Congress enacted the Employee Retention Credit (“ERC”) during the COVID-19 pandemic to help employers retain their workforce and stay current on payroll despite economic difficulties that plagued the world. The legislation provided a specific route for employers to claim the ERCs but left much to be desired with respect to specifics related to eligibility to claim the ERCs and other mechanics of the credit. When the credit was enacted, the Congressional Budget Office estimated that approximately $85 billion would be paid out pursuant to the ERC program. Now, the Taxpayer Advocate Service estimates that the IRS has processed over 3.5 million ERC claims and has refunded approximately $230 billion on these submissions as of September 28, 2023—almost three times the original estimated cost—and there are currently estimated to be 1,000,000 claims in the IRS backlog. Of course, this raised huge red flags within the IRS.

In July 2023, the IRS heightened its scrutiny of ERC claims, intensified audits, and launched criminal investigations targeting promoters and businesses associated with dubious claims. Due to large amounts of believed fraud and overly aggressive claims, the IRS paused processing new ERC claims starting on September 14, 2023; that moratorium remains today. The IRS has already distributed over 20,000 letters to employers, disallowing their ERC claims based on factors such as nonexistent businesses or a lack of eligible employees. Additionally, the IRS announced the initiation of letters proposing tax adjustments for up to an additional 20,000 employers who had claimed erroneous or excessive ERC amounts. These letters are going to employers of all sizes and even relate to ERC claims below $10,000. The IRS appears very confident on its ability to recoup inappropriately claimed ERCs as illustrated by the fact that $77 billion of the total $78 billion cost of the recently proposed Wyden-Smith tax proposal (H.R. 7024) is expected to be financed by the IRS recouping fraudulent ERC claims over the next decade.

Background

ERC claims generally relate to the second, third, and fourth quarters of 2020 and the first, second, and third, quarters of 2021. A taxpayer’s eligibility for the ERCs is determined under one of two tests. The first is a mechanical gross receipts reduction test, which compares quarterly revenue in 2020 and 2021 against the corresponding quarter in 2019 to determine if revenue in the applicable quarter decreased enough to qualify. The second test (often called the “suspension test”) is more nuanced and relies on a number of facts and circumstances.

The IRS believes that the vast majority of the fraudulent and ineligible claims stem from taxpayers utilizing the suspension test. Specifically, a number of new “accounting” firms were formed to promote and solicit taxpayers to file ERC claims in exchange for a percentage of the cash refunded. These new “ERC mills” were the biggest promoters for utilizing the suspension test to claim ERCs, and many of the claims have been found to be erroneous or fraudulent. However, traditional accounting firms may have also incorrectly applied the suspension test since the application of such test is not as clearly defined as the gross receipts test. It is crucial to understand that even if a taxpayer has a valid claim utilizing the suspension test, the IRS will require significant documentation to substantiate a claim under that test.

Claim Withdrawal

In October of 2023, the IRS announced a withdrawal process for small business owners and other taxpayers to rescind their ERC claims and prevent future repayment of the credit (plus possible interest and penalties) if the taxpayer hasn’t yet received the refund. Taxpayers may only use the ERC withdrawal option if all of the below factors apply:

1. The ERC claim was made on an adjusted employment tax return (Forms 941-X, 943-X, 944-X, CT-1X).
2. The taxpayer filed its adjusted return only to claim the ERC, and the taxpayer made no other adjustments.
3. The taxpayer seeks to withdraw the entire amount of their ERC claim.
4. The IRS hasn’t paid the claim, or the IRS has paid their claim, but the taxpayer hasn’t cashed or deposited the refund check.

Voluntary Disclosure Program

In December of 2023, the IRS announced a voluntary disclosure program (“VDP”) for taxpayers who received payments of their ERC claims from the IRS. Under the VDP, taxpayers can repay 80% of the ERCs received and potentially avoid penalties and interest, while keeping the remaining 20% of the ERCs. In guidance released by the IRS explaining its VDP program, the IRS noted that employers who do not utilize the VDP, or who are found ineligible, may be subject to a whole host of civil penalties (and interest) including: (1) failure-to-pay; (2) failure-to-file; (3) failure-to-deposit; (4) accuracy related penalties; (5) civil fraud penalties; (6) fraudulent failure-to-file penalties combined with the failure-to-file penalties; and (7) trust fund recovery penalties.

Taxpayers only have until March 22, 2024, to utilize the VDP, so taxpayers that received ERCs should not put off determining whether there claim was legitimate.

Next Steps

If you are concerned about the viability of your ERC claim, it is important that you take action now. If you have not yet received your ERC refund, you may want to consider withdrawing that claim. If you have already received an ERC refund, you should consider whether you should utilize the VDP to avoid future IRS issues. If your ERCs relied on the suspension test, then whether to utilize one of these programs is of even more importance. If you believe you qualified under the suspension test and do not wish to utilize either program, then you should ensure you have the proper documentation in place to substantiate your claim and be prepared to defend an IRS audit.