The Internal Revenue Service (“IRS”) has recently devoted great attention to detecting, investigating, and prosecuting fraud, particularly as it relates to the Employee Retention Tax Credit (“ERC”) post-COVID. On a webinar broadcast on July 25, 2023, hosted by the IRS’s Office of Fraud Enforcement and National Fraud Counsel, the presenters noted that ERC claims top the IRS’s “Dirty Dozen” list of tax scams at the moment. This presentation came hot on the heels of:
- The IRS’s recent publication of regulations, effective July 24, 2023, authorizing assessment of various tax credits paid under pandemic-era legislation (the “Final Regulations”);[1]
- The IRS’s release of Chief Counsel Memo AM 2023-005 June 30, 2023, which discussed whether businesses experiencing certain supply chain disruptions, but not subject to a government-mandated shutdown, qualified for the ERC; and
- The IRS’s publication of “Frequently asked questions about the Employee Retention Credit” on its website.[2]
Thus, IRS investigations of suspected ERC fraud are likely to increase in the future, and businesses that took the ERC should be aware of what this might mean for them.
Employee Retention Credit — How Does It Work?
Generally speaking, the ERC is a fully refundable credit available to eligible employers against employment taxes. The credit is limited to employment taxes, reduced by certain credits, “on the wages paid with respect to the employment of all the employees of the eligible employer for” such quarter.[3] Different rates apply depending on the quarter:
- March 13, 2020 – Dec. 31, 2020: 50% of up to $10,000 of qualified wages per employee.[4]
- Tax Year 2021: 70% of up to $10,000 of qualified wages per employee per quarter.[5]
- ERC coverage under IRS Section 3134 is limited to “wages paid after June 30, 2021, and before October 1, 2021”, though recovery startup businesses may claim the credit in Q4 of 2021 as well.[6]
Eligible employers are generally employers carrying on an active trade or business, certain tax exempt organizations, and tribal entities carrying on a trade or business. Government employers are generally excluded (with some exceptions), as are household employees. The number of employees, and whether they were paid while not providing services, will impact eligibility.[7]
Depending on the time period, eligible employers must either (a) have had their operation of their trade or business “fully or partially suspended during the calendar quarter due to orders from an appropriate governmental authority limiting commerce, travel, or group meetings (for commercial, social, religious, or other purposes) due to” COVID-19;[8] (b) meet the requirements of the gross receipts test;[9] or (c) be a recovery startup business.[10]
The IRS takes the position that the ERC is not available for employers who were not subject to a government-imposed shutdown order due to COVID-19, but merely faced supply chain disruptions.[11] There is a limited exception in cases where the employer’s suppliers “are unable to make deliveries of critical goods or materials due to a governmental order that causes the supplier to suspend its operations” and, under the facts and circumstances, the business’s “operations are fully or partially suspended as a result of the inability to obtain critical goods or materials from its suppliers because they were required to suspend operations.”[12] In the IRS’s eyes, merely being inconvenienced by supply chain issues or having to pay higher prices for supplies is not sufficient.[13]
Generally, an employer may not claim the ERC for wages used to obtain certain other tax and non-tax benefits, such as wages paid with the proceeds of Paycheck Protection Program loans that were forgiven.[14] Likewise, a deduction is not allowed on the business’s income tax return for ERC wages.[15] Furthermore, wages paid to certain employees who are owners or related to owners of a business did not qualify for the credit at all, with similar rules also applying to partnerships, estates, and trusts.[16]
The IRS also pointed out during the webinar’s Q&A session that qualification for the ERC takes into account business operations and not the location of an employee. Shifting employees to working from home, thereby continuing operations despite government-mandated office closures, therefore would not qualify for the ERC.
IRS Investigations of Fraud
The IRS’s Office of Fraud Enforcement and the National Fraud Counsel are leading investigations into ERC abuse and fraud. The Office of Fraud Enforcement provides “oversight and direction for fraud policy and operations” and “assists in identifying indicators of fraud, developing enforcement recommendations and developing potential criminal fraud referrals to IRS Criminal Investigation, and pursuing civil fraud penalty assertions[.]”[17] The webinar’s presenters took care to point out that there is no statute of limitations on civil tax fraud, and a five-year statute of limitations applies to any ERC erroneously taken during the third and fourth quarters of 2021.[18] The Final Regulations also increased the IRS’s power to investigate and claw back refunds taken fraudulently or in error. The IRS has developed data-driven methods for flagging returns that raise suspicion, which will then be investigated further. Some examples include flagging the returns of businesses formed during the COVID-19 pandemic and those businesses that filed returns for the first time in years. Also, the IRS will outright reject refund claims where key data is clearly inconsistent, such as when a business is formed by an individual or individuals who are deceased or businesses that did not exist during the relevant time period.
The IRS also has noted that:
- Phishing schemes and other identity theft strategies — targeted at both taxpayers personally and their businesses — are common in relation to ERC fraud;
- Taxpayers should beware consulting groups who offer or offered their services to help taxpayers claim the ERC, particularly when those groups advertise or advertised large refunds and charge or charged up front for their services; and
- Taxpayers that inappropriately claimed the ERC may not avoid penalties for underpayment of tax or fraud by pointing out that their tax preparer or the person who advised them to take the credit is a CPA or attorney.
Conclusion
Businesses that have claimed excess or inappropriate amounts of the ERC will be liable for the whole amount of the credit excessively or inappropriately taken, together with penalties and interest. Businesses that are concerned about previously filed claims for the ERC — or are already under audit for the same — should seek experienced legal counsel to advise them regarding the propriety of the credits they took. In addition to gathering documentation to substantiate claims for the credit, taxpayers also should be prepared to file an amended return to correct any error, and to pay any unpaid tax along with applicable penalties and interest.
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[1] See TD 9978.
[2] Available at https://www.irs.gov/coronavirus/frequently-asked-questions-about-the-employee-retention-credit.
[3] IRC Section 3134(b)(2). See also Coronavirus Aid, Relief, and Economic Security Act (hereafter “CARES Act”) Section 2301(a) as amended by Taxpayer Certainty and Disaster Relief Act of 2020 (hereafter “Relief Act”) Section 206; CARES Act Section 2301(a), as amended by Relief Act Section 207. See the American Rescue Plan Act of 2021 and the Infrastructure Investment and Jobs Act for coverage of the latter half of 2021.
[4] CARES Act Section 2301(a), (m), as amended by Relief Act Section 206; IRS Notice 2021-20.
[5] CARES Act Section 2301(a), (b), (m), as amended by Relief Act Section 207; IRS Notice 2021-23(III)(D).
[6] IRC Section 3134(n). Recovery startup businesses are defined in IRC Section 3134(c)(5) and are limited to a maximum credit per quarter of $50,000. IRC Section 3134(b)(1)(B).
[7] See CARES Act Section 2301(c)(3)(A), as amended by Relief Act Section 207(e)(1); IRS Notice 2021-23(III)(E); IRS Notice 2021-20(III)(G).
[8] IRC Section 3134(c)(2)(A)(ii)(I). See also CARES Act Section 2301(c)(2)(A)(ii)(I) as amended.
[9] IRC Section 3134(c)(2)(A)(ii)(II). See also CARES Act Section 2301(c)(2)(A)(ii)(II) as amended.
[10] IRC Section 3134(c)(2)(A)(ii)(III).
[11] See OCC IRS Memo AM 2023-005 (June 30, 2023), scenarios 4-5.
[12] IRS Notice 2021-20(III)(D) Q&A 12.
[13] See OCC IRS Memo AM 2023-005 (June 30, 2023), scenarios 4-5.
[14] See Relief Act Sections 206-07; CARES Act Section 2301(g)(2); IRS Notice 2021-20.
[15] See CARES Act Section 2301(e), as amended; IRC Section 3134(e).
[16] See IRC Section 3134(e); IRC Section 51(i)(1); IRC section 152(d)(2); CARES Act Section 2301(e), as amended; IRS Notice 2021-49.
[17] IRS, Mission, Office of Fraud Enforcement At-a-Glance, https://www.irs.gov/about-irs/office-of-fraud-enforcement-at-a-glance (last accessed July 28, 2023).
[18] See IRC Section 3134(l).
