Employer’s Guide to ERC Audits

Employer reviewing ERC audit guidelines

What to Expect if the IRS Audits your Employee Retention Credit

In 2022, the IRS announced that it would focus on ERC audits. This means that the agency is going to audit many businesses that claimed employee retention tax credits (ERC) on their payroll tax returns. Typically, the IRS only has three years to audit business returns, but the agency has extended the statute of limitations to five years for select returns with this credit.

If you claimed the credits correctly, you simply need to prove your eligibility to the IRS during the audit process. Unfortunately, this can be a paperwork-heavy, time-consuming process, and even if you’re eligible to claim the credits, you risk failing the audit if you don’t provide the IRS with the right proof. Because these credits are so valuable, failing an ERC audit can be very expensive.

This guide explains what to expect during the audit process. If you’ve received an IRS audit notice or want to get a second opinion on your ERC claim, contact the experienced team at Wiggam Law today. We provide personalized, high-quality services and can help you through any IRS audit.

What to Expect From an ERC Audit

If the IRS selects your payroll return for an audit, the auditor will ask you to back up the details on the return. Generally, the process starts with the IRS sending you a notice about the audit. The notice will outline the next steps you should take.

Typically, you will set up a meeting with the auditor on the phone. This is called a desk audit. Sometimes, the notice will tell you to mail the requested documents to the IRS, which is called a correspondence audit. In rare cases, the auditor will come to your place of business and conduct what’s know as a field audit.

Typically, with a payroll audit, you show the IRS records of the payments you made to your employees, and the auditor may also ask you to provide time sheets, pay rates, and copies of state withholding returns. During an ERC audit, the auditor may also ask you about these details on your payroll tax return, but they will also request documents that prove you were eligible to claim the ERC.

Then, the auditor will review your information and make a determination about your return. If they agree with the information on your return, they will issue a “no change” report, and you won’t owe any money or lose your ERC. They will adjust if they disagree with the information on your return. Usually, this means that the auditor reduces or eliminates the ERC, and by extension, you end up owing money to the IRS.

You have the right to protest the audit results if you disagree, but there’s usually a very strict time frame. You may lose your chance to appeal if you miss the appeal deadlines, which is why hiring an experienced tax attorney can increase your chances of staying organized and making a successful audit case.

ERC Audit Notifications

If the IRS selects your return for audit, it will send you a notice in the mail. The notice will state which returns are being audited. For instance, it may say that the IRS is auditing your Q3 2020 Form 941 (Employer’s Quarterly Federal Tax Return).

Generally, you will also receive an information document request (IDR). The IDR explains which elements of the return the IRS is auditing, and it includes a list of the documents you need to provide. If you’re curious what an IRS ERC audit notice looks like, check out an official redacted notice below:

ERC Information Document Request Redacted Example

Documents for ERC Audits

As indicated above, during an ERC audit, you may need to provide documents about the wages you paid to your employees, just as you normally would during a payroll tax return audit. However, to ensure you only claimed the credit on eligible wages, you must disclose if any of the wages were paid to family members.

Additionally, you will have to provide documents about your eligibility to claim the ERC. Depending on the situation and why you claimed the credits, you may need to provide documents about the following:

  • The worksheets used to calculate the credit — Generally, this refers to Worksheets 2 and 4 from the Form 941-X instructions. If you don’t have these worksheets, a tax pro can help you create them based on the information on your tax return.
  • Proof that you qualified based on a reduction in revenue — If you claimed the ERC based on a decline in gross receipts, you will need to prove that your revenue was low enough to claim the credit. To establish this fact, you will need to provide sales records and potentially copies of your federal business income tax returns.
  • Proof that you qualified based on a suspension of operations — If you claimed the ERC based on a full or partial suspension of operations, you must provide the relevant government order that caused the suspension and documents showing how your operations were suspended. For instance, this may include government restrictions that prevented you from operating at full capacity.
  • Proof that you qualify as a recovery start-up business — Recovery start-up businesses were able to claim the ERC in the last two quarters of 2021. Most other businesses were not allowed to claim the credit in these quarters. If applicable, you may need to prove that you started after a certain date and that your revenue was below the threshold established for these types of businesses.
  • Information about Paycheck Protection Program (PPP) Loans — You can claim the ERC if you received a PPP loan, but you cannot claim this credit on wages that were paid with the PPP loan. To establish that fact, you may need to provide records about the PPP loan and exactly how the funds were used.
  • Information about wage expenses on your business’s income tax return — If you claimed ERC credits, you must reduce the wage expense on your federal income tax return by the amount of the credit. If the IRS audits your ERC claim, you will likely have to back up the math used to calculate the wage expense on your tax return.

Why is the IRS Auditing ERC Claims so Heavily?

The IRS is focusing on these tax returns because a lot of business owners claimed the ERC incorrectly. Some taxpayers claimed the credit even though they didn’t have a suspension of operations or a significant decline in revenue. Others claimed the credit on wages that didn’t qualify, and still, others erroneously claimed the credit on wages that they paid with PPP loans or didn’t reduce the wage expense on their federal income tax returns correctly.

In some cases, the issues were mistakes. The rules for claiming the credits were confusing, and some taxpayers simply filed returns with errors. In other cases, business owners filed ERC claims based on the advice of ERC mills that are notorious for aggressively taking on clients that don’t qualify for these credits. The rise of ERC mills is one of the main reasons the IRS is focusing on these audits.

The Rise of ERC Mills

An ERC mill is a company that exclusively focuses on helping business owners claim the ERC by amending their payroll tax returns. At first blush, there is certainly nothing wrong with a company that helps people claim tax credits. Unfortunately, these companies have abused the credit, and they have encouraged ineligible people to claim the credits.

According to the IRS, these companies aggressively promote the credits online and on the radio. When prospective clients contact them, these unscrupulous tax professionals urge ineligible people to file. Then, they charge large fees or take significant portions of the credits. Representatives from these companies also tend to overlook the fact that you must reduce the wage expense claimed on your federal income tax return if you claim the ERC.

How to Report ERC Mills

If you believe that a company is urging ineligible people to claim ERCs or is abusing the credit in other ways, you can report them. To make a report, file Form 14242 (Report Suspected Abusive Tax Promotions or Preparers).

If you’ve been working with an ERC-focused company and you’re not sure whether or not you should claim the credits, reach out to us for a second opinion. The tax attorneys at Wiggam Law can review your situation and make sure that applying for ERC credits is a sound idea in your situation. If you’ve already filed, we can do a risk assessment on your returns to determine the likelihood of an ERC audit and guide you through the audit process if you do receive an audit.

Wage Expenses and ERCs

If you claim the ERC, you are supposed to reduce the wage expense on your business income tax return by the amount of the credit. Depending on the structure of your business, you may need to adjust one of the following:

  • Schedule C of Form 1040 (Individual Income Tax Return)
  • Form 1065 (Partnership Tax Return)
  • Form 1120-S (US Income Tax Return for an S-Corporation)
  • Form 1120 (US Corporation Income Tax Return)

If you filed one of the first three returns, you will also need to update your personal income tax return to adjust for the change in income. If you amended your payroll tax returns to claim the ERC, you should have also amended your business’s federal income tax return and your personal tax return. If you didn’t, you may need to correct this issue during the ERC audit. This can create an unexpected tax bill for business owners.

The wage expense typically includes the wages you’ve paid employees plus the employer part of payroll taxes. However, some tax preparers put the wages on the wage expense line, and they put the payroll taxes in the tax and licenses section. Whether you reduce the wage expense or the tax claim, the adjustment will reduce your business deductions and increase your profits.

For instance, if you claimed $10,000 in ERC and didn’t reduce your wage expense correctly, the ERC auditor may examine and update your federal income tax return. The tax consequences vary based on your business structure and your tax bracket, but for a sole proprietor in a top tax bracket, this could potentially create a $5,230 income tax bill.

Additionally, the IRS will add penalties to your account for the unpaid tax as well as interest. If you have incurred penalties for an ERC-based adjustment to your income tax return, you should apply for penalty abatement. If you haven’t had any other penalties in the last three tax years, and have consistently filed your tax returns on time, you should be able to get relief.

Penalties for Failing an ERC Audit

If you fail the audit, the penalties will be based on the tax liability generated by the audit, and they will vary depending on the situation. Accuracy-related penalties are 20% of the adjusted tax liability. If the IRS thinks you committed fraud by claiming the credits, the penalty can be 75% of the unpaid tax.

Voluntary Disclosure for Erroneous ERC Claims

At the time of writing, there is not a voluntary disclosure program focused exclusively on the ERC. However, the IRS has been discussing creating an ERC voluntary disclosure program. This would allow employers who think they claimed the credit erroneously due to the advice of an ERC mill to come forward voluntarily.

However, you may be able to submit a voluntary disclosure through the IRS’s Voluntary Disclosure Practice or submit amended returns to fix an ERC mistake. The Voluntary Disclosure Practice is for people who may have committed tax crimes. Taxpayers who have made a mistake and did not act with intent, can make a disclosure to the IRS by filing amended returns and voluntarily correcting their ERC.

The IRS suggests consulting with a tax professional before applying for the program or submitting amended returns. The IRS can waive penalties if you voluntarily submit amended returns before they contact you. If you qualify for voluntary disclosure practice, the IRS could provide immunity from criminal prosecution and reduce possible penalties.

Statute of Limitations on ERC Audits

Normally, the IRS has three years to audit business tax returns, such as the 941 (Employer’s Quarterly Payroll Tax Return and the 944 (Employer’s Annual Payroll Tax Return). However, the IRS has extended the audit statute of limitations to five years for Q3 and Q4 2021 payroll tax returns, and the agency has proposed extending the statute to five years for all returns with ERCs. Congress has not yet adopted the agency’s proposal.

Usually, the clock for the statute of limitations starts on the latter of the day your return was due or filed. However, for payroll tax returns, the timer doesn’t start until April 15 of the year following the reporting quarter. If you amend the return after the original due date, the statute of limitations starts on that day.

When to Hire a Pro for an ERC Audit

If you receive the audit notice and have all of the requested documents, you may just want to respond independently. However, if you don’t have the right documents or if you’re not confident that your claim was legitimate in the first place, you should seek help from a tax professional. You should also seek help if you just want support during the audit. Dealing with audits and communicating with the IRS on your own can be very stressful.

Many people reach out for help once they’re in the midst of the audit. They may want help to deal with the auditor, to understand audit notices, or to protest decisions when they disagree. If you’re not sure where to start, contact a tax professional for a consultation. They’ll talk with you about your situation and outline how they can help you.

Get Help From ERC Specialists

At Wiggam Law, we specifically focus on helping people with tax problems. We have extensive experience guiding our clients through all kinds of business and personal tax audits. We can also help with penalty abatement, payment plans, settlement requests, and other tax issues.

To get help with tackling your tax issues, contact us today for a consultation.