The IRS May Leverage “Erroneous Refund Procedures” to Extend Audit Timeline for ERC Claims on Employer Tax Returns
The IRS has three years to audit most ERC claims and five years to audit claims from the last two quarters of 2021. However, analysts speculate that the agency may rely on a little-known rule called “erroneous refund procedures” to extend the audit timeline for all employer tax returns with ERC credits. Wondering if your return is at risk? Here’s what you need to know.
To get help now, contact us today at Wiggam Law. Our team has done extensive work with the Employer Retention Credit (ERC), and our experienced tax attorneys can help you review your returns, assess your audit risk, and defend you through an audit. In the meantime, here’s a look at everything you need to know.
How Long Does the IRS Have to Audit ERC Claims?
Normally, Form 941 (Employers Quarterly Federal Tax Return) is subject to a three-year statute of limitations, which expires on April 15th of the third year following the return due dates. For example, if you file a Q1 2022 return on April 31, 2022, the IRS has until April 15, 2026, to audit it.
However, under the American Rescue Plan Act of 2021, ERC claims filed for the third and fourth quarters of 2021 are subject to assessments within a five-year statute of limitations. That means the IRS has until April 15, 2027, to audit these returns.
Currently, the Treasury Department is facing a bill proposal for an extension of the five-year statute to all quarters for which ERC was available. If passed, this would extend the audit deadline for 2020 ERC claims to April 15, 2026. At the time of writing, there is no indication that Congress will pass a bill to make these changes, so for now, the five-year limitation applies only to ERC claims filed for Q3 and Q4 of 2021.
Erroneous Refund Procedures May Extend Audit Timeline
The IRS might employ erroneous refund procedures to give the agency more time to bring suit against a taxpayer’s fraudulent ERC claim. Under IRC Section 7405, with respect to erroneous refunds, the IRS can bring action against a taxpayer in one of two circumstances:
- If the refund was erroneously made after the limitation period, or
- If it appears that any part of the refund was induced by fraud or misrepresentation of a material fact.
Regarding ERC claims, the IRS would be relying on the second element. This is an aggressive route that the IRS rarely uses, but with the rise of ERC mills coupled with little to no guidance on how to regulate employers claiming ERCs, the IRS has been considering this tactic. In fact, with some suspicious ERC claims, the IRS has challenged and even sued taxpayers.
Erroneous Refund Lawsuits
For the IRS to succeed in a suit brought against a taxpayer under IRC Section 7405(b), the agency must prove the following:
- A refund was made to the taxpayer,
- The refund was issued in error, and
- The suit was timely filed.
Regarding the third element, the IRS is generally limited to bringing such action within two years of refund issuance. However, in instances of suspected fraud or misrepresentation, the time period is extended from two to five years.
How does this affect you? Here’s an example. Say that you amended your Q2 2020 payroll return on the very last day that you could claim a refund (April 15, 2024). The IRS issued you a refund two months later on June 15, 2024, and then, the IRS decided to use the erroneous refund procedures to review your claim. Based on these rules, the agency could review your claim until June 15, 2026, but if fraud were involved, the agency would have until that date in 2029.
What if You Already Received a Refund for ERC?
Most employers who claimed the ERC did so through amended returns rather than on their original returns. Again, this gives the IRS extra time to review the return for accuracy. As noted above, if the IRS uses the erroneous refund procedures, the agency has two years from the date the refund was issued to audit your return. If the agency thinks fraud was involved, it has five years under these rules.
Just because you received a refund check as a result of your ERC claim does not necessarily mean that you were entitled to it. Since March 2022, the IRS has identified over 11,000 suspect returns claiming ERC. The IRS warned employers to beware of ERC “mills” that promote ERC claims by taking improper positions relating to a taxpayer’s “eligibility for and computation of the credit.” Unfortunately, even if you worked with an unscrupulous preparer, you are still responsible for the information reported on your return.
What to Expect Moving Forward
As the IRS investigates these claims, findings could prompt Congress to move forward with implementing a five-year statute proposal through all ERC available quarters. If this happens, the agency won’t have to rely on the erroneous refund procedures. Instead, it will just have the additional time to review these returns.
Regardless of the rule the IRS uses to audit your return, you must be aware of the potential consequences. If you fail an ERC audit, you can not only lose the credits, but you may also incur audit penalties ranging from accuracy-related penalties to criminal fraud charges. Don’t take this risk lightly — contact an experienced tax attorney to help you navigate the situation.
Effects on Business Income Tax Returns
The ERC does not exist in a silo. Employers who correctly claimed the ERC should have reduced the wage expense on their income tax return by the amount of the credit. By extension, if the IRS disallows the ERC, these employers should increase the wage expense on their tax return. That, in turn, reduces their business’s income tax liability, generally leading to a refund.
However, taxpayers have a limited amount of time (three years) to amend tax returns for refunds. This creates a conundrum. If the IRS uses the erroneous refund procedures and disallows an ERC, it’s likely too late for the business owner to amend their income tax returns for a refund. To safeguard against this risk, business owners may want to file a protective claim for income tax refund.
Protective Claim for Income Tax Refund
Filing a protective claim allows the credit to be reversed if the refund is recouped. Here’s the technical explanation: IRC Section 280C says that you cannot include credits in your wage expense. This is called a Section 280C disallowance. However, if you lose the credit, you also want the 280C disallowance to be reversed. By filing a protective claim, you set the wheels in motion for this to happen.
Get Help With ERC Audits
At Wiggam Law, we work closely with our clients to customize solutions for their unique situations. The ERC was designed to help employers, but unfortunately, predatory companies convinced many employers to claim these credits erroneously. If you may have worked with an ERC mill, don’t sit around worrying about an audit. Instead, take a proactive approach and get help today.
The steps you should take vary depending on your unique situation, but in almost all cases, the legal team at Wiggam Law can help. We have extensive experience guiding clients through all kinds of IRS issues related to audits and payroll taxes. Whether you’ve been contacted about an ERC audit or are just worried about additional scrutiny on your return, we urge you to contact us today at (404) 233-9800 or fill out the online consultation form to see how we can help you.