For more than two years, I’ve been helping small businesses figure out if they qualify to receive employee retention tax credits, a Covid-era lifeline extended by the federal government that was designed to keep struggling companies alive. Although helping these businesses is rewarding work, it can be fruitless at times – many don’t meet the specifications to qualify for this assistance.
A complex web of Internal Revenue Service rules must be navigated before a business can legitimately file an amended tax return to claim the employee retention tax credits, also known as ERTC or ERC. But that hasn’t prevented predatory third parties from aggressively pushing companies to file for the credits in exchange for a cut of the proceeds whether they meet the criteria or not.
These fly-by-night firms convince companies they have nothing to lose, but that’s categorically untrue – business owners are ultimately responsible for returns filed erroneously or fraudulently. In these circumstances, the credits must be paid back, and the taxpayer may also owe penalties and interest. This could put the business in a far worse position than if it had never applied for the credits in the first place.
Now that the chaos of Covid has receded and the IRS has cleared much of the backlog of amended returns, the agency has set its sights on chasing down suspicious claims by ramping up audits and criminal investigations against businesses that filed questionable claims. In total, the IRS has received about 3.6 million ERTC claims since the program began in March 2020.
As of July 31 this year, the IRS had launched 252 investigations of potentially fraudulent ERTC claims totaling $2.8 billion. Thousands more have been referred for audit. The agency is levying interest charges, penalties, and even criminal charges in some cases if taxpayers can’t prove they are entitled to the credits. The agency considers this such a high priority that it listed ERC claims at the top of its annual “Dirty Dozen” list of tax scams this year.
“The warning follows blatant attempts by promoters to con ineligible people to claim the credit,” the IRS reported. It has issued bulletins warning taxpayers to be wary of widespread advertising appearing on the radio, television, and social media that hypes the credit as easy money.
“You may even get ads that look like official government letters, or texts, emails and phone calls advertising ERC eligibility,” the agency cautioned.
And taxpayers will have a longer period of exposure to potentially face IRS reviews and audits than they usually do when it comes to the ERTC. Usually, the IRS must assess additional taxes within three years of the return’s original filing date with some exceptions, such as in cases where there is a substantial error or evidence of fraud. But that timeline has been extended to five years for the ERTC. That’s because the deadline to file amended returns claiming the ERTC can expire at the same time as the standard statute of limitations, leaving the IRS with little to no time to reassess the claim.
I suspect many business owners are living in fear that the IRS will select their return for scrutiny because they know their paperwork isn’t ready. Or worse yet, they know that the analysis and preparation of their returns was performed by an organization that was not qualified to do this work. I recently had a conversation with a CPA firm that is losing clients because they would not bend the interpretation and file the amended returns.
Although most of the IRS rules on the credits are clear and concrete, there are some gray areas when it comes to how full and partial shutdown tests of normal business are defined. In my line of work as a financial consultant, I have seen it all, ranging from companies that clearly qualify under the rules, to those that hope they qualify, to those that absolutely do not qualify given their circumstances.
When the IRS selects returns for review to verify eligibility for claiming the ERC, it is crucial that the company being reviewed is ready with all its supporting documents. The audit notice is not the time to start preparing for the review. In my experience, every company that claims these credits should be audit ready before it even files its amended returns.
Employee retention tax credits were designed to support businesses that continued to pay employees when they either had to shut down or faced significant declines in gross receipts from March 13, 2020, to Sept. 30, 2021. The credits can be claimed on an original or amended employment tax return, IRS Form 941.
The credit has been so popular that it has cost the federal government’s coffers far more than originally estimated. The Congressional Budget Office initially projected it would cost $55 billion over a decade, then revised that figure to $85 billion, which was still an underestimation – the IRS has already paid out more than $152 billion in refunds.
In July, IRS Commissioner Danny Werfel spoke about the fallout at a special roundtable session for tax professionals in Atlanta.
“The amount of misleading marketing around this credit is staggering, and it is creating an array of problems for tax professionals and the IRS while adding risk for businesses improperly claiming the credit,” Werfel said. “A terrible scenario is unfolding that hurts everyone involved – except the promoters.”
Moratorium on New Claims
On Sept. 14, Werfel announced that effective immediately, the IRS has imposed a moratorium on new claims. The halt will remain in place until at least the end of the year. The IRS issued a press release stating this move is intended “to protect honest small business owners from scams.”
“We could no longer tolerate growing evidence of questionable claims pouring in,” Werfel said. “The further we get from the pandemic, the further we see the good intentions of this important program abused. The continued aggressive marketing of these schemes is harming well-meaning businesses and delaying the payment of legitimate claims, which makes it harder to run the rest of the tax system. This harms all taxpayers, not just ERC applicants.”
ERTC claims that have already been filed but not yet paid out will continue to be processed, the IRS stated, but at a much slower speed, with a timeframe of 180 days or even longer.
In addition to increasing its audits on ERTC claims already paid out and scrutinizing outstanding claims more carefully, the IRS is also conducting criminal investigations into the promoters that are helping businesses file fraudulent claims. To mitigate the damage these schemes have caused to small businesses, the IRS is developing a new settlement program for businesses that were duped by exploitive promoters. They are also planning to soon offer a withdrawal option for those whose claims are pending but not yet processed, though they warned this won’t protect taxpayers who willfully filed fraudulent claims from potentially facing criminal investigation and prosecution.
Gather The Evidence
There are two primary sets of documents a company should assemble to support its ERTC filing. First is the calculation of gross receipts on a quarterly basis that compares 2019 to 2020 and 2019 to 2021. The numbers used in this calculation should foot to the income statement (using the cash basis method) that is produced by your accounting system. And ideally, the cash receipts should also foot to the cash deposits from the bank statements. Some adjustments to the bank statements might be necessary for unrelated deposits such as investment or loan proceeds.
The second set of documents pertain to determining the number of eligible employees and qualified wages, and then calculating the credit that is available. There are key rules in this determination that must be followed. Companies cannot claim ERTC credits on wages that were already paid by funding obtained from the Paycheck Protection Program (PPP). To properly adjust for this, a company will need to review its PPP forgiveness application and ensure that the wages paid by PPP are not part of the ERTC credit calculation.
Another rule is that wages paid to the owners cannot be claimed for ERTC credit. In fact, not even wages paid to family members of the business owners should be included in the ERTC credit calculation. There are many other rules to be aware of when determining eligible wages.
Finally, 2020 and 2021 have different multipliers and limits to use when determining the available credit.
Both years allow up to $10,000 in qualified wages, but for 2020, those wages have a 50% multiplier per employee for the entire year, while 2021 has a 70% multiplier per employee per quarter. That made 2021 a much more generous timeframe to qualify for ERTC.
The support for this set of documents should also include the payroll reports by employee for each qualifying quarter. This allows the reviewer to substantiate the credit calculation by verifying the wage shown on the payroll report.
The Devil’s in the Details
Completing this analysis and amending a tax return for the ERTC is not an easy task. Determining whether your business qualifies must be handled with great attention to detail. I have encountered companies that claimed the refund simply because it was available for selection in their payroll system. Some companies had service providers complete these amended returns without a thorough review of the necessary numbers.
It is very important to note that many of these service providers are not validating the quality of the financial numbers the company is reporting. They are merely taking the information provided by the company to determine the amount of the refund. The analysis of eligibility is only as good as the data it is based on. Companies with incomplete or inaccurate financial statements need to be careful of the eligibility determination. I have reviewed several companies’ financials and ultimately concluded that some of these companies were not eligible, solely based on the fact that the financials were inaccurate. For example, bank statements were not reconciled, or the accounting system could not produce cash based reports, etc.
Out of the millions of returns that have been filed, I wonder how many businesses fall into each of these buckets – audit ready, could be ready for audit, or definitely not ready for audit. Some might even find themselves in the unenviable “I have no idea how the qualification and credits were determined” bucket. No matter which category your business falls into, avoiding the issue isn’t going to make the problem disappear if the IRS comes calling. Getting prepared now can save you significant stress and anxiety down the road.
For more financial insights and assistance, check out my website: https://blackburncap.com/