The IRS recently issued a news release identifying seven signs that a business’s Employee Retention Tax Credit (the ERC) may be incorrect. The IRS identified these warning signs based on feedback from tax professionals and IRS compliance personnel.

In other ERC news, the IRS Commissioner testified before the House Ways and Means Committee that the IRS is still receiving thousands more ERC claims per week than it is processing, and the IRS Office of Chief Counsel issued a memorandum concluding that third-party payors are liable for underpayments and penalties related to returns they file that underreport and underpay employment taxes.

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 almost two years, the IRS has engaged in a concerted effort to stamp out fraudulent ERC claims.

Claimed properly, the ERC provides a financial lifeline to eligible businesses. Improper claims, however, can cause financial disaster to businesses.

The ERC Seven Red Flags

According to a February 13, 2024, news release, the seven suspicious signs of an incorrect ERC claim identified by the IRS are:

1. Claiming the ERC for Too Many Quarters. While most businesses have the opportunity to test their ERC eligibility for seven quarters (all four quarters of 2020 and the first three quarters of 2021), the IRS has indicated that it is uncommon for a business to actually qualify for the ERC in all seven quarters.

2. Relying on Nonqualified Government Orders. One of the ways a business qualifies for the ERC is as a result of a government order. However, not all government orders qualify. For a government order to qualify:

• The government order must have been in effect during the periods the employer is claiming the ERC
• The employer’s operations must have been fully or partially shut down by the government order during the periods the employer is claiming the ERC
• The government order must have been due to the COVID-19 pandemic
• The government order must have actually been an order — not a recommendation, a statement during an interview or a suggestion.

In addition, not all government orders qualify. For instance, many orders from the Occupational Safety and Health Administration (OSHA) do not qualify as government orders enabling a business to qualify for the ERC.

3. The Business has Too Many Employees and Incorrectly Calculated the ERC. Not all payments to all employees count as qualified wages for the ERC. Differences in the law in 2020 and 2021 changed dollar limits, credit amounts, and the definition of qualified wages. As a result, many businesses erroneously use the same credit amount in multiple or all periods for every employee, which can easily cause a miscalculation in the amount of the ERC.

4. Incorrectly Claiming that Supply Chain Issues Caused a Decline in Gross Receipts. Another way to qualify for the ERC, even if a business does not qualify under the gross receipts test, is if one of its suppliers qualifies under the government order test and the business had to fully or partially shut down as a result of those supply chain interruptions. Qualifying for the ERC due to a supply chain issue, however, is not common and the IRS will look closely at claims relying on a supply chain disruption.

5. Claiming Too Large of an ERC. In 2020, businesses could only claim an ERC in the amount of up to $5,000 per employee for the entire year. In 2021, businesses could claim an ERC in the amount of up to $7,000 per employee per quarter. While the IRS acknowledges that a business could qualify for the ERC for an entire calendar quarter if their business operations were fully or partially suspended due to a government order during the quarter, the IRS believes that to be uncommon. As a result, the IRS is reminding businesses that they can claim the ERC only for wages paid during the period in which the business was fully or partially shut down, and not necessarily the entire quarter. Businesses should keep accurate payroll records to support their claim that wages are qualifying wages for all periods claimed.

6. Business Did Not Pay Wages or Did Not Exist During the Eligibility Period. As basic as it sounds, the IRS offers a reminder that businesses may only claim the ERC if they existed during the tax periods in which they claimed the ERC and if they paid wages during the periods in which they claimed the ERC. In December 2023, the IRS sent more than 20,000 letters denying the ERC to businesses that did not meet this basic requirement. These are easy claims for the IRS to disallow, and the types of claims that fall far over the line of a business making a mere mistake.

7. The Sunshine of the ERC Promoter. Businesses should think twice if a company marketing or promoting the ERC gives them news that is too good to be true or tells them they “have nothing to lose.” The IRS offers a reminder that businesses incorrectly claiming the ERC risk repayment requirements, penalties, interest, audits and the potential expenses of hiring an accountant or lawyer. They would likely need professional help to resolve the incorrect claim, amend previous returns or represent them in an audit.

IRS Commissioner Testimony Before House Ways and Means Committee

The IRS Commissioner testified Feb. 16, 2024, before the House Ways and Means Committee. Some key takeaways related to the ERC include:

• The IRS has processed approximately 1,000 to 2,000 ERC claims per week since the processing moratorium on new ERC claims began on September 14, 2023.
• During the first week in February, the IRS received approximately 17,000 to 20,000 ERC claims. All of those claims will be barred if the Tax Relief for American Families and Workers Act of 2024 is enacted with the proposed retroactive January 31, 2024, sunset date for ERC claims.
• The IRS is hoping to end the moratorium on processing ERC claims received after September 14, 2023, in April or May.

Legal Advice Relating to Third-Party Payors

The IRS Office of Chief Counsel issued a Generic Legal Advice Memorandum on February 5, 2024. It concluded that third-party payors are liable for underpayments and penalties related to returns they file that underreport and underpay employment taxes. Specifically, it confirmed that when businesses use third-party payers (such as Section 3504 agents, professional employer organizations and certified professional employer organizations), and the third-party payer underpays employment taxes because the third-party payer improperly claimed the ERC, both the third-party payer and the business are liable for the underpayment and any penalties.

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