This year, the Internal Revenue Service (IRS) issued several warnings encouraging people to carefully review Employee Retention Credit (ERC) guidelines before attempting to claim the tax credit as ERC mills and other bad actors continue to push ineligible people to file. On September 14th the IRS even announced a moratorium on the processing of Employee Retention Credit claims received on or after September 14, 2023, such that they will not begin to process these claims until at least January 2024.
Since the IRS has signaled an increased commitment to fighting ERC fraud, business owners who have filed, or plan to file, must be prepared. An IRS inquiry or audit doesn’t automatically indicate that your claim is incorrect—it just means that is just being reviewed and may require supporting information to proceed with the filing.
The IRS utilizes several methods to select Employee Retention Credit applications to audit, including random selection and computer-generated algorithms that flag certain filings. Applicants are not required to submit supporting documentation with their initial 941-X applications, so the IRS has to sort through millions of filings using its own approach to detecting improper and fraudulent claims.
The IRS has not disclosed the entire audit selection criteria to the public. However, applicants should be aware of some well-defined Employee Retention Credit filing “red flags.” Inconsistencies across filings can flag your return in an algorithm screening or lead an auditor to scrutinize your claim further. The IRS has issued consistent warnings about improper ERC claims.
The idea of being audited after filing for the Employee Retention Credit is daunting. Potential applicants should collaborate with experienced tax and legal professionals to stay in the know when it comes to IRS red flags. Investing in a reputable advisor can save you time, money, and headaches. Continue reading to explore potential ERC filing inaccuracies and other factors the IRS may or may not consider “red flags,” as well as how to put your organization in the best possible position to file an accurate Employee Retention Credit claim.
Common IRS “Red Flags”
The following factors are commonly known as ERC “red flags,” meaning that the IRS may scrutinize a filing more closely if one or more of these factors is present in the initial application. These can lead to audits or the need for supplementary documentation, so review them carefully.
Failure to vet your organization’s numbers can lead to miscalculations—and inaccurate numbers—in your Employee Retention Credit. The IRS has access to all your originally filed returns, such as income and payroll tax returns, so it is well aware of prior wages paid and revenue numbers. One unintended miscalculation can lead to inconsistencies between the claimed figures on your Form 941-X and prior tax records. This raises an automatic red flag to the IRS. Thus, a close review of your Form 941-X ERC application, plus accurate and consistent financial documentation, is vital.
In comparison to accidental mathematical inaccuracies, intentionally filing an ERC claim with inaccurate information can involve criminal repercussions. Claiming inflated wages never paid upon and ineligible wages (such as owner or family member wages) are both examples of misrepresentation that constitute fraud when filing for the ERC. The IRS is well aware of fraudulent applications; the IRS Criminal Investigation division is actively working to identify fraud and promoters of fraudulent claims.
Filing false claims can lead to credit repayment, interest and financial penalties, and criminal liability.
Is your organization properly registered? The IRS can easily determine whether or not your company is real and properly registered. Other considerations include ensuring you have a Tax ID (Employee Identification Number or “EIN”) and verifying that your taxes are up to date.
The crux of avoiding an audit is to make sure all the preliminary, fundamental paperwork is accurate and valid. Even innocent mistakes—such as typos and miscalculations—may lead to consequences as your ERC claim progresses. IRS investigators may not jump to negative conclusions about every application with minor typos or miscalculations, but it may prompt closer examination if basic information doesn’t align with what the IRS has on file.
Some industries have a history of increased fraud or suspicious filings. The IRS takes this into account to mitigate the risk associated with those industries. As a result, some industries may be more likely to be audited than others solely based on past infractions with the IRS.
For example, in terms of the Employee Retention Credit, IRS investigators may look closer at industries that suffered less than others as a result of COVID-19-related shutdowns or social distancing orders. Some of these industries include accounting firms, law firms, tech businesses, and other remote-work-friendly occupations.
Firms in “red flag” industries should provide detailed evidence for their claim. Experienced CPAs and tax attorneys will have a working knowledge of these industries and the intricacies of ERC eligibility regulations.
Unusually large claim amounts.
The IRS often assesses whether a taxpayer who received the Employee Retention Credit amended their income tax returns for 2020 and 2021 to reflect their new standing. An employer receiving an ERC refund is not required to include the credit in its gross income figure for federal income tax purposes, but the amount of ERC claimed should reduce expenses that an eligible employer could otherwise deduct on its federal income tax return. This may increase federal taxable income. Taxpayers who fail to convey owed back taxes are likely to be audited.
Factors Commonly Miscontrued as “Red Flags”
In response to confusion surrounding the Employee Retention Credit, the IRS issued guidance related to eligibility in 2021. The 2021 guidelines decreased misconceptions, and business owners have become more aware of the tax credit. However, misconceptions about the ERC remain and have made the filing process difficult to navigate without qualified assistance.
Here are some factors that organizations may mistakenly believe are ERC red flags to the IRS.
Filing as an essential business.
Like non-essential businesses, essential businesses were subjected to regulations and restrictions that may qualify them to receive ERC funds. In 2023, the financial qualifications for ERC fund eligibility were lowered. The threshold for gross receipts dropped from 50% to 20% for 2021. Qualifying businesses that faced just a 20% decline in revenue during the pandemic are eligible for the ERC funds. Even without a decline in revenue, employers showing substantial proof of how their business was impacted by COVID-19 and satisfying a gross receipts test may still qualify.
For instance, hospitals and other healthcare organizations were deemed essential during the pandemic, and many of those organizations didn’t lose necessarily revenue during the pandemic. However, they were forced to increase staffing due to the operational impact of the pandemic, despite adverse working conditions. However, the staffing increase was a response to regulations that limited how many patients (per staff member) hospitals could see.
Being a Paycheck Protection Program loan recipient.
The CARES Act established the Paycheck Protection Program (PPP) to prevent economic downfall during the pandemic and provide small businesses with funds to pay up to eight weeks of payroll costs. Employers don’t have to choose between the PPP and the ERC. The Consolidated Appropriations Act of 2021 allows employers to claim ERC funds for any wages that were not added to the payroll costs reported for PPP loan forgiveness.
Some may think that being a recipient of another COVID-19-related benefit is automatically a red flag to the IRS, but it is not. However, businesses need to avoid double-dipping—claiming the ERC for wages already covered by a forgiven PPP loan. When designating wages as ERC wages after an employer has had a PPP loan forgiven, a qualified ERC advisor must take a thoughtful approach while concurrently deploying a strategy to optimize the ERC-qualified wages.
Another misconception is that filing post-pandemic is an automatic red flag. Businesses may think that because the tax credit technically expired in September 2021, they can no longer apply for or receive the credit. However, qualified businesses can still amend their filings for the ERC until 2025. Business owners must file IRS Form 941-X, which is used to make corrections to originally filed Form 941s. This can only be done up to three years after the initially filed payroll tax returns. However, within that time frame, there is no limit to how many times you can file an amended form.
The IRS provides that, “For purposes of the period of limitations, Forms 941 for a calendar year are considered filed on April 15 of the succeeding year if filed before that date.” So, 941-Xs for eligible quarters in 2020 must be submitted to the Internal Revenue Service by April 15, 2024. The ERC deadline to claim funds for eligible quarters in 2021 must be submitted by April 15, 2025.
Partner with a Qualified Advisor to File Your ERC Claim
Accounting for factors that may be viewed as red flags (and may result in an audit) along with required documentation, filing deadlines, and proactive audit preparation is daunting to any leader who just wants the best for their organization. Consulting with experienced, qualified tax and legal professionals is the first step to determining ERC eligibility and filing a legitimate claim for the credit. You can avoid the hassle and headache associated with filing a claim by employing the help of a qualified advisor.
Expert ERC firms are led by certified public accountants and tax attorneys with extensive experience in the legal test related to the ERC. With an arsenal of professionals on hand, a qualified advisor can ensure that all eligibility criteria are met for each applicable period before submitting a claim for the credit. They will also provide a detailed, CPA-certified, audit-ready report to their clients outlining their eligibility and wages claimed. Additionally, ERC experts will advise employers to refrain from claiming or overclaiming the credit when they do not have a clear path to eligibility.
EZ-ERC offers qualified advisors who are just a quick email or call away. There is no commitment and no up-front fees for a review of eligibility. Get in touch with EZ-ERC to get started.