IRS Audits of Employee Retention Credit
The Employee Retention Credit (ERC) is a popular payroll tax credit. However, it’s also possible that the IRS may audit your company if the ERC is misused. To get the most out of this credit and avoid issues with the IRS, it pays to know what it is, how it works, and what you can do to ensure that you follow all IRS guidelines.
The ERC gained considerable popularity in December of 2020 when changes to the tax law allowed for taxpayers who received a PPP loan to claim it. The ERC was designed to help employers keep employees on salary during the COVID pandemic.
Before getting started, remember that having a tax professional by your side can make this process much easier. Consider consulting with your trusted tax professional Mike Habib, EA today when it comes to the ERC and other tax issues. Mike represents audited taxpayers before the IRS and appeals.
Consult with our Whittier, Los Angeles based tax representation firm today at 1-877-78-TAXES [1-877-788-2937].What is the ERC - Employee Retention Credit?
This is a refundable payroll tax credit that can be applied to up to $5,000 per employee for 2020. And up to $7,000 per employee for the first three calendar quarters of 2021. This means a total of $26,000 for each employee.
However, the fourth quarter of 2021 is no longer eligible unless it is used for a recovery startup business or RSUB. The RSUBs have a cap of $50,000 per quarter that apply to the third and fourth quarter of 2021.Eligibility Requirements
To become eligible for the ERC, there are two types of requirements.
A drop of up to 50% in gross receipts in any or all the quarters in the year 2020 as compared to 2019. The eligibility extends until a recovery of gross receipts reaches at least 80% in a single quarter.
A drop of up to 20% in gross receipts in any or all quarters in the year 2021 as compared to 2019. You can elect to use the immediately preceding calendar quarter. For example, you can test the second quarter of 2021 by comparing the first quarter of 2021 to the first quarter of 2019.
There are a few other tests as well which are part of the eligibility requirements.
- Limited Travel, Commerce, or Group Meetings because of COVID Pandemic
- Greater than Nominal Impact on Business Receipts or Employee Hours
- Telework is not Adequate Substitute for Conducing Business Operations
While meeting such requirements may seem straightforward, there are issues that business owners need to address. Otherwise, the chances for an IRS audit loom larger.Employee Eligibility Requirements
Along with the other requirements, the employer need to have the following number of employees in their company to qualify for ERC.
2020 ERC: 100 or fewer employees in 2019
2021 ERC: 500 or fewer employees in 2019
This will qualify for a small eligible employer. Keep in mind the aggregation rules for this usage. But to calculate you will need to do the following.
- 30 hours per week or 130 hours per month for FTE
- Determine the FTEs for each month, then divide by twelve
- This is different than PPP where full-time equivalency test was required
There will be documentation required for this area. There is some flexibility in terms of the documentation itself, but the taxpayer should not be close to any of the thresholds in this regard.Test for Gross Receipts
This is the total amount of revenue, which includes the net of returns and allowances. You will need to review your general ledger to ensure the amount is included and accurate. Because you can bet the IRS will review it as well. Keep in mind that aggregation rules will apply.
Even if you use a different method for book purposes, the method of tax accounting must be the same that the taxpayer used for that year. In terms of business combinations, there is a safe zone if it occurred in 2020 or 2021.
In terms of an IRS audit, there will normally be a request for the general ledger detail or tracing exercises to the tax return which will be examined.Issues with ERC
The IRS in October of 2022 issued a warning that taxpayers should be alert for third parties that promise tax savings through the ERC. The warning included watching out for companies that offered their services for a large upfront fee or a fee contingent on the refund received. Plus, it encouraged taxpayers to claim the ERC even if they didn’t meet the requirements.
An improper claim means being required to repay the credit and pay additional penalties with interest. All this leading to an IRS audit.Conditions for an IRS Audit
The IRS has been aggressively pursuing ERC claims to ensure that they meet the requirements. Such audits usually cover the following areas.
- Eligibility & Aggregation
- Number of FTEs in 2019
- Wages that Qualify
- A Double-Dipping using PPP along with other Credits
In addition, other areas of calculating the credits are used as well. One example of IRS auditing involves calculating the gross receipts to see if there is any shifting between the quarters of the calendar year. But there is more to what the IRS will do.
Government Orders: As part of the audit, the IRS will ask for government orders along with an explanation on their effect on the business.
For example, a supply chain issue related to the COVID pandemic that came from a government order will show how it affected the taxpayer. Such as an order that affected the delivery of supplies with no alternate sources available.
Before Being Paid: ERC claims made before they are paid are subject to audits. This in addition to interviewing the taxpayer for further information. Not only for early ERC claims, but for any information about elements that contradict the requirements for claiming an ERC.
Consult with our Whittier, Los Angeles based tax firm representation today at 1-877-78-TAXES [1-877-788-2937].Did You Suspend Business Operations?
If this occurred, you would need to answer whether you recognized an order from the US government which limited travel, group meetings, or commerce during the COVID pandemic. Plus, if your employees were able to work through telework during this time.
If you did suspend operations, did it have a substantial impact on your business? Keep in mind there is a safe harbor of 10% based on Notice 2021-20 in Q&A #13.
For the IRS audit, they will request copies of any US government orders that demonstrate the restrictions placed on your business and how long they lasted. You will also need to show how your business was affected by such orders. The burden is on you to demonstrate such impacts.Get Prepared for an Audit
You may believe that doing all the work will avoid an IRS audit. And in most cases that will be true. But even the best can make a mistake, not fill in the correct information, or provide accounts that may result in the IRS taking greater notice. What follows are a few tips to help keep you from making obvious mistakes that will almost certainly bring about an audit.
- Were the proper wages used?
- Wages cannot be “double dipped” with FFCRA, PPP, or other credits
- Post-Termination: Severance and similar payments cannot be used
Remember to stay within the wage limit of $10,000 that runs from March 31st, 2020 to December 31st, 2020. And for the first three calendar quarters for 2021, $10,000 for each.
In preparing for the possibility of an audit, keep in mind that the IRS will normally analyze the wages per individual based on the calculations made in the ERC. This goes back to the documents filed such as W-2s and the like. Plus, a reconciliation of the totality of wages that were filed using Forms 941.
For employers that have a large employee base, the IDRs require proof of why the qualifying wages were paid to employees who did not provide services. This can be a tricky task if you are not fully versed on what happened and need to account for any discrepancies.What to Do if you are Audited for ERC
Even your best efforts may result in the IRS deciding to conduct an audit anyway. Do not panic. Remember that sometimes the IRS conducts automatic audits that may nor may not mean you have done anything wrong.
But if you are informed by the IRS that the audit is about the ERC claims you have made, then you should do the following.
- Prepare the ERC calculation or eligibility analysis
- Amend the claim, if possible, in your initial response to the IRS
- Submit verifying responses
Remember that an IRS audit, as annoying as it may be, is not personal. Which means you do not take it personally. Be polite, give direct answers, and do what you can to let the IRS agent do their job. Keep in mind that they are simply trying to get at the truth, so do not let your emotions get in the way.
Plus, getting professional tax help can be most beneficial when facing an IRS audit. Whether it is for ERC compliance or some other issue, an experienced tax professional can be invaluable in responding to the IRS. If you are being audited, call your trusted tax professional Mike Habib, EA today to get the guidance needed in providing a proper response and resolution. Mike represents audited taxpayers before the IRS and appeals.
Consult with our Whittier, Los Angeles based tax representation firm today at 1-877-78-TAXES [1-877-788-2937].