Will the IRS Audit Your ERC Credit? Audit Risks and What to Expect
In 2022, the IRS launched an ERC audit program. The agency plans to pay close attention to these credits, and it has announced that auditors plan to give special scrutiny to payroll tax returns with ERC credits. Should you be worried? If you’ve claimed the credit, this guide looks at red flags that heighten your risk of an audit, and then, it explains what to expect if you’re selected for an audit.
To learn more, contact us at the W Tax Group. We can talk with you about your audit risk, help you correct inaccurate returns, or guide you through the audit process. We have extensive experience in helping businesses with all kinds of payroll tax issues including ERC audits and penalties.
Why the IRS Audits Employee Retention Credits
The IRS has decided to take a closer look at ERC claims due to the high number of erroneous claims. This credit was created to help employers who kept employees on the payroll during the COVID pandemic. It was worth up to $10,000 per employee in 2020, and it was up to $7,000 per employee per quarter in 2021.
Because the credit was new and the rules were confusing, many people made mistakes while filing. Even worse, many unscrupulous companies abused this credit by making false claims. They convinced business owners to claim the credit even when they weren’t really eligible. By increasing audits, the IRS hopes to find and reverse incorrect claims of this audit.
ERC Promotions: A 2023 Dirty Dozen Tax Scam
In 2022, the IRS started issuing warnings about ERC abuse. Its warnings were primarily focused on ERC mills that were created with the sole purpose of “helping” businesses claim this credit. In 2023, these businesses were still targeting employers with abusive ERC promotions. In response, the IRS named ERC promotions as its top 2023 dirty dozen tax scam.
Every year, the IRS creates a list of the worst scams targeted against consumers and the IRS. In addition to putting this scam on the list, the IRS also launched a program to target ERC abuse. This combines public education and increased audit scrutiny.
Red Flags That Can Trigger an ERC Audit
So, are you likely to be audited? The IRS can randomly select any return for an audit, but your risk is higher if your return has one of these red flags:
- Excessive credits claimed — in particular if your credits are high compared to usual wages reported or when compared to the rest of your industry.
- Discrepancies between the numbers on your payroll tax return and other forms such as W3 or your business income tax return.
- Claimed the credit on wages paid with a PPP loan.
- Didn’t update the wage expense on your business income tax return (1140 Schedule C, Form 1065, Form 1120-S, Form 1120).
- Claimed the credit for Q4 2021 but you aren’t a recovery start-up business.
- Return filed by a known ERC mill.
Figuring out if you worked for an ERC mill can be tricky but it’s not impossible. If you answer yes to any of the following questions you probably worked with a mill which increases your risk of errors and audits:
- Did the company advertise heavily?
- Was the company created to focus on ERC credits?
- Did the company promise that you could get the credits before learning about your business?
- Did the company fail to ask for documents to support your eligibility?
- Did the rep fail to ask about your number of full-time employees in 2019?
- Was the fee for services a percentage of the credit?
If you answered yes to any of the above questions, you probably worked with a mill and you may want to have a tax attorney review your return for accuracy.
ERC Audit Notifications
If you are selected for an ERC audit, the IRS will notify you through the mail. The letter typically instructs you to call an IRS auditor by a certain date and time. On the phone call, the auditor will tell you which documents you need to provide.
You can (and should) have a tax professional represent you. To do so, prepare Form 2848 (Power of Attorney and Declaration of Representative) or Form 8821 (Tax Information Authorization) and send it to the IRS before your phone meeting.
Supporting Paperwork for ERC Claims
The basic premise of an audit is that you provide paperwork to back up the claims on your income tax return. With an ERC audit, the auditor may ask for the following:
- Employee time cards or other proof of wages earned.
- Documents supporting other eligible expenses used to claim the credit.
- Proof of relationship with employees if applicable — for instance, you weren’t allowed to claim the ERC for certain relatives.
- Revenue records to show a decline in revenue or proof of operational restrictions.
- Worksheets used to calculate the credit.
These are the most common documents you will be asked to provide, but the auditor may ask for other records. They may also want to see other tax returns such as your business income tax return that has numbers that should line up with the numbers on this return.
Outcomes of ERC Audits
After reviewing your paperwork, the auditor will decide if you pass or fail the audit. If you pass, that means that the IRS accepts your return as filed. If not, the IRS will adjust your return. Small changes are usually not a big issue, but if the changes are substantial, you may face audit penalties.
Penalties for Incorrect ERC Claims
An ERC audit penalty will apply if the IRS makes significant changes to your return. There is an accuracy-related penalty that applies if you make errors that substantially reduced your tax bill. In cases of fraud, the penalty can be very high, but generally, you will only incur a civil penalty. Criminal audit penalties are very rare.
Effects on Other Tax Returns
Depending on the results of your ERC audit, you may need to adjust other tax forms. The most significant change you will need to make is to your business income tax return. Here’s an overview of what to expect.
Regardless of the structure of your business and the annual return that you file, you are allowed to claim a wage expense. This includes all of the wages, benefits, and employer payroll taxes that you paid during the tax year. But if you claimed the ERC, you should have reduced your wage expense accordingly.
To give you a very basic example, imagine that you had a $80,000 wage expense, but then, you claimed a $10,000 ERC. That would have reduced your wage expense to $70,000. If you claimed the wage expense correctly and the IRS disallows your ERC, you should go back and increase the wage expense on your tax return. In this example, you should increase your wage expense to $80,000.
Generally, that type of change results in a lower tax liability and thus a refund if you have already paid your tax bill. However, that can be problematic in this situation. The IRS normally has three years to amend payroll tax returns, and you have three years to amend tax returns for a refund.
However, if you amended your payroll returns to claim the ERC, the audit statute of limitations doesn’t start until the date you submitted the amended return. Thus, it’s possible that the IRS may audit your return at a point when it’s too late to claim a refund on your income tax return.
For this reason, it’s critical to get in front of the audit and make changes proactively. Then, you’re more likely to be able to make changes to your business income tax return that lead to a refund.
How to Appeal Your ERC Audit Results
Auditors make mistakes. Some auditors will adjust your return or take away the credit even if you’re eligible. If you disagree with the results of your ERC audit, you can appeal, but you must do so in writing.
File Form 12203 (Request for Appeals Review) or write the IRS a protest letter. Make sure that you send the letter to the right department or your appeal may be summarily denied. Outline the reasons that you disagree with the auditor and provide any documents that support your side of the issue.
For best results, you should definitely work with a tax professional at this stage in the process. They can help ensure that you are interpreting the tax law correctly, providing the right documents, and making sound arguments to the auditor.
Note that the appeals process has strict deadlines, but if you miss them, you aren’t necessarily out of luck. Depending on the situation, you may be able to request an audit redetermination or pay under protest and request a refund.
What if I Claimed the ERC Incorrectly?
If you know that you filed an incorrect return, you should amend the return to correct your mistake. Amending the return allows you to avoid audit-related penalties.
If you owe tax after you file the return, you may be able to set up an installment agreement. However, if your business is still operating, you can usually only set up payment plans on up to $25,000 in tax debt.
Proactively amending your return is much better than waiting for the IRS to “catch you”. If the IRS selects you for an audit, you may face penalties and interest at that time.
Help — Someone Tricked Me Into Claiming the ERC
If you believe that you worked with an ERC mill, you should report them to the IRS. You can do so by filing Form 14242 (Report Suspected Abusive Tax Promotions or Preparers).
Unfortunately, however, you are ultimately responsible for the information on the tax returns that you file. Even if someone else completed your payroll return, you are supposed to review the details for accuracy. If something is incorrect or fraudulent, you personally can bear the responsibility for that. That means you will be responsible for any tax due plus interest and penalties.
When to Hire a Tax Attorney for an ERC Audit
An attorney can be invaluable when you’re dealing with ERC issues. This credit is a one-time credit with very confusing rules, meaning that many accountants and tax preparers don’t fully understand the rules. To protect yourself, you need someone who understands this credit inside and out.
Here are some situations where you should consider hiring an attorney:
- You’re worried that you claimed the credit incorrectly and you want an independent review of your return.
- You’ve been selected for an audit and you want to make the process as easy as possible for yourself.
- You’re in the midst of an audit and feeling overwhelmed, confused, or unheard.
- You’ve just failed an ERC audit and want help appealing.
Not sure if you should hire outside help? Then, contact us at the W Tax Group for a free consultation. We’ll talk briefly with you about your situation and then help you decide the best path forward.
At the W Tax Group, we never press unwanted services on people. Instead, we carefully evaluate your situation and help you find the very best services for your unique needs. We customize all of our offerings around our clients’ situations. Facing an audit is almost always stressful, but it’s even worse when you have tens of thousands of dollars in tax credits on the line. Don’t deal with this on your own — instead, get help today.