The Internal Revenue Service (IRS) has announced that it has trained 300 employees to handle employee retention credit (ERC) audits. The agency is auditing payroll tax returns that claim this credit at very high rates. If you’ve been contacted about an ERC audit, this guide explains what to expect before, during, and after the audit.
To get help now, contact us at Damiens Law today. We have extensive knowledge about the ERC in particular and tax audits in general, and we can help you navigate this process with as little stress as possible. In the meantime, keep reading to learn more.
What Is an ERC Audit?
An ERC audit is when the IRS audits tax returns that claim the employee retention tax credit (ERTC). This includes Forms 941 (Employer’s Federal Quarterly Tax Return) and Forms 944 (Employer’s Federal Annual Tax Return) filed in 2020 and 2021. It also includes the amended versions of these forms (941-X and 944-X). If selected for an audit, filers will need to prove their eligibility to claim this tax credit.
How Does the IRS Notify Business Owners About ERC Audits?
If the IRS selects you for an ERC audit, it will send an audit notice to your last known address. If you claimed this credit and you have changed your address since the last time you filed a tax return, you should update your address with the agency. Otherwise, you may miss the audit notices. If that happens, the IRS may disallow the credit and assess a tax liability without you even realizing what’s going on.
The audit notice will explain the type of audit, the issues being audited, and the next steps you need to take. Here are the main types of ERC audits:
- Correspondence — You mail the auditor documents that back up the details on your payroll tax return, and you handle most of the process through the mail.
- Desk — The audit notice instructs you to set up a phone meeting with the auditor. Then, you send in supporting documents and talk about them on the phone.
- Field — The auditor comes to your place of business to conduct the audit. This is likely to be rare (but not impossible) with ERC audits.
Often, the notice will include an Information Document Request (IDR). This outlines the documents you need to provide and tells you where to send them.
What Documents Do You Need for an ERC Audit?
The premise of an audit is simple. The auditor asks you to back up the details reported on your tax return. You provide the supporting documents. Then, the auditor reviews them and decides whether or not you filed an accurate tax return.
In most cases, as long as you have good bookkeeping records and receipts, you should easily be able to back up the information on your tax returns. Unfortunately, this can be a bit more challenging with an ERC audit, as you may not have all the details you need in your records. Take a look at the types of records you may need to provide:
Proof of your eligibility for the credit
Employers could claim the ERC based on three different criteria. Here are the documents you will need based on why you claimed the credit.
- Revenue reduction — Employers could claim this credit if they suffered a significant decline in revenue. To prove that you qualified, you will need to provide sales or revenue records from the quarter(s) you claimed the credit as well as the comparison quarters. For most businesses, the comparison quarter was the same quarter in 2019. For instance, if you claimed the ERC in Q3 2020, you would need to show that your revenue that quarter was a certain percentage lower than the revenue your business collected in Q3 2019. However, if your business wasn’t open in 2019, you could claim the credit in 2021 based on a reduction in revenue compared to the same quarter in 2020.
- Suspended operations — If you didn’t qualify based on a reduction in revenue, you may have claimed the credit based on suspended operations. If so, you will need to prove that your operations were suspended during the dates when you claimed the credit. For instance, if you claimed the credit for your restaurant due to a government order banning dine-in eating, you will need to provide details about that government order. To back up your claim, you may need a copy of the government order as well as a written explanation of how it affected your operations.
- Recovery start-up businesses — You qualify as a recovery start-up business if you opened after February 15, 2020, and your annual average gross receipts were under $1,000,000 for the last three years. If you claimed the ERC based on being a recovery start-up, you will need to prove the day you started the business and potentially provide revenue records that show you’re under the threshold.
Proof that you paid qualifying wages
Only a certain amount of wages qualified for this credit. To prove that you only took the credit on qualified wages, you may need to provide the following types of information:
- Credit worksheets — Form 941-X had two worksheets to help people calculate the employee retention credit. You didn’t have to include these worksheets when you filed, but you may have to provide them if you get audited.
- PPP expenses — If you received a paycheck protection program (PPP) loan, you will need to show which wages you paid with the loan. Then, you will need to establish that you didn’t claim an ERC on any of those wages.
- Relationship with employees — You cannot claim the ERC on wages paid to the relatives of majority owners. This includes children, grandchildren, siblings, step-siblings, parents, grandparents, nieces/nephews, and aunts/uncles, as well as sons-in-law, daughters-in-law, brothers-in-law, sisters-in-law, mothers-in-law, and fathers-in-law.
- Number of employees in 2019 — If you had more than 100 average full-time employees, you could only claim the ERC in 2020 on wages paid to employees who were not working. In contrast, smaller businesses could claim the credit on wages paid to employees who were working. For 2021 ERC claims, this number was bumped up to 500. In both cases, you may need to prove the number of employees your business had in 2019.
Additional payroll details
ERC audits focus specifically on this tax credit, but the auditor may also ask about the wages reported on your tax return. This element of the process is similar to a traditional payroll audit, and you may need to provide time sheets, wage reports, payroll records, payroll stubs, and bank account statements.
Does the ERC Audit Affect Other Tax Returns?
The employee retention credit didn’t just affect your payroll tax returns. It also had implications for your business income tax return and potentially your personal income tax return.
Here’s why. If you claimed the ERC, you were supposed to reduce the wage expense on your business income tax return by the amount of the credit. For instance, say that your wage expense was originally $100,000, and this was the amount you reported on your business income tax return. Then, you amended your payroll tax returns and claimed a $20,000 ERC.
At this point, you should have amended your business income tax return to reduce your wage expense from $100,000 to $80,000. This, in turn, would have increased your profits by $20,000 and thus increased your tax liability.
The ERC auditor may look at your business income tax return to see if it accurately reflects the ERC. If not, they may adjust your income tax return. If you’re a sole proprietor, the adjustment will be to your schedule C, and it will automatically adjust your personal income tax liability. If you file a partnership, S-corp, or corporate return, you will need to make the changes to those returns and then make additional adjustments to your personal income tax return.
What If You Fail the ERC Audit?
What if the auditor looks at your documents and decides that you don’t qualify for the ERC? Then, they will issue an audit report that details the changes to your payroll tax return, and they will let you know how much you owe.
At this point, you can protest the changes, but you must do so quickly. Usually, you only have 30 days to appeal an audit decision, and if you miss the deadline, you won’t be able to appeal.
ERC Audit Penalties
If you “fail” an audit, the auditor may also add penalties to your account. If they believe that you were negligent in following the tax laws, they may apply a 20% accuracy-related penalty. This is 20% of the underreported tax. In cases of fraud, the penalty is 75% of the tax.
The IRS can bring criminal tax fraud charges against people who attempt to defraud the government by illegitimately taking false tax credits. This is rare, but it can lead to prison time and up to a $100,000 fine for individuals and a $500,000 fine for corporations.
How Long Does the IRS Have to Audit ERC Claims?
The IRS has extended the statute of limitations on payroll tax returns from the last two quarters of 2021 from three years to five years. This means that the agency has until April 2027 to audit these returns. The statute was extended with the American Rescue Plan Act.
At the time of writing, the IRS has not extended the statute of limitations for the other six quarters during which employers could claim this credit. However, the agency has put this request on its 2024 agenda. It is highly likely that the statute of limitations may change from three years to five years on these returns.
For most returns, the statute of limitations starts on the later of the due date or the date you file. However, with payroll returns, the timer starts on April 15 following the year the quarter occurred. For instance, Q1, Q2, Q3, and Q4 payroll returns for 2020 were due on April 30, 2020, July 21, 2020, November 2020, and February 2, 2021, and the statute of limitations for auditing these returns started on April 15, 2021. Currently, the IRS has until April 15, 2024, to audit these returns, but if the agency extends the statute, it will have until April 15, 2026.
If you filed an amended return after the due date, the statute of limitations typically starts on that day.
What If You Claimed the ERC Incorrectly?
What if you haven’t been selected for an audit, but you’re worried that you claimed these credits incorrectly? In that case, you may want to reach out to the IRS through its voluntary disclosure process.
Voluntary disclosure allows you to come clean about tax issues, and in exchange, the IRS will reduce the penalties on your account and/or absolve you of criminal liability. There are different voluntary disclosure processes depending on whether or not you believe that you committed a tax crime.
To be on the safe side, you should always consult with a tax attorney before using the voluntary disclosure options. In fact, the IRS encourages taxpayers to get help with this issue.
Why Is the IRS Auditing ERC Claims?
The IRS is auditing these claims due to widespread abuse of the ERC. These credits were worth up to $30,000 (and sometimes more) per employee, and false claims can cost the government a lot of money.
In fact, the IRS audits all kinds of credits at very high rates. For example, the usual audit rate is about 1 of every 200 income tax returns, but for returns that claim the Earned Income Tax Credit (ERTC), the audit rate is about 15 of every 100 returns.
Additionally, the employee retention credit was highly abused. In the last few years, several businesses popped up that exclusively focused on this credit. Unfortunately, many of these businesses used deceptive practices, often misleading business owners into claiming credits they didn’t qualify for.
These businesses have earned the name “ERC mills” — This just means that they’re churning out employee retention credits at a fast and furious rate with minimal regard for the law. The IRS has issued several notices telling people to avoid these businesses. The agency also urges taxpayers to report companies that claim the ERC incorrectly.
If you believe that you claimed the ERC through a mill, you may want to have a tax professional review your claim. They can help you decide if the return was filed legitimately. If so, they can help you decide if you should make changes or look into the voluntary disclosure.
Why Contact a Tax Pro
Should you contact a tax pro for help with ERC audits? In some cases, you can represent yourself during an audit. For instance, if you claimed a modest employee retention credit and you have the supporting details, you may not need professional help to get through the audit. Often, the accountant who helped you prepare the payroll tax returns may also be able to help you with the audit — However, it’s important to note that most tax preparers charge extra to help clients with an audit, and if you’re paying for the services, you may want to go with a pro who has dedicated audit experience.
Here are some signs that you should contact a tax professional:
- The IRS has contacted you about an ERC audit, and you’re not sure what to do.
- You understand the audit notice but don’t have the supporting documents.
- You’re not sure how to prove that you had a suspension of operations during COVID.
- The auditor seems to be applying the tax law incorrectly, and you want knowledgeable assistance.
- The auditor has rejected your supporting documents and disallowed the credits.
- You want to appeal an audit decision.
- You’re dealing with penalties after an ERC audit.
Remember that the ERC was a one-time program with fairly complicated rules. Although the IRS has trained 300 employees to audit these returns, they may have knowledge gaps. To ensure your rights are protected and that you get the best result possible, you need to work with a tax attorney who understands the employee retention tax credit inside and out — that’s Damien’s Law.
Get Help With Employee Retention Tax Credits
At Damien’s Law, we help our clients deal with all kinds of tax problems, from unaffordable tax bills to audits and more. Are you facing an ERC audit? Are you worried that your return may be audited? Already failed an audit? Regardless of where you are in the process, we can help you deal with the situation.
To learn more, contact our office today. We’ll start with a free consultation to talk about your audit and any other concerns you have. Then, we’ll talk about how we can help you. Don’t lose this valuable credit. Don’t be stressed through an audit. Instead, let our expert help provide the relief you need.
