In October, the IRS issued a news release to warn employers to be wary of third parties who are advising them to claim the Employee Retention Credit (ERC) by filing amended payroll tax returns for various quarters in 2020 and 2021. The IRS cautioned that some third-party advisory firms are taking improper positions related to taxpayer eligibility for and computation of the credit. Further, these third parties may not be advising the taxpayer that wage deductions claimed on the business’ federal income tax return must be reduced by the amount of qualified wages used in computing the credit.
The IRS encouraged business taxpayers to be cautious of advertised schemes and direct solicitations promising tax savings that are, in essence, too good to be true. Taxpayers are always responsible for the information reported on their tax returns. Improperly claiming the ERC could result in taxpayers being required to repay the credit along with penalties and interest.
The IRS news release did not give any specifics but a quick internet search for “ERC credit” or “ERTC credit” and a review of various firms’ web sites could leave a reader with the false impression that:
- qualifying for the ERC is easy “if [a] business has been affected by the pandemic”;
- ERC qualification could be determined by a short phone call (e.g., 6 minutes, 15 minutes);
- only a cursory online questionnaire needed to be completed or a “few documents” submitted to the advisory firm;
- the necessary documentation essentially consists of payroll reports and governmental orders;
- there is a streamlined or perfected process to keep time to a minimum; and
- there was minimal risk of adjustments from an IRS audit (e.g., [using this firm] helps ensure you avoid an audit” or that “you obtain . . . an audit-proof strategy”).
It is possible that the advisory firms whose websites we looked at do indeed have a more robust ERC qualification and computation process than would be apparent from the face of their websites. While our review was limited in scope, our impression was that the promised quick and easy process seems to run in the face of the extensive guidance that IRS has issued to provide rules for ERC eligibility and computations based on qualified wages paid during various dates.[1] For example, in our random review, we did not find consistent or direct mention of the following basic points (offered as examples):
- Eligibility for the ERC is not a one-time test and needs to be factually determined on a quarter-by-quarter basis based on the then-applicable governmental orders, their specific impact on the business and/or the changes in gross receipts when compared to the relevant testing period.
- While many businesses were subject to some governmental order (e.g., masking, social distancing) necessitating the business to modify its operations, for the business to qualify for the ERC, the governmental order needed to, in fact, cause more than a nominal effect on the employer’s business operations.
- In cases where the employer was itself not subject to a governmental order suspending its operations, but its suppliers were required to suspend their operations, the actual rule provides that the employer must not have been able to procure critical goods or materials from alternative suppliers, and as a result, the supply chain disruption caused the employer’s own operations to be fully or partially suspended.
- Where an employer operating in multiple jurisdictions relies on the fact that a governmental order requires a full or partial suspension of operations in some, but not all, jurisdictions for the employer to qualify, the employer needed to establish a policy to operate consistently across all jurisdictions.
Also, we did not find any mention that when wages (and qualified health plan expenses) are considered to be “qualifying wages” and used as the basis in the ERC computation, those wages (and qualified health plan expenses) are no longer deductible on the taxpayer’s income tax return. Accordingly, an amended federal income tax return needs to be filed for the tax year that the wages were deducted.
ZHF Observations – Review your ERC claim and be prepared for potential IRS audit
The IRS has begun training its personnel and rolling out its ERC audit procedures. It is too soon to know what manner the audits will take and what specific data the IRS will request.
Based on our experience in gathering contemporaneous support for similar tax savings projects, except in instances where the employer was eligible because of the decline in gross receipts, we would expect the interview process to be comprehensive and focused on the interviewer gaining an understanding of specifics (and developing a written narrative and gathering documentation) regarding how applicable governmental orders caused a full or partial suspension of the employer’s business in each of the potentially qualifying quarters.
We would expect the documentation to include more than just a governmental order and an “x” marked in a survey box, but also include a specific written discussion about how the order impacted various aspects of the actual business operations and caused there to be more than a nominal effect on the employer’s operations.
Even if the taxpayer relied on a third-party adviser to review the ERC and prepare the documentation and computation, taxpayers need to be mindful that they will still be responsible for any penalties and interest if the IRS determines that the taxpayer was not entitled to a refund for the ERC. Right now, while memories are fresh, taxpayers should review the sufficiency of their ERC documentation and supplement it if necessary. In some cases, review by an independent advisor or attorney may be warranted.
The mere fact that IRS issues a refund for the ERC credit does not mean that there is no risk of audit. In this regard, note that various members of Congress have expressed delays regarding the backlog in processing amended Form 941 returns. Thus, there may be a tension between identifying even basic processing errors up front versus the speed of processing the Form 941-X.
PEOs: Taxpayers who are Professional Employment Organizations (PEO’s) “must” be able to obtain from the client and provide to the IRS records that substantiate the client’s eligibility. Thus, if the PEO’s clients tell them that they are eligible for the ERC, the PEO should make sure that it has the underlying records (substantiating eligibility), particularly if the PEO claimed the ERC on the original aggregated Form 941 as an offset to the employment taxes of the client. In those cases, alongside the client employer, the PEO would also be liable for any employment taxes that are due as a result of an improper ERC claim.
For questions about what steps should be taken to review the sufficiency of an ERC claim or how to prepare or respond to an employee retention credit audit, please contact H.T. Astrov or one of the other tax professionals at Zaino Hall & Farrin LLC.
[1] See, Notice 2021-20, Notice 2021-49 and Rev. Proc. 2021-33 (for wages paid After March 12, 2020 and before January 1, 2021), Notice 2021-23, Notice 2021-49 and Rev. Proc. 2021-33 (for wages after December 31, 2020 and before July 1, 2021), Notice 2021-49 and Rev. Proc. 2021-33 (for wages after June 30, 2021 and before October 1, 2021) and Notice 2021-49 and Notice 2021-65 (for wages after September 30, 2021 and before January 1, 2022). The IRS website also contains a useful 2020 vs. 2021 Comparison Chart for a summary of how some of the basic rules for the ERC differ for each quarter.