Preparers).
How to Pay ERC Audit Penalties and Additional Taxes
If the IRS imposes an ERC audit penalty, it is due in full immediately. Failure to pay the understated tax plus the penalty can lead to more penalties, and the IRS will assess interest on your account.
If you're no longer in operation, you can request a payment plan on your tax bill and penalties. Generally, you can take up to six years to pay off the debt. If you can't afford to pay, you may want to look into an offer in compromise settlement or currently not collectible status.
Businesses that still have their doors open face different rules about payment plans. Usually, the IRS will only approve payment plans on business taxes if you owe $25,000 or less and can afford to pay off the balance in the next two years.
Get Help With ERC Penalties, Audits, and Disclosures
Are you stressed about an ERC penalty? Want to disclose mistakes or fraudulent claims on your return? Facing an audit and looking for guidance? Need help requesting penalty abatement? If any of these are true, you should reach out to a tax professional.
Using TaxCure, you can search for tax professionals based in your local area who have experience with tax audits, penalties, and business taxes. Don't drown in audit penalties. Instead, contact a tax pro for a consultation today.