Article

So you've been selected for an ERC audit, here's what to expect

Oct. 3, 2023 · Authored by James Creech

The Employee Retention Credit (ERC) has been a hot button issue over the last year or so. The IRS has loudly proclaimed that while the credit itself is not a tax shelter, there are a number of promotors that have taken advantage of the minimal substantiation that needs to be supplied when claiming the credit. This has led to third party ERC firms promoting the credit and telling taxpayers that they qualify even if they may not.

When there is a potential for this kind of abuse the IRS leads with enforcement. Over the last year, starting with a series of exploratory exams to determine what the baseline of compliance was, these exams have become more and more widespread. It is strongly suspected that every large ERC claim receives some type of review prior to being paid, and that many of the claims that are not in line with the historical payroll are being assigned for field review.

Claim for refund vs. income tax return

ERC audits, like many claims for refund, are shorter exams than a traditional income tax return exam. This expedited timetable can lead taxpayers to feel as if the burden of proof is shifted and they must demonstrate that they are eligible for the credit rather than the IRS proving the credit was overstated.

Because the ERC credit is filed using an amended 941 form without substantiation a field auditor has little to no information at their disposal when assigned a credit review. This means the information document request (IDR) is expansive. The IRS wants to know why the taxpayer is eligible, how the calculations where done, and what sort of prohibited funds such as PPP loans could have been used to pay wages.

Once these documents are provided the auditor will request an initial interview. Frequently this initial IDR package and the interview notes form the basis of the determination. While there are often subsequent IDRs they are generally more focused and the taxpayer is notified of the eligibility of the credit and the adjustment amount in weeks as opposed to months or years like a typical audit.

Eligibly and how it was determined matter

One recent development in ERC audits has been in the initial interview phase. Auditors want to know how the taxpayer learned of the credit and who did the eligibility testing. A taxpayer must answer questions about what they were promised, how they learned of the promotor, and was there a contingency fee paid. Implicit in this line of questioning is that a taxpayer who found an ERC focused shop by attending a free dinner at a fancy steakhouse and paying a contingency fee for the credit is less likely to prevail under audit than a taxpayer who leveraged a reputable tax preparer.

The Form 940 is reviewed in detail

Form 940 is the form on which the federal unemployment taxes are reported and paid. Generally this is a low priority form because there is either a .06% or 6% rate imposed on the form and each employee has a low cap that is subject to the rate. However many 940s are not completed correctly and the payroll company uses the .06% reduced rate without properly reporting which employees receive the reduced rate. Many audits result in increases to the amount reported on the 940; independent of any adjustments to the ERC claimed on Form 941. This can be an unpleasant surprise when the bulk of the audit is spent on ERC eligibility or demonstrating that PPP funds were properly taken into account when calculating the credit.

ERC audits are stressful, time intensive, and occasionally an existential threat to a business who desperately needs a cash lifeline. While it may not be possible to go back in time to avoid using a promotor to claim the credit, understanding what the IRS is looking for can help minimize the risks that come from being selected for an ERC exam.

Baker Tilly offers a complimentary ERC Questionnaire that assists taxpayers with this determination. Please feel free to reach out to your Baker Tilly advisor with any questions.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.