How to Avoid Employee Retention Credit (ERC) Scams

A small industry of specialist firms has sprung up to help business owners claim the Employee Retention Credit (ERC), a governmental tax incentive intended for companies stressed by the pandemic.

But businesses need to be careful not to get scammed. Promoters sometimes claim that “all employers are eligible” without evaluating an employer’s individual circumstances. This is not true, as eligibility for the ERC is a highly factually intensive analysis, and many employers do not meet the eligibility requirements.

The IRS warned business owners last October to be on the lookout for third parties promoting improper ERC claims. It renewed that warning in March 2023, stating in a release ERC scammers “continue to be promoters who aggressively mislead people and businesses into thinking they can claim these credits.” The IRS even added fraudulent claims involving the ERC to its annual “Dirty Dozen” list of tax scams. 

These promotions may rely on inaccurate information about eligibility or how the credit is calculated, the IRS said.

Properly Claiming the ERC

Eligible taxpayers can claim the ERC on an original or amended employment tax return for qualifying wages. To be eligible, an employer must have:

  1. Sustained a “full or partial suspension” of operations due to an order from an appropriate governmental authority limiting commerce, travel, or group meetings because of COVID-19 during 2020 or the first three quarters of 2021;
  2. Experienced a “significant decline in gross receipts” during 2020 or the first three quarters of 2021; or
  3. Qualified as a “recovery startup business” for the third or fourth quarters of 2021.

Improper claims for the ERC tend to be based on promoters taking an aggressive position on “full or partial suspensions” without thoroughly analyzing the taxpayer’s situation.

Improper “Full or Partial Suspension” Positions

Many ERC promoters have used unjustified positions to claim the ERC. This includes citing:

  • Guidance and recommendations from federal bodies such as the Centers for Disease Control and Prevention (“CDC”) do not qualify as suspension orders because that guidance is not mandatory.
  • Increases in costs to successfully maintain pre-pandemic levels of operations are not a factor in IRS guidance.
  • Shutdown orders do not apply to the employer itself (i.e., shutdown orders applicable to employer customers), which do not qualify under Notice 2021-20.
  • A voluntary shutdown of an employer that was not required to close due to a governmental order. Many “critical infrastructure” or “essential” businesses exempted from most or many state and local governmental orders chose to close offices or branches during the height of the pandemic, but unless they were ordered to do so by a governmental order, this alone would not justify an ERC claim.
  • A governmental order closed an employer’s workplace, but the employer could continue operations comparable to before the closure via telework.
  • Modifications to operations that do not rise to the level of a “partial suspension” because the modification did not have a “more than nominal effect” on the employer’s business operations, meaning that it did not result in a reduction in an employer’s ability to provide goods or services in the normal course of business of not less than ten percent.
  • Reliance on broadly applicable “supply chain issues” without specific citation to a governmental order that, under the facts and circumstances, led to a lack of supply of critical goods or materials that caused the inability of the employer to operate.

Issues Raised on IRS Audit

The IRS will be aggressively auditing ERC refund claims. Employers who are audited on their ERC claims should expect the IRS to demand the following, which have been raised in ERC audits thus far:

  1. A list of employees who were paid wages for which the ERC was claimed.
  2. Whether any of the employer’s employees who received wages under the ERC are related to owners.
  3. The amount of wages paid to each employee for which the ERC was claimed.
  4. Documentation that operations were fully or partially suspended due to an appropriate governmental authority due to COVID, including copies of each governmental order.
  5. Documentation demonstrating how the employer determined that either “more than a nominal” portion of the business was suspended or that a required modification had a “more than nominal impact” on the business.
  6. Copies of income tax returns, employer tax returns, and Form W-2s for all related entities if the employer is part of an aggregated group of employers.

Five-Year Limit on Civil Actions for Recovery of Erroneous Refunds

Internal Revenue Code (“Code”) Section 7405(b) allows the government to bring a civil action to recover any portion of a tax imposed that was erroneously refunded. Under Code Sections 7405(d) and 6532(b), the statute of limitations for bringing such an action is two years from making the refund and extends for five years for any cause of fraud or misrepresentation of a material fact. Therefore, the statute of limitations for the IRS to bring an action to reclaim an ERC refund will not end until at least two years after the refund is made.

The Payment of a Claim Is Not IRS Acceptance

The fact that the IRS pays an employer’s claim for the ERC does not mean that the IRS agrees that the employer is entitled to the credit. Only when the relevant statute of limitations has expired and the IRS’ ability to bring a civil suit has expired can an employer feel comfortable knowing that the government will not challenge the claim.

Consequences of Taking Aggressive Positions

The Code provides for many different penalty provisions that could apply in the case of an erroneous ERC claim. Some of these include but are not limited to: penalties for inaccuracy (20%), penalties for erroneous claim for a refund (20%), penalties attributable to fraud (75%), or evasion of employment taxes (100%). Taxpayers always bear the burden of substantiating reasonable cause to avoid penalties and must exercise ordinary business care and prudence in reporting proper tax liability.

Therefore, potential penalties (as well as interest on the ERC credit) could total much more than the original ERC credit received in the first place.

Consult a Tax Professional

It’s very confusing for small businesses because of the various requirements, so it is advisable to consult with a tax professional that is familiar with the ERC rules.

Patel Law Offices offers a strategy session to discuss how to resolve your legal problem. Conveniently schedule online today with our online scheduler and questionnaire.