By Charles Dean Smith, Jr., CPA
Earlier in September, the IRS halted all new Employee Retention Credit (ERC) claims due to rampant fraud and an overflow of highly suspicious credit claims. Most of these claims have come from ERC mills, which target taxpayers with promises of large refunds, regardless of their eligibility. Now, as ERC claims are on pause, thousands of small businesses may be on the hook for payroll tax audits and significant penalties if the IRS determines their claim is questionable.
Employee Retention Credit Fraud
The IRS added ERC fraud to its annual list of Dirty Dozen tax scams in 2023 – early evidence that more IRS scrutiny was already underway. They expected a certain amount of ERC eligibility fraud, but nothing like what’s recently been received especially in the 2nd and 3rd quarters of 2023
In the past 90 days alone, close to 600,000 claims were filed – about 15 percent of all ERC claims since the program’s inception. It’s expected that most of these new claims are either fraudulent or otherwise ineligible to receive a refund. These most recent filings will likely be subject to closer IRS scrutiny.
As of July 31, 2023, the IRS has investigated more than 250 fraudulent claims totaling $2.8 billion. At that time, 15 investigations led to federal charges. That is a small amount, but it’s also worth considering that thousands of claims have been referred for an audit or additional IRS correspondence requests to be sent to the taxpayer ERC focused payroll tax audits have just started this summer as the new team of newly trained ERC auditors have now been deployed. ERC audit activity is expected to increase significantly in the 4th quarter of 2023.
In general, to qualify, a business must have sustained a full or partial suspension due to governmental orders or experienced a significant decline in gross receipts compared to 2019. If they started their business during the pandemic, they may also qualify, so long as they meet an annualized gross receipt threshold. For most businesses, ERC expired on September 30, 2021; only qualified recovery startup businesses – those that began operations during the pandemic – can claim the credit for the fourth quarter in 2021.
ERC Mills and Fake Promises
Within those parameters, there are several specific definitions that spell out the requirements for ERC. It’s in these definitions that many ERC mills lure in taxpayers with their vague interpretation of the IRS guidance, especially in their area of a supply chain disruption. ERC mills often stretch the eligibility requirements using the supply chain disruption or the applicability of an ineligible and broad governmental suspension order. These providers then claim they can get all business taxpayers the full amount – $26,000 per employee – when in reality it would be an ineligible credit claim. Or, ERC mills avoid certain rules altogether.
For example, we have seen ERC mills fail to inform clients of one very important ERC requirement: that they must amend their income tax returns and pay taxes on income equal to their ERC refunds. The proof of the filing of an amended income tax return to report the ERC expense adjustment is often the first item that is requested by the IRS during an ERC payroll tax audit.
In response to these aggressive ERC marketing claims, The IRS issued a legal advice memo (GLAM 2023-005) on July 21 that specifically addresses the use of the supply chain disruptions to determine ERC eligibility. The IRS memo gives five business examples of a supply chain disruption and only one very limited business operations example actually resulted in ERC eligibility for the taxpayer. This long overdue IRS guidance and clarification effectively shuts down the main ERC eligibility determination and claims that most ERC mills have been using in their aggressive advertising campaigns. Unfortunately, many taxpayers had already engaged these ERC mills to prepare their ERC calculations and amended tax return filings using the supply chain disruption as the sole determination for their ERC eligibility.
Other behaviors that hint at an ERC mill include:
- Aggressive promotional campaigns
- Unsolicited calls, texts, emails, or ads
- Any promise or statement of a specific refund amount or decision in minutes without a thorough review of business operations
- Fee structures based on a percentage of the refund
Further, ERC mills will claim that a CPA doesn’t want the business to receive the refund or that the business is eligible, even when they aren’t. These types of misleading and egregious promotions are red flags. Another clear sign that a business is dealing with an ERC mill is if the company is not a certified public accounting firm or that it opened its doors in recent months to specialize in only payroll credit filings.
Taxpayers should always exercise extreme caution before engaging with or paying an ERC mill to prepare any amended payroll tax returns.
Building Awareness
Timing matters, especially with the IRS.
The agency has until April 15, 2027 to pursue an audit and erroneous refund action for ERC claims from the third quarter of 2021. This five-year extension is more than the standard three because of the ERC tax law updated that were implemented in 2021. Treasury has proposed extending the statute of limitations for all quarters the ERC could be claimed. The statute of limitations could also be considered unlimited if the IRS suspects taxpayer fraud was involved in the ERC tax return filing.
If a refund is issued for any quarter the ERC was available, the IRS has two years to determine if it was wrongly issued. And if that happens, the business must pay back the refund plus a potential 20 percent erroneous refund penalty and interest. The resulting financial position could be worse than if the business had never received a refund in the first place considering the additional income tax due on the required ERC expense adjustment and fees paid to the ERC provider
Even if a third party prepares and submits the ERC claim on behalf of their client, the taxpayer is always still financially responsible for what is reported on their tax return.
Businesses should be able to ask the ERC preparer for a detailed worksheet on their eligibility and calculations used to determine the payroll tax refund amount. If that information is unavailable or doesn’t add up, the claim’s legitimacy should be evaluated. This ERC evaluation is often best performed by the CPA or financial advisor that a business already has a client relationship with. This ERC documentation should also be retained in the event of a future IRS examination.
Timeline for Future or Recently Filed Employee Retention Credit Claims
Businesses that submitted an ERC claim right before or after the IRS halted ERC processing on September 14 will likely have to wait longer for their refund. The IRS notes that a normal processing time could be 180 days or longer. Even legitimate claims will be closely examined. It’s possible that the IRS will now initiate an examination even before the ERC refund is issued.
As of now, eligible taxpayers have until April 15, 2024 to file retroactive ERC claims for 2020 credits. The deadline for filing 2021 ERC claims is April 15, 2025. It’s expected that the IRS will release additional guidance soon so that businesses can still continue to submit their legitimate 2020 claims. However, this also means that processing claims could take much longer in 2024 when the IRS has a backlog of claims on top of the normal 2023 tax season filings. The IRS has also discussed allowing amended 941X forms to be electronically filed starting in early 2024 to allow for improved processing times and implementation of new electronic fraud checks before the ERC refund is issued.
For businesses that will be subject to an audit on a fraudulent ERC claim, there may be new IRS options coming soon to either repay the refund amount or withdraw a claim before it’s finalized. The IRS guidance is expected to address these and other ERC processing issues before the end of 2023.
Given the current climate surrounding the Employee Retention Credit, it’s best to work with a qualified tax advisor. This will become necessary if an audit is involved, but this scenario can be avoided with an accurately prepared ERC claim based on known tax laws and the updated IRS ERC guidance. If it sounds too good to be true, it usually is.
If you suspect a promoter is actually a fraudulent ERC mill, you can report it anonymously to the IRS by completing a under IRS guidance that was issued in October of 2022
Do you think your business might have an eligible retroactive ERC claim for 2020 or 2021, or do you have questions about a previously submitted claim? Contact Charles Dean Smith, Partner on PBMares’ Tax team.
