ERC Audits

erc tax audit penalties and process

Worried about an ERC audit? Then, you are definitely not alone, and this may be a valid fear. Over the last couple of years, numerous companies have popped up and convinced businesses to claim this credit. In some cases, these companies have helped businesses claim a credit that they justly deserved, but in other cases, they’ve coerced business owners into making dubious claims.

The IRS is well aware that this has been happening, and in response, the agency has decided to put a heavy focus on ERC audits. This announcement has made some business owners reluctant to amend their returns and claim the credit retroactively. It’s put others into a panic that they may have claimed the credit erroneously. Regardless of where you are on this spectrum, this guide is designed to help.

Here’s the bottom line — if you are eligible for this credit, claim it. It will save your business money. If you are unsure, consult with a specialist, and consider amending your returns voluntarily if you claimed the credit improperly. To get help now, contact us at Seattle Legal Services, PLLC today.

What Is the ERC?

This is a credit that the IRS offered to employers during the COVID pandemic. The credit was designed to offset payroll costs for businesses that kept employees on the payroll in spite of reduced revenue or operational restrictions.

The rules for claiming the credit varied. For 2020, employers could claim up to 50% of qualified wages, up to $10,000 for the year. In 2021, the credit was worth 70% of qualified wages, up to $10,000 per quarter. To qualify for the credit, businesses needed to show that their revenue was a certain percentage lower than the same quarter in 2019. Or they could qualify based on operational restrictions — such as stay-at-home mandates or not allowing restaurants to have dine-in service.

In 2020, businesses with more than 100 employees could only claim the credit if they paid employees who were not working, while businesses with less than this number could claim the credit for paying employees to work. This number was bumped up to 500 for the 2021 ERC, and in both cases, it was based on the business’s number of full-time employees in 2019.

The IRS had special rules for businesses that opened after February 15, 2020. Dubbed “recovery start-up businesses”, these companies were allowed to compare 2021 sales to 2020 sales, instead of 2019 sales. They were also able to claim the credit for one to two more quarters than other businesses.

Why Is the IRS Auditing the ERC?

The IRS is auditing the ERC due to a belief that many employers have claimed this credit incorrectly. This is due both to confusing rules about the credit and the rise of ERC mills.

What Is an ERC Mill?

An ERC mill is a company that was formed exclusively to help business owners claim this credit. These companies advertise aggressively, and they are notorious for telling business owners that they can qualify regardless of whether they do or not. Typically, these firms take a significant portion of the credit in payment, and they don’t offer audit defense or protection.

Here are some signs that you may have worked with an ERC mill when you claimed this credit:

  • The rep told you that you’d qualify before looking at your situation.
  • The tax preparer didn’t ask questions about your eligibility. They didn’t look at your revenue or talk with you about operational restrictions.
  • The tax preparer urged you to claim a credit for disqualified employees such as certain employees who are related to you.
  • The tax preparer amended your payroll tax returns, without amending your business’s federal income tax returns.
  • The company charged a fee based on the size of your credit.

If any of the above elements describe your situation, you may have worked with an ERC mill. To be on the safe side, consider having a knowledgeable accountant review your payroll tax returns. If you claimed the credit incorrectly, they can help you amend your returns to correct the errors. It’s much better to correct this issue proactively than to wait for an audit.

How to Reduce the Risk of an Audit

If you’ve already filed, there’s not much that you can do to reduce your chance of an audit. You risk facing an audit if the IRS sees a red flag on your return such as reporting more wages during COVID than during pre-COVID quarters or that your return was filed by a known audit mill.

If you’re thinking about claiming the ERC but are worried about an audit, just ensure that you claim the credit correctly and keep all of your supporting documents. Unfortunately, there’s nothing you can do to prevent the IRS from randomly selecting your return for an audit. However, as long as your return is correct and your documents are well-organized, you should be able to navigate the audit process relatively easily.

Note that you have until April 15, 2024, to amend payroll tax returns from 2020. You have until April 15, 2025, to amend payroll tax returns from 2021. If you have a legitimate right to this credit, don’t miss out on claiming it. This credit is very valuable, and it can put money into your pocket. Don’t let fear of an audit cost your business money.

Deadline to Audit Payroll Returns With ERC Credits

How long does the IRS have to audit payroll returns with ERC credits? For 2020, the IRS has until April 15, 2024. For the first half of 2021, the IRS has until April 15, 2025. For the second half of 2021, the IRS has until April 15, 2027 — the usual deadline has been extended by two years.

However, if you submit an amended return, the deadline is three years from the date you filed, and it’s five years from the filing date for Q3 and Q4 returns.

Usually, the IRS has three years to go back and audit returns. However, if fraud is involved, the agency has an unlimited amount of time to audit the return. This rule also applies to fraud on payroll returns.

How Do I Know If I’m Being Audited?

The IRS will send you a notice if your payroll return is selected for an audit. However, it’s important to note that these notices don’t always come through certified mail. If you have recently changed your business address, you should update your address with the IRS. This will help to ensure that you don’t miss any important letters.

What to Expect During an ERC Audit

The initial notice will outline the type of audit you’re facing and the information that the auditor wants to see. You should reply by the date listed on the notice, but if you need more time, just call and ask. IRS auditors will usually grant an automatic 30-day extension.

During the audit, you will provide documents that back up your eligibility for the ERC. The auditor will review the documents and request additional information as needed. Then, they will determine if they want to accept your return as filed or make changes.

If they disallow your ERC, you will owe money. At that point, the taxes are due in full. If you can’t afford to pay, you may be able to request a payment plan. Usually, the IRS only approves monthly payments for businesses if you owe less than $25,000 and can afford to pay off the balance in three years or less.

Penalties for Failing an ERC Audit

If you fail the audit[1], you may face penalties as well as an additional tax liability. The exact penalties vary based on the situation, but they can range from relatively mild late payment penalties to very stringent fraud penalties.

However, you may be able to offset some of the penalties by increasing the wage expense on your business income tax return — note that this only applies if you claimed your wage expense correctly when you claimed the ERC credit.

Can You Appeal an ERC Audit?

If you fail an audit and disagree with the auditor’s interpretation of the issue, you can appeal. Generally, you must appeal within 30 days of receiving the audit determination. The appeal process is complicated, and once you exhaust your options, you won’t be able to revisit the case. To protect your finances, you should consider working with an experienced audit attorney.

Wage Expense and the ERC

When you file your business tax return, you get to claim a deduction for your wage expense. This is true whether you file a partnership return (1065), an S-corp return (1120-S), a C-corp return (1120), or a sole prop return (Schedule C of 1040). The deduction is based on the wages and taxes you paid on behalf of your employees, and it directly lowers your taxable business income.

If you claimed an ERC, you were supposed to reduce your wage expense accordingly. To give you a very simple example, imagine that you claimed $20,000 in ERC credits in 2020. Then, you subtract that amount from your wage expense on your business tax return. Let’s say that you claimed $55,000 as a wage expense on your 2020 return. This was the amount of wages you paid your employees plus the employer portion of Medicare and Social Security tax and your state and federal unemployment tax minus the ERC.

However, a few years later, you faced an ERC audit, and the auditor disallowed your $20,000 credit. At this point, you can amend your business income tax return and increase your wage expense to $75,000. This directly reduces your business’s taxable income and saves you some money. Although you won’t be able to recoup all of the credit that you lost, you’ll get back roughly 15 to 40% of the credit, depending on your tax bracket and other factors.

Unfortunately, the expanded statute of limitations on 2021 ERC claims may render this process impossible for some business owners. Here’s why. You only have three years to amend a tax return for a credit. Thus, if the IRS audits your payroll tax returns after the three-year window, you may not be able to amend your business income tax returns if you fail the audit. At the time of writing, this information is correct, but some analysts expect the IRS to extend the statute to claim a refund so that it’s in line with the ERC audit statute of limitations.

Why You Should Hire a Tax Pro

The ERC was passed very quickly with a host of legislation designed to help the country get through the COVID pandemic. There were four pieces of legislation that created and refined these credits — the CARES Act, the Relief Act of 2021, The American Rescue Plan Act of 2021, and the Infrastructure and Jobs Act.

This makes the credit very confusing. Even seasoned tax professionals who don’t deal with this credit on a regular basis, don’t necessarily understand the rules and requirements. On top of that, the ERC mills have created even more confusion about the eligibility of this credit.

To protect your business from audit penalties or loss of the credit, you should consult with a tax professional. They can help you ensure that you get the credit if you’re eligible. They can help you file audit-proof returns if needed. They can also help you get through an audit if the IRS selects your return for a second look.

Payroll tax issues are fairly complicated, and the ERC makes them even more complex. Luckily, you don’t have to deal with all of this on your own. We can help you demystify this credit, deal with IRS auditors, appeal unsatisfactory audits, request penalty abatement, and more. To get help, contact us at Seattle Legal Services, PLLC today.