The Internal Revenue Service (IRS) recently issued a news release identifying five new signs that a business’s Employee Retention Tax Credit (ERC) may be incorrect. It has also begun issuing a third round of letters denying ERC claims. New compliance initiatives are coming and criminal investigations of ERC claims are on the rise, with the government winning cases that go to trial.
For background, the ERC is a legitimate, refundable tax credit designed to help businesses that continued to pay employees while they were shut down due to the COVID-19 pandemic or that experienced a significant decline in gross receipts in 2020 and 2021. While Congress designed the ERC with the laudable goal of helping businesses survive the pandemic by encouraging them to keep employees on their payrolls, ERC fraud has run rampant and unscrupulous promoters have pushed businesses that do not qualify for the credit to file improper ERC claims. For over two years, the IRS has engaged in a concerted effort to stamp out fraudulent ERC claims.
More ERC Red Flags
In a news release issued on February 13, 2024, the IRS identified seven signs of an incorrect ERC, which we discussed here. On July 26, 2024, the IRS issued a news release identifying five new warning signs it has identified while analyzing and processing ERC claims. These new red flags address:
1. Essential businesses that could fully operate and did not have a decline in gross receipts. Businesses relying on a government order because they did not have a decline in gross revenue need to show that their operations were partially or fully suspended or that modifications impacted their ability to operate. The mere existence of a government order, or a modification due to a government order that did not affect the ability to operate, will not support an ERC claim.
2. Businesses unable to show how a government order fully or partially suspended its operations. A business claiming that a government order resulted in a partial or full suspension of operations needs to be able to provide information supporting that claim. The IRS claims that too many businesses have not provided enough information to support their claim that they were partially or fully shut down.
3. Businesses reporting family members’ wages as qualified wages. Business owners cannot include wages paid to related individuals (spouses, children, siblings, ancestors, nieces, nephews, aunts, uncles, in-laws or household members) or the majority owner as qualified wages entitled to the ERC.
4. Businesses using wages already used for Paycheck Protection Program (PPP) loan forgiveness. If a business received a PPP loan and the Small Business Administration forgave the loan, the business cannot claim the ERC with respect to wages it reported as payroll costs in order to have its PPP loan forgiven – no double dipping is allowed.
5. Large employers claiming wages for employees who provided services. Large employers (more than 100 full-time employees in 2019 for 2020 ERC claims and more than 500 full-time employees in 2019 for 2021 ERC claims) cannot claim the ERC for employees who provided services – the ERC is only available to these large employers for wages paid to employees who were not providing services.
ERC Civil Compliance Initiatives
These red flags underscore the detail with which the IRS is reviewing ERC claims. For instance, the moratorium has given the IRS time to digitize and analyze about one million ERC claims representing more than $86 billion, and associated compliance efforts relating to erroneous ERC claims exceed $2 billion since the moratorium began.
In addition, this summer the IRS began issuing tens of thousands of letters denying claims to businesses whose claims show “clear signs of being erroneous.” Unfortunately, the letters are not uniform: Even though all taxpayers with denied claims have the right to an appeal before the IRS Independent Office of Appeals or to file litigation, only some letters advise taxpayers of their right to go file an appeal before the IRS Independent Office of Appeals, only some letters advise taxpayers they may immediately pursue litigation, and some letters do not notify taxpayers of either option.
The IRS is also acting inconsistently regarding the reasons for denying the claims. In some letters, the IRS claims businesses were not operating as a trade or business, didn’t experience a full or partial suspension of operations due to a government order, didn’t have the required decline in gross receipts, or didn’t indicate it was a recovery startup business. But other letters are not providing any reason at all or are denying ERC claims for operating businesses that are disregarded entities for federal income tax purposes. And in all cases, it appears the IRS is simply disallowing ERC claims without first asking taxpayers for additional information which might support the ERC claim.
More favorably for taxpayers, the IRS is beginning to process claims that it deems are “low-risk." But even in this context, the IRS emphasizes that the risk level for a business’ ERC claims may vary from quarter to quarter. So, taxpayers may obtain a recovery for some quarters but still have to wait longer for other quarters.
In the coming days and weeks, the IRS expects to issue more information on new compliance initiatives involving ERC claims. One initiative appears to be a reopening of the Voluntary Disclosure Program, which previously resulted in the recovery of approximately $225 million.
Criminal Enforcement
The IRS has begun 500 criminal investigations related to the ERC. To date, the IRS obtained a conviction on every ERC fraud case that it has taken to trial. Expect the number of criminal investigations to increase as the IRS continues to invest Inflation Reduction Act funding in COVID-19 relief program investigations.
Tax Relief for American Families and Workers Act of 2024 Fails to Pass the Senate
On August 1, 2024, the Senate voted 48-44 against passage of the Tax Relief for American Families and Workers Act of 2024. The bill, which we previously wrote about here and here, would sunset the ERC early, contains provisions that increase penalties applicable to ERC promotors and includes tools that allow the IRS to pursue improper claim that have already been filed. The bill easily passed the House of Representatives with bipartisan support on January 31, 2024, but has been stuck in the Senate ever since. While the bill may come up for another Senate vote, its ultimate passage appears unlikely especially as the presidential election nears.
Takeaways
Businesses should continue to review their ERC claims as enforcement activities are increasing on both the civil side and the criminal side.
The withdrawal option is still available, if necessary, for improper claims and will continue to be available so long as the moratorium continues. And in coming weeks the voluntary disclosure program may reopen, although it’s expected that the IRS will offer less favorable terms than it previously imposed.
Moreover, as claims are denied, businesses will need to decide whether to move forward with the Office of Appeals or file litigation. As the Office of Appeals becomes busier – both with regular cases and the new volume of ERC matters it will be handling – businesses will have to decide when the time is right to simply move forward and file refund litigation.
In all cases of denied ERC claims, businesses should consider submitting a Freedom of Information Act request for the entire administrative file related to their ERC claim, including the denial. The administrative file will give the business a better understanding of the process by which the IRS concluded an ERC claim was invalid.
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