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ERC Audit

What to Expect from a Federal ERC Audit

The Employee Retention Credit (ERC) was introduced by the U.S. government as a response to the economic disruptions caused by the COVID-19 pandemic.

Designed to encourage businesses to keep employees on their payroll despite challenging economic conditions, the ERC offers a refundable tax credit to eligible businesses.

Employee Retention Credit (ERC) Audit
The IRS has increased audit activities concerning the Employee Retention Credit (ERC) claims.

However, due to widespread misinformation and the involvement of some dishonest third-party claim facilitators, the Internal Revenue Service (IRS) has significantly increased its audit activities concerning ERC claims.

Suppose you are a business owner who has claimed this credit. In that case, it's essential to understand what an ERC audit entails, the potential penalties for incorrect claims, and the amnesty programs available to rectify any issues.

ERC audits are shorter than a traditional income tax return exam like many refund claims. This expedited timetable can cause taxpayers to feel the burden of proof is shifted. They must demonstrate they are eligible for the credit rather than the IRS proving the credit was overstated.

Since the ERC credit is filed using an amended 941 form without substantiation, a field auditor has little or no information when assigned a credit review.

This means the information document request (IDR) is expansive. The IRS wants to know why the taxpayer is eligible, how the calculations were done, and what prohibited funds, such as PPP loans, could have been used to pay wages.

Once these documents are provided, the auditor will request an initial interview. Frequently, this initial IDR package and the interview notes form the basis of the determination.

While there are often subsequent IDRs, they are generally more focused, and the taxpayer is notified of the eligibility of the credit and the adjustment amount in weeks as opposed to months or years, like a typical audit.

What is the Employee Retention Credit?

The ERC allows qualifying businesses to receive credits against their payroll taxes for employee wages during specific pandemic periods.

To be eligible, businesses must have experienced a significant decline in gross receipts or been fully or partially suspended due to government orders related to COVID-19.

The intricacies of eligibility criteria and the calculations involved have led some businesses to rely on third-party consultants to file claims, which has sometimes resulted in claims for which they were not eligible.

The Rise in ERC Audits

Recent trends indicate an uptick in audits related to the ERC, triggered by the IRS's growing concern over fraudulent claims. Numerous businesses, often guided by dishonest third-party companies, have submitted claims without fully meeting the eligibility requirements.

ERC Audits

This has compelled the IRS to take stringent measures to verify the legitimacy of ERC claims, ensuring that only qualifying businesses benefit from this credit.

Auditors want to know how the taxpayer learned of the credit and who did the eligibility testing. A taxpayer must answer questions about what they were promised, how they learned of the promotor, and whether a contingency fee was paid.

Implicit in this line of questioning is that a taxpayer who found an ERC-focused shop by attending a free dinner and paying a contingency fee for the credit is less likely to prevail under audit than a taxpayer who leveraged a reputable tax preparer.

What Happens During an ERC Audit?

An ERC audit typically begins with the IRS notifying the business of its intent to review the ERC claim. This notification outlines the specific information and documents required for the audit.

During this period, companies need to gather comprehensive documentation that substantiates their eligibility and the accuracy of their claim.

This includes payroll records, financial statements, and other relevant documentation demonstrating the business's adherence to the eligibility criteria. The audit itself may consist of any/all of the following stages:

  • Initial Assessment: The IRS reviews submitted ERC claims compared to the business's tax returns and financial statements to identify discrepancies.
  • Documentation Review: Auditors will request and review detailed records of wages paid and proof of business disruptions due to COVID-19.
  • Interviews: IRS representatives may conduct interviews with business owners and possibly employees to verify information and gather additional insights.

Form 940 is the form on which the federal unemployment taxes are reported and paid. Generally, this is a low-priority form because the rate imposed is low, and each employee has a low cap subject to the rate.

However, many 940s are not completed correctly, and the payroll company uses a reduced rate without correctly reporting which employees receive the reduced rate. Many audits increase the amount reported on the 940, independent of any adjustments to the ERC claimed on Form 941.

What are the Penalties for Incorrect ERC Claims?

Businesses found to have inaccurately claimed the ERC may face several penalties, including:

  • Repayment: The immediate consequence is the repayment of overclaimed credits with interest.
  • Accuracy-related Penalties: If the claim was due to negligence or disregard of rules, a 20% penalty on the underpayment might be imposed.
  • Fraud Penalties: In cases of intentional fraud, the penalties can be as severe as 75% of the underpayment.

Is Amnesty Available?

In December 2023, the IRS announced the "voluntary disclosure program," a partial amnesty program for businesses who had incorrectly claimed the ERC.

Under the program, businesses who voluntarily disclosed their incorrect claim and agreed to repay would be forgiven 20 percent of the total credit repayment with no penalties or interest.

The deadline to take advantage of amnesty was March 22, 2024, so the program is currently closed as of the time of this writing. However, the IRS has signaled that they may reopen the program later.

How Should You Prepare for an ERC Audit?

If your business is facing an ERC audit, taking the following proactive steps can help mitigate potential issues:

  • Understand Your Rights: Familiarize yourself with your rights as a taxpayer, including the right to know why the IRS is requesting information, the right to appeal disagreements, and the right to confidentiality.
  • Gather and Organize Documentation: Ensure all records relating to ERC claims are accurate and readily available.
  • Consult a Tax Professional and an Attorney: Engage with a knowledgeable tax advisor who can guide the audit process and help represent your interests before the IRS. If you're facing the possibility of severe penalties or a criminal investigation regarding an ERC claim, a federal criminal defense attorney can also negotiate favorable terms while ensuring your rights are protected.

ERC audits are stressful, time-consuming, and sometimes a threat to a business desperately needing a cash lifeline. Understanding what the IRS is looking for can help minimize the risks associated with an ERC exam.

Contact our federal criminal defense lawyers for more information. Eisner Gorin LLP is based in Los Angeles, CA.

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