Watch Out: IRS Audits of ERC Claims Expected

The IRS has begun to audit ERC refund claims filed for 2020 and 2021. While the audit process is just starting, it is expected to increase over time as the IRS has indicated it is interested in auditing ERC claims.

It is anticipated that the audits will not be limited to specific industries or company sizes; any business filed for the ERC could come under IRS scrutiny.

Knowing whether or not you should be concerned begins with identifying any red flags that may exist with your ERC claim. You may even want to get ahead of the issue and review your eligibility position now to be prepared should the IRS choose to audit your claim.

Problems in an IRS ERC audit

If you cannot prove that you had the right to claim the ERC on your payroll return, you will have problems in an IRS ERC audit. To prove that you claimed the credits legitimately, you need to provide the IRS auditor with documents that support your claims, such as the following:

Proof of Revenue

Businesses could only claim this credit if they significantly reduced revenue or operational restrictions. To prove that you qualified based on revenue, you must 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 were not open in 2019 can use 2020 revenue numbers as their baseline.

Operational Restrictions Information

If you claimed the credit based on operational restrictions, you will need proof of the restrictions. For example, if your restaurant could not have dine-in service, you may want to provide newspaper articles about the restrictions’ dates or government notices.

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 could only 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 did not 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 do not have the worksheets you used to calculate the returns, a tax attorney may help you reconstruct these records.

The above are the documents 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 you do not 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 did not make the proper 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, assessed for every month 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. This penalty can increase quickly when dealing with dozens of employees and significant credits.

When to Get Help With an ERC Audit

It is best to deal with an IRS audit with the help of a qualified tax professional. They know the language, understand the requirements, and have experience dealing with auditors.

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 aggressive ERC ‘mill’ and are 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. The auditor has proposed changes to your return, and you disagree.
  7. The audit determination letter says you owe a significant tax liability plus penalties.
  8. You want help to appeal the results of the audit.

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