If you took advantage of the Employee Retention Credit you might be surprised to learn that the IRS is stepping up its auditing efforts on those who took this credit. The goal is to find the taxpayers who received this tax credit when they weren’t supposed to.
Many businesses took advantage of this credit and filed misleading returns, but many more were tricked into filing fraudulent returns. During the COVID pandemic, multiple ERC mills popped up, and they often convinced business owners to claim this credit whether they truly qualified or not. In either case, you need to be aware of the risks and understand how to apply for amnesty.
So what happens if the IRS audits your ERC and finds a problem? You could face the possibility of tax penalties, although there is the possibility of amnesty in certain situations.
What Is the Employee Retention Credit?
The Employee Retention Credit (ERC) is sometimes referred to as the Employee Retention Tax Credit (ERTC) and is a refundable tax credit for eligible business and tax-exempt entities. The goal of this credit was to encourage eligible organizations to keep employees on their payroll during the coronavirus pandemic.
There are specific eligibility requirements and they vary based on when the employer applies for the credit. That being said, to be eligible for this tax credit, an employer must have either:
- Suffered from a partial or total reduction in business operations as a result of the coronavirus pandemic,
- Experienced a significant drop in gross sales during 2020 or part of 2021, or
- Qualified as a recovery startup business in part of 2021.
The credit applied to quarters from 2020 and 2021, but many businesses claimed the credit retroactively by amending their payroll returns in 2022 or later years.
Why Is the IRS Doing ERC Audits?
The IRS became aware that some third-party entities were advertising how they could help businesses and other eligible organizations apply for the ERC. Many of these entities charged hefty fees and were often encouraging businesses to apply for these credits even when they knew the businesses weren’t eligible.
In other situations, these third parties were negligent as to how these credits worked or chose to withhold vital details about ERC eligibility from businesses. This would prevent the businesses from making an informed decision as to whether they should apply for this credit. To crack down on the ERC going to ineligible taxpayers, the IRS began increasing the number of ERC audits.
Will My ERC Get Audited?
It’s impossible to know for sure, but multiple factors could increase the likelihood of an ERC audit. Some of the factors include:
- Your returns contain incorrect, inconsistent, or missing information.
- Your ERC is large in relation to your typical payroll.
- You used a third-party entity that the IRS knows has fraudulently or negligently helped taxpayers apply for the ERC.
- You have a history of tax problems with the IRS.
- You applied for the ERC by amending your payroll tax returns, but did not also amend your business income tax returns.
What Happens if I Get Audited and the IRS Finds a Problem?
What can happen depends on the type of error found and your level of responsibility for that error. In the majority of cases, you will likely face a monetary penalty because taking a tax credit you’re not supposed to usually results in you understating your tax liability.
If this understatement is big enough, you can face an accuracy-related penalty. This penalty is 20% of the tax understatement and usually applies if you intentionally or negligently broke the IRS’ rules or your understatement is at least $5,000 or 10%.
The Failure to Deposit Penalty applies if you don’t make your employment tax deposits on time, in the correct amount, or in the right way.
If you should not have taken an ERC credit, it probably means you should have sent a larger employment tax deposit to the IRS when submitting a prior return. The amount of this penalty varies, but in the ERC audit context, it’s 10% of the unpaid deposit amount. This penalty can rise to 15% if you don’t pay it within 15 days of the IRS’ demand for payment.
Trust Fund Recovery Penalty
The TFRP applies if you don’t collect and pay the taxes you withhold from your employees’ paychecks. These taxes include income and employment taxes (like Social Security and Medicare). If you correctly received the ERC, you wouldn’t have to make these deposits. If you incorrectly received the ERC, then you would not have made these deposits even though you should have. Therefore, you would be subject to the TFRP. If you must pay the TFRP, you will pay 100% of the unpaid tax.
The above-referenced penalties could become far more severe if you committed fraud. If you commit fraud to receive the ERC, you will not only lose the credits, but you’ll also pay a penalty of 75% of any understated tax amount. Fraud exists if you took deliberate steps to take the ERC when you knew you shouldn’t or you tried to cover up your mistake(s) relating to the ERC. This can include actions such as:
- Lying to an auditor.
- Using fake information to claim the ERC, such as fake Social Security numbers of employees that don’t exist.
- Intentionally not maintaining records (or destroying records) relating to your ERC claims.
If the IRS concludes you engaged in fraud, at a minimum, you’ll have to pay the applicable civil penalty, but criminal prosecution for tax evasion is also a possibility. If you are found guilty in a criminal court, you could face up to $100,000 in fines and up to five years in prison.
Does the IRS Have a Forgiveness or Amnesty Program for ERC Errors?
Yes, there is something called the Employee Retention Credit Voluntary Disclosure Program, or ERC-VDP. Businesses and tax-exempt organizations that received the ERC but now believe they shouldn’t have can avoid ERC audits and penalties if the following conditions are met:
- The taxpayer agrees to repay the ERC, less 20%;
- The taxpayer cooperates with an IRS request for more information; and
- The taxpayer signs a closing agreement.
In addition to having to only pay back 80% of the ERC, another advantage of the ERC-VDP is that you can also avoid paying any interest on the ERC you eventually pay back. Then there’s the fact that you don’t need to amend any relevant income tax returns to reduce wage expenses.
To apply for the ERC-VDP program, you’ll have to complete IRS Form 15434, Application for Employee Retention Credit Voluntary Disclosure Program. You’ll also need to complete IRS Form SS-10, Consent to Extend the Time to Assess Employment Taxes if your application includes tax periods ending in 2020.
But what if you’ve already completed an ERC audit and the IRS finds you should not have received your ERC? In this case, you may be able to convince the auditor to remove some or all of the penalties if your ERC was the result of an ERC mill tricking you into applying for the credit. If this defense applies to you, it’s also a good idea to file IRS Form 14242, Report Suspected Abusive Tax Promotions or Preparers.
What Is the Statute of Limitations for ERC Audits?
The IRS has three years to audit most ERC claims, but has an additional two years if the payroll returns they need to audit were filed in the last half of 2021. And if the IRS suspects fraud, they can complete ERC audits as far back as they want. The statute of limitations clock typically starts on April 15 of the year after you file the relevant returns.
For example, if the IRS audits a return filed in the fourth quarter of 2020, they have until April 15, 2024, to conduct an ERC audit, not the fourth quarter of 2023. Also, keep in mind that there are efforts to extend this three-year statute of limitations for most ERC audits to five years for all ERC audits.
Facing the Possibility of an ERC Audit?
If you think you might have improperly received the ERC credit, there is a reasonable chance you could get audited. As scary as that sounds, you can avoid an ERC audit and potential penalties if you correct your mistake. However, you must act quickly, as the IRS is far more willing to show leniency if you come forward before an ERC audit occurs.
Damiens Law can help determine if you have a potential ERC problem and if so, guide you through the process of correcting any errors or omissions before things get worse. To learn more about your ERC audit risk and the potential for penalties or amnesty, please contact us for a free initial consultation.