ERC Audit Process, Penalties, and Appeals

erc tax audit penalties and process

You’ve been hearing about ERC audits for months, but today, you received the dreaded notice in the mail. The IRS is auditing your payroll returns to assess the legitimacy of your employee retention credit (ERC). What should you do? First, don’t panic. While an audit can feel very scary, the process may be more straightforward than you think — particularly if you filed a correct return and have the supporting paperwork.

If not, the process may get a bit more complicated, and it can lead to penalties. However, an experienced audit attorney can help you. To get guidance now, contact us at Seattle Legal Services, PLLC. In the meantime, here’s a look at the audit process and an explanation of what happens if you fail.

The ERC Audit Process

An ERC audit is similar to any other audit, except in this case, the auditor is looking at a very specific element of your return — the employee retention tax credit. Here’s a brief overview of the process:

  • Initial contact — The auditor will send you a letter explaining which returns have been selected for an audit and outlining the documents you need to provide.
  • Deadline or extension — You have two options: 1) reply by the deadline noted on the letter or 2) contact the auditor and request a 30-day extension.
  • Audit meeting — Usually, your ERC audit meeting will take place over the phone, but in select cases, the auditor may come to your place of business or have you come to their office. In some cases, you will handle everything through the mail.
  • Supporting documents — To substantiate your eligibility for the ERC, you will have to provide the auditor with documents. You may mail them to the IRS in response to an Information Document Request (IDR) or bring them to in-person meetings. In some cases, you can send the documents electronically.
  • Document review — Your auditor will review the documents that you have provided, and they will request additional documentation as needed.
  • Audit proposal — After reviewing your documents, the auditor may propose changes to your account. You generally have the opportunity to provide additional documentation at this time.
  • Audit determination — The auditor will send out a letter letting you know the results of the ERC audit. The letter will either state that no changes were made or it will outline the proposed changes.
  • Tax assessment — About a month after the determination letter, the IRS will formally assess the taxes against you. Now, you can either appeal the audit results or pay the tax liability.
  • Penalties — Depending on the situation, the auditor may assess penalties to your account.

If you disagree with the assessment, you should appeal as soon as you can. If you’ve been representing yourself thus far, you should consider hiring audit representation at this point. An experienced audit attorney can help ensure that you provide the right documents, and as needed, they can argue with the IRS auditor about their interpretation of the tax code.

Ideally, however, you should retain counsel to help you as early as possible during the audit process. Audits and payroll taxes are generally complicated issues, but they become more confusing when the ERC is involved.

Reasons You May Fail an ERC Audit

To put it simply — you will fail an ERC audit if you cannot prove that you had the right to claim the ERC on your payroll return. To prove that you claimed the credits legitimately, you need to provide the auditor with documents that support your claims such as the following.

Proof of Revenue

Businesses could only claim this credit if they had a significant reduction in revenue or operational restrictions. To prove that you qualified based on revenue, you will need to provide sales statements, profit and loss reports, bank statements, or other documents that show your business’s revenue for the quarter the credit was claimed and the comparison quarter from 2019. Businesses that claimed the credit in 2021 and weren’t open in 2019 can use 2020 revenue numbers as their baseline.

Info About Operational Restrictions

If you claimed the credit based on operational restrictions, you will need proof of the restrictions. For example, if your restaurant couldn’t have dine-in service, you may want to provide newspaper articles about the dates of the restrictions or notices from the Department of Health. Even personal notes or photos may help to establish your right to claim the credit based on operational restrictions.

Employee Payroll Documents

The ERC is based on the wages you paid to qualifying employees. To that end, you may need to provide documents such as time sheets or pay stubs that show how much your employees worked during the quarters you claimed the credits. You may also need to show that the employee paychecks cleared your bank account.

Number of Employees in 2019

If your business had over a certain number of employees in 2019, you were only able to claim the credit if you paid furloughed (non-working) employees. If you were under the threshold, you could claim this credit on wages paid to working employees. The threshold was 100 employees for the 2020 credits and 500 employees for the 2021 credits.

ERC Worksheets

You didn’t have to include ERC worksheets when you filed or amended your payroll returns, but you were supposed to keep these documents for your records. If you don’t have the worksheets that you used to calculate the returns, a tax attorney may be able to help you reconstruct these records.

The above are the documents that are the most likely to be requested, but as needed, the auditor may request other documents. You should never hide information from the IRS, but if you’re uncomfortable with an auditor’s request, contact a tax attorney for guidance.

Penalties for Failing ERC Audits

If the IRS decides that you don’t qualify for the ERC credit, the auditor will adjust your returns, and you will owe taxes. Due to the high value of this credit, the tax liability is also likely to be high. Additionally, you may face the following penalties:

Late Deposit Penalty

The IRS assesses a late deposit penalty ranging from 2 to 10% of the taxes owed if you pay your payroll taxes late. If you claimed a credit erroneously, you probably didn’t make the right deposits, and thus, the auditor may decide to assess this penalty.

Failure-to-Pay Penalty

The auditor may add a failure-to-pay penalty to your account. This penalty is 0.5% of the unpaid tax, and it’s assessed for every month that you are late. It can get up to 25% of your balance. Depending on the situation, the auditor may decide to backdate this penalty based on the original due date of your payment, or they may only assess this penalty if you pay the tax liability from the audit late.

Accuracy-Related Penalty

This is a penalty that the IRS assesses on returns that understated tax liability due to negligence or disregard of the tax code. This penalty is 20% of the understated tax. When you’re dealing with credits that are $10,000 per employee per quarter, this penalty can add up quickly if the IRS takes your credits away.

Tax Fraud Penalties

In cases of fraud, the IRS can assess a 75% penalty. In other words, if the auditor disallows a single $10,000 credit, the fraud penalty will be $7,500. When you’re dealing with dozens of employees and dozens of big credits, this penalty can snowball quickly.

What If You Owe Tax Due to an ERC Payroll Audit?

Whether you’re facing penalties or not, an unexpected tax bill can put a kink in your budget. Here are some options to help you resolve the tax liability from your ERC audit:

  • Express business payment plan — If you owe less than $25,000, you can pay off the bill in three years, and you’re usually compliant with tax laws, the IRS will let you make monthly payments.
  • Installment agreement — If you owe more than $25,000, the IRS will usually only let you set up a payment plan if your business is no longer operating. However, in this case, you can take up to six years to pay.
  • Offer in compromise — This is when the IRS lets you settle for less than you owe, but you may not be able to qualify if you’re still operating. To apply, you need to complete detailed statements about your business and personal finances.

You should also apply for penalty abatement. That can help to reduce your tax liability and make it more manageable to get back on track. Even if you don’t think you’ll qualify, you should at least ask the IRS to remove the penalties.

When to Get Help With an ERC Audit

In almost all cases, it’s easier to deal with an IRS audit with the help of a tax attorney. They know the language, they understand the requirements, and they have experience dealing with auditors. That said, you can certainly handle your own audit if you feel comfortable.

Not sure what you want to do? Here are some signs that you should contact a tax attorney:

  1. You know that you made a mistake on your tax return.
  2. You worked with an ERC mill and you’re worried that they made mistakes.
  3. You don’t understand the audit notice.
  4. You lost your supporting documents.
  5. Your business is no longer in operation.
  6. You want to minimize stress during the audit process.
  7. You feel like the auditor is treating you unfairly.
  8. The auditor has proposed changes to your return and you disagree.
  9. The audit determination letter says that you owe a significant tax liability plus penalties.
  10. You want help to appeal the results of the audit.

At Seattle Legal Services, PLLC, we have extensive experience helping people deal with audits, payroll tax problems, unexpected tax liabilities, and other tax issues. You don’t have to deal with this stress on your own. Instead, contact us today to get help.