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It’s not a secret: everyone should expect to see employee retention credit (ERC) claim audits proliferate in the near future. Indeed, the IRS has devoted time and resources to repeatedly warn about third-party tax credit advisors that improperly filed (or may yet file) for credits on behalf of unsuspecting clients. Unfortunately, many small business owners were pressured or misled by abusive ERC promoters into filing ineligible claims. This doesn’t mean that every ERC claim will be audited; however, thousands of ERC cases have already been referred for audit, according to the IRS, and more are expected as IRS compliance activities intensify.1 

Taxpayers and tax professionals should be preparing themselves now. But what does preparation for a potential ERC audit really entail? Importantly, it involves a combination of both understanding and action. Let’s consider below what you need to know and do.

Have Questions? Call us for Your consultation.

Purpose, Perspective, and General Format

Perhaps the first thing to understand is that the IRS conducts ERC audits to ensure that employers are properly claiming the ERC. If the audit results in an IRS determination that the employer was not entitled to the ERC in full or part, then the IRS may try to recover the improperly refunded amount along with penalties and interest. 

Remember, being selected for an IRS audit doesn’t necessarily mean a claim is improper; in other words, wrongdoing is not a prerequisite. The audit process allows the employer to engage—cooperatively and transparently—in a dialogue with the IRS that may ultimately demonstrate the claim’s merit.

Briefly, it is helpful to visualize how an audit may be conducted. The IRS initiates ERC audits with a letter notifying the recipient of audit selection and describing the issues that will be examined. This letter is more formally known as an Information Document Request (Form 4564). Typically, ERC audits will be conducted in one of the following manners:

  1. Correspondence Audit (or, “Audits by Mail”). In this scenario, the IRS will communicate via correspondence and telephone. The IRS will request documents required to verify elements of the claim, and you will be responsible for replying with the information within any and all IRS-provided deadlines. If you’ve taken steps ahead of time to prepare and have your documents in order, this can be a relatively streamlined process. Note that correspondence audits are typically reserved for less complex issues.
  2. Area Office Audit or Field Audit. When a more complex issue, or issues, are implicated, and cannot be resolved via correspondence, the IRS Area Office or Field Office may conduct the audit. Such audits typically feature in-person interviews and may occur in a taxpayer’s place of business or representative’s office.

Who are the ERC Auditors?

Recognizing that a dialogue will be opened with the IRS during an audit, it’s good to appreciate who will be conducting an ERC audit.

In the summer of 2023, when the IRS announced its new phase of increasing scrutiny on questionable ERC filings, it clarified that this included “intensifying compliance work and putting in place additional procedures to deal with fraud in the program.”2 In the same announcement, the IRS emphasized that it “has trained auditors examining ERC claims posing the greatest risk.”3

It didn’t take long after that announcement to see its effect. IRS employment tax specialists (many operating under the title of “Revenue Agent”) are in fact conducting ERC audits. And as the IRS promised, it has trained these specialists specifically for ERC audits, equipping them with sophisticated knowledge of the complex ERC rules and processes. 

Recognizing the Issues and Getting Organized

Taxpayers and their professionals should recognize, and review together, the potential non-compliance areas most likely to be investigated in an ERC audit. This review should, in effect, be a comprehensive internal compliance check of your claim, including, but not limited to:

  • Small eligible employer v. large eligible employer distinction (e.g. ensure accurate full-time employee count and wages were paid to not provide services)
  • Worksheets supporting how the ERC was calculated and reported on Forms 941-X (remember, credit limitations should have been applied on a per-employee basis)
  • Application of aggregation rules
  • Calculation of gross receipts
  • Partial suspension of operations test (identification of governmental orders, scrutinizing nominal effect, etc.)
  • Supply chain disruption
  • Documentation related to PPP (and other federal relief programs) (e.g., ensuring no overlapping use of wages for ERC and PPP)

Organization is imperative and will help you substantiate your positions when you respond to the IRS regarding potential non-compliance areas. The recordkeeping requirements of Notice 2021-20 should be followed carefully, so that employers can readily substantiate why they are eligible and that they paid qualified wages. Examples of such documentation include:

  • All governmental orders suspending business operations.
  • Records used by the employer to determine whether more than a nominal portion of its operations was suspended due to a governmental order or whether a governmental order had more than a nominal effect on operations.
  • Records demonstrating a gross receipts decline.
  • Records showing who received qualified wages and how much. 
  • Substantiation for qualified health plan expense calculation in the ERC context. 
  • Copies of Forms 941 and 7200.

*Note: Ideally, documentation should have been contemporaneously compiled during the credit analysis and calculation. Unfortunately, many aggressive promoters neglected this step. There is still time to work with a trustworthy professional to correct this now before an audit.

Choose Your Representation Wisely

Appreciating the auditors’ targeted training should naturally prompt the following inquiry: if I receive notice of an ERC audit, who is going to represent me

Taxpayers must tread carefully here. Many of the aggressive ERC promoters included contractual provisions in their service agreements that promised representation or support during an IRS audit. Understandably, some taxpayers are caught weighing the benefits and risks of using those services. Some pros and cons in that evaluation may look like this:

Decisions like that may be difficult; however, it should be absolutely clear that a taxpayer needs a tax professional with most, if not all of, the following attributes:

  • Highly skilled in tax controversy matters, including audits (a tax controversy attorney is ideal)
  • Knowledgeable and experienced in all aspects of the ERC process
  • Adept in complex statutory and regulatory interpretation and application
  • Dedicated to understanding the specifics of their clients’ situations
  • Committed to staying up to date with any and all forthcoming guidelines and regulations
  • Communicates effectively and zealously advocates on their client’s behalf

Conclusion

Understanding and action are key to being prepared for a potential ERC audit. Appreciating the nature of an audit and taking the appropriate proactive steps may protect your claim, or dramatically reduce or eliminate your exposure to penalties. Frost Law attorneys have years of experience in tax controversy matters and ERC eligibility and overall compliance. If you need assistance don't hesitate to reach out to us at (410) 497-5947 or schedule a confidential consultation.

Footnotes

  1. IR-2023-169 (Sept. 14, 2023). See also IR-2023-193 (Oct. 19, 2023) where the IRS states that “since mid-September, the IRS has received approximately 3.6 million claims for the credit over the course of the program.” You can read more about measures the IRS has taken recently, such as implementing a processing moratorium and announcing a withdrawal initiative.
  2. IR-2023-135 (July 26, 2023).
  3. Id.
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Understanding ERC Audits and Proactive Measures You Should Take

Published on
November 9, 2023
Understanding ERC Audits and Proactive Measures You Should Take
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It’s not a secret: everyone should expect to see employee retention credit (ERC) claim audits proliferate in the near future. Indeed, the IRS has devoted time and resources to repeatedly warn about third-party tax credit advisors that improperly filed (or may yet file) for credits on behalf of unsuspecting clients. Unfortunately, many small business owners were pressured or misled by abusive ERC promoters into filing ineligible claims. This doesn’t mean that every ERC claim will be audited; however, thousands of ERC cases have already been referred for audit, according to the IRS, and more are expected as IRS compliance activities intensify.1 

Taxpayers and tax professionals should be preparing themselves now. But what does preparation for a potential ERC audit really entail? Importantly, it involves a combination of both understanding and action. Let’s consider below what you need to know and do.

Have Questions? Call Our Team Today.

Purpose, Perspective, and General Format

Perhaps the first thing to understand is that the IRS conducts ERC audits to ensure that employers are properly claiming the ERC. If the audit results in an IRS determination that the employer was not entitled to the ERC in full or part, then the IRS may try to recover the improperly refunded amount along with penalties and interest. 

Remember, being selected for an IRS audit doesn’t necessarily mean a claim is improper; in other words, wrongdoing is not a prerequisite. The audit process allows the employer to engage—cooperatively and transparently—in a dialogue with the IRS that may ultimately demonstrate the claim’s merit.

Briefly, it is helpful to visualize how an audit may be conducted. The IRS initiates ERC audits with a letter notifying the recipient of audit selection and describing the issues that will be examined. This letter is more formally known as an Information Document Request (Form 4564). Typically, ERC audits will be conducted in one of the following manners:

  1. Correspondence Audit (or, “Audits by Mail”). In this scenario, the IRS will communicate via correspondence and telephone. The IRS will request documents required to verify elements of the claim, and you will be responsible for replying with the information within any and all IRS-provided deadlines. If you’ve taken steps ahead of time to prepare and have your documents in order, this can be a relatively streamlined process. Note that correspondence audits are typically reserved for less complex issues.
  2. Area Office Audit or Field Audit. When a more complex issue, or issues, are implicated, and cannot be resolved via correspondence, the IRS Area Office or Field Office may conduct the audit. Such audits typically feature in-person interviews and may occur in a taxpayer’s place of business or representative’s office.

Who are the ERC Auditors?

Recognizing that a dialogue will be opened with the IRS during an audit, it’s good to appreciate who will be conducting an ERC audit.

In the summer of 2023, when the IRS announced its new phase of increasing scrutiny on questionable ERC filings, it clarified that this included “intensifying compliance work and putting in place additional procedures to deal with fraud in the program.”2 In the same announcement, the IRS emphasized that it “has trained auditors examining ERC claims posing the greatest risk.”3

It didn’t take long after that announcement to see its effect. IRS employment tax specialists (many operating under the title of “Revenue Agent”) are in fact conducting ERC audits. And as the IRS promised, it has trained these specialists specifically for ERC audits, equipping them with sophisticated knowledge of the complex ERC rules and processes. 

Recognizing the Issues and Getting Organized

Taxpayers and their professionals should recognize, and review together, the potential non-compliance areas most likely to be investigated in an ERC audit. This review should, in effect, be a comprehensive internal compliance check of your claim, including, but not limited to:

  • Small eligible employer v. large eligible employer distinction (e.g. ensure accurate full-time employee count and wages were paid to not provide services)
  • Worksheets supporting how the ERC was calculated and reported on Forms 941-X (remember, credit limitations should have been applied on a per-employee basis)
  • Application of aggregation rules
  • Calculation of gross receipts
  • Partial suspension of operations test (identification of governmental orders, scrutinizing nominal effect, etc.)
  • Supply chain disruption
  • Documentation related to PPP (and other federal relief programs) (e.g., ensuring no overlapping use of wages for ERC and PPP)

Organization is imperative and will help you substantiate your positions when you respond to the IRS regarding potential non-compliance areas. The recordkeeping requirements of Notice 2021-20 should be followed carefully, so that employers can readily substantiate why they are eligible and that they paid qualified wages. Examples of such documentation include:

  • All governmental orders suspending business operations.
  • Records used by the employer to determine whether more than a nominal portion of its operations was suspended due to a governmental order or whether a governmental order had more than a nominal effect on operations.
  • Records demonstrating a gross receipts decline.
  • Records showing who received qualified wages and how much. 
  • Substantiation for qualified health plan expense calculation in the ERC context. 
  • Copies of Forms 941 and 7200.

*Note: Ideally, documentation should have been contemporaneously compiled during the credit analysis and calculation. Unfortunately, many aggressive promoters neglected this step. There is still time to work with a trustworthy professional to correct this now before an audit.

Choose Your Representation Wisely

Appreciating the auditors’ targeted training should naturally prompt the following inquiry: if I receive notice of an ERC audit, who is going to represent me

Taxpayers must tread carefully here. Many of the aggressive ERC promoters included contractual provisions in their service agreements that promised representation or support during an IRS audit. Understandably, some taxpayers are caught weighing the benefits and risks of using those services. Some pros and cons in that evaluation may look like this:

Decisions like that may be difficult; however, it should be absolutely clear that a taxpayer needs a tax professional with most, if not all of, the following attributes:

  • Highly skilled in tax controversy matters, including audits (a tax controversy attorney is ideal)
  • Knowledgeable and experienced in all aspects of the ERC process
  • Adept in complex statutory and regulatory interpretation and application
  • Dedicated to understanding the specifics of their clients’ situations
  • Committed to staying up to date with any and all forthcoming guidelines and regulations
  • Communicates effectively and zealously advocates on their client’s behalf

Conclusion

Understanding and action are key to being prepared for a potential ERC audit. Appreciating the nature of an audit and taking the appropriate proactive steps may protect your claim, or dramatically reduce or eliminate your exposure to penalties. Frost Law attorneys have years of experience in tax controversy matters and ERC eligibility and overall compliance. If you need assistance don't hesitate to reach out to us at (410) 497-5947 or schedule a confidential consultation.

Footnotes

  1. IR-2023-169 (Sept. 14, 2023). See also IR-2023-193 (Oct. 19, 2023) where the IRS states that “since mid-September, the IRS has received approximately 3.6 million claims for the credit over the course of the program.” You can read more about measures the IRS has taken recently, such as implementing a processing moratorium and announcing a withdrawal initiative.
  2. IR-2023-135 (July 26, 2023).
  3. Id.