Employee Retention Credits: What to Know for 2023 and IRS Claim Examinations

By Thomas E. Bayer, CPA, CExP – Sikich LLP – August 23, 2023
Employee Retention Credits: What to Know for 2023 and IRS Claim Examinations

Since its introduction under the CARES Act in March 2020, the Employee Retention Credit (ERC) has significantly impacted many for-profit and not-for-profit employers, large and small.

While the ERC got off to a slow start — as most employers opted instead for a Paycheck Protection Program (PPP) loan — the enhancements of the ERC under “CARES 2” in December 2020 allowed the credit to be available to employers even if they obtained a PPP loan (although the same wages could not be used for both the ERC and the PPP). The floodgates opened as employers wanted to learn how the ERC worked and whether they would be eligible for this incentive.

In 2023, ERC third-party providers continued to flood the airwaves with marketing campaigns causing employers that hadn’t previously pursued ERC refunds to ask their advisors to take a fresh look at this opportunity before the statute of limitations starts to expire in 2024. Some of these ERC providers were professional and diligent in following IRS guidance to assist employers. However, others were not. Some were aggressive in their search for business owners and pushed the envelope in their interpretations of the IRS’s ERC guidance. As a general rule, these providers receive a percentage — often 15% to 35% — of an employer’s ERC refund. 

In the fall of 2022, the IRS began cautioning employers about aggressive providers (the IRS refers to them as “mills”) contacting unsuspecting taxpayers — many of whom did not qualify for the ERC. The IRS warnings on the ERC continued this year:

  • IRS' most recent warning on ERC Scam Promotions
  • IRS alert to tax practitioners about concerns of professionals not following IRS standards. In this alert, the IRS cautioned practitioners about their responsibility in working with ERC situations. The IRS notes that “to fulfill their professional obligations to clients and to tax administration, practitioners (attorneys, CPAs, and enrolled agents) must meet the applicable provisions in Circular 230.” A key aspect of Circular 230 involves a practitioner exercising “Diligence as to Accuracy” (Section 10.22(a) of Circular 230). The IRS notes the following in its alert:
    • If the practitioner cannot reasonably conclude (consistent with the standards discussed in this guidance) that the client is or was eligible to claim the ERC, then the practitioner should not prepare an original or amended return that claims or perpetuates a potentially improper credit.
      • Additionally, if a practitioner learns that a current client did not comply with the ERC requirements in a prior tax year, the practitioner must, under Section 10.21, promptly inform the client of the “noncompliance, error, or omission” and any penalty or penalties that may apply.

Therefore, not only must employers be cautious in pursuing ERC claims, but tax practitioners must also exercise diligence in working with the ERC. 

  • On March 20, 2023, the IRS embarked on its annual “Dirty Dozen” campaign of tax scams. At the top of the IRS list in 2023 was abuse of the ERC. 

Tax practitioners are at times caught in the middle advising employers about the ERC. For instance, a CPA makes a thorough assessment that an employer is not eligible for the ERC, only to have an ERC provider tell the employer they are entitled to a refund.

Providers are aggressively pushing large ERC claims in cases where there is not even a hint of gray. This puts the employers and, in some cases, the CPA in a quandary.

As practitioners, we acknowledge that sometimes gray areas can occur in dealing with tax issues, but several providers are aggressively pushing large ERC claims in cases where there is not even a hint of gray. This puts the employers and, in some cases, the CPA in a quandary.

IRS Backlog of Forms 941-X

The IRS recently reported that they are processing 20,000 Forms 941-X per week in the Cincinnati and Ogden Service Centers, but the number of new forms processed is still growing.  Going forward, the IRS hopes to double the number processed to 40,000 per week. This same report notes that the backlog of Forms 941-X as of May 17, 2023, was 879,000. 

It is being reported that the IRS is reviewing larger ERC refund claims more closely and, in some cases, requesting additional information from the taxpayer before processing the claim. In the event clients are preparing a Form 941-X, it is not advisable to provide additional, explanatory attachments to the Form as it is believed this has the potential to cause confusion and potential delay in the processing of the Form. Here’s a complete article on the backlog: May 2023 IRS Backlog Report

Red Flag with Government Orders

As we know, there are two main methods an employer can follow to be eligible for the ERC. The first method involves a significant decline in the employer’s gross receipts in a calendar quarter compared to the same quarter in 2019. This is an objective and generally straight-forward calculation for ERC eligibility. 

The other method of eligibility involves a full or partial shutdown of the employer due to a government order. This is a much more subjective determination. Many ERC providers present the opportunity to generate refund claims under this method. In some cases, they use aggressive and seemingly unsupportable legal positions to help employers qualify for the ERC. It is anticipated that these aggressive positions of relying on a government order to justify any ERC will cause impacted employers to be subject to IRS audits that will consume time and resources, and the ERC may ultimately be disallowed.  

If contemplating going down this path, we recommend obtaining a careful review of this position by a professional advisor or legal expert who has expertise in this area and is not paid a fee based on the amount of the refund.

This government order argument is very difficult to document for essential businesses that were less impacted by these orders, and employers must ensure there is a clear linkage from the government order to the operational impact. Additionally, the IRS requires that the government order produced “more than a nominal impact” to the business, and this standard is difficult to document and quantify.

We understand the IRS will look closely at the specific metrics of how a business was impacted by a government order, not just some vague narrative without any details. We find that other business factors such as a drop in customer demand are the actual reason for a decline in operational metrics, and these sorts of factors cannot be considered. 

Practitioners should take an objective, unbiased approach in review of these ERC claims.  Many of the ERC providers are suggesting employers can rely solely on OSHA guidelines, foreign government orders, or industry-wide disruptions in supply chains as being a government order. All of these factors may have contributed to the disruption of normal business operations, but they are not considered government orders that meet the standard outlined in the IRS guidance.

IRS Activity Regarding ERC – June 2023 Update

The IRS trained a team of auditors, and their recent audit guide was published by various sources. It followed the guidance in IRS Notice 2021-20 and other subsequent guidance very closely. Thus far, audit activity has been limited. The IRS appears to be targeting larger ERC claims and there are reports of PEOs being audited. PEOs were tasked with having to continuously amend their Form 941s filed as customer-employers submitted ERC refund claims to them.  

A 2022 report issued by the U.S. Treasury Inspector General referenced “Category A” ERC claims that would be subject to a second level of review. It is our understanding this would apply to any quarterly ERC refunds of $200,000 or more. 

During an examination, the IRS will request documentation from employers concerning its ERC claim and whether it complies with IRS guidance. Some disputed cases will eventually find their way to the courts, as legal arguments supporting ERC eligibility due to a full or partial shutdown from a government order will be tested.

The IRS audit process continues to develop. Key areas of focus for the IRS are as follows:

  • Aggregation Rules. Owners of employers that also own other businesses, or are otherwise part of a control group: these employers are required to carefully review and apply these aggregation rules. There are some complicated IRS rules that must be analyzed to see if companies must be combined. If they must aggregate with other employers, then all the ERC limitations and rules must be done on the combined amounts of the companies.
  • Partial Suspension of Operations due to Government Orders. As noted above, these rules are very subjective, and offer limited examples in the IRS guidance. These rules have been subject to aggressive interpretation for the purpose of asserting ERC eligibility.
  • Number of Employees: There are different thresholds to be treated as a Small Employer for ERC purposes in 2020 vs. 2021. Again, careful review of these varied rules is an area of focus in IRS audits.

Additionally, it is important to understand the IRS expects employers to retain documentation that supports the ERC claim. Since the guidance was limited, we are closely monitoring audit activity to better understand the documentation expectations of the IRS.  Here are several items of note:

  • IRS auditors are requesting actual copies of government orders where the full or partial suspension argument is applicable. Additionally, and equally important, the employer is required to document how their operations changed due to the government order. It is not enough to simply cite a specific government order and the timeframe it was in effect. Implementation of the order must also be apparent.
  • Also, for employers who claim ERC eligibility from a government order, the IRS is requesting detailed, quantifiable evidence of the impact to the operation.  Operational metrics used by management should show a negative impact, and the impact would ideally meet the “more than nominal” safe harbor test of at least 10%.
  • For ERC claims with large employers (>100 employees in 2020 and >500 employees in 2021), the definition of eligible employees and whether the employees were in fact “not working” is an area of IRS scrutiny as well. The interpretation of “not working” is where opportunity lies for some aggressive ERC providers.  
  • Lastly, the IRS is generally unimpressed with voluminous reports from providers that lack the required substantiation and evidence.

These are some initial items of note from IRS audit activity specifically. We expect to have a better understanding of the required audit documentation required and the other IRS procedures with disputed claims by the end of 2023.

Further, the IRS Criminal Investigations (CI) division is also active. We are aware of ongoing investigations of “ERC mills”, a term coined by IRS and many other professionals. This is something also to continue to monitor closely.

What Does an Employer Do Now with the ERC? 

Be Diligent. Compare your situation considering the IRS rules on the ERC. The company officer signing the ERC refund claim on behalf of the employer bears the responsibility to be diligent in determining the employer’s ERC eligibility, reviewing the ERC calculations, and gathering the ERC support for its files.

For employers that have engaged or plan to engage an ERC provider, consider the following:

  • Does the agreement require payment of the provider their fees before the ERC refunds are received?
  • In the event the ERC claim is disallowed in an audit, will the provider refund their fees? 
  • Has the provider presented the employer with all of the supporting documentation that is requested in the event of an IRS audit? 
  • For employers who have already filed for an ERC claim, review all documentation retained and request any missing information from your provider.
  • Lastly, for those that are considering pursuit of ERC refunds, perform a cost-benefit analysis and determine the net amount that will be received after all fees and additional taxes on amended tax returns are paid.  In the event of an IRS audit, this will require time and attention and resources, and possibly penalties and interest if the audit outcome is not favorable.

Final Thoughts

  • Faulty Claims. For employers who are having “buyer’s remorse” and believe the ERC claim filed is not valid, it has been strongly suggested to the IRS that they should develop a voluntary disclosure or amnesty program that would allow employers to self-report and repay ERC claims that they have determined to be faulty. The IRS has not indicated that they plan to initiate such a program currently. Therefore, for those employers, they should work with their advisors and/or legal counsel to consider repayment of the refund and filing amended income tax returns.
  • Timeframe to File.  For employers still considering filing for a claim: don’t rush the filing of your ERC claim. We would suggest waiting until later this year for ERC claims for 2020. We believe we will learn more about IRS actions as the year progresses.  The statute of limitations does not start to run until April. 15, 2024 for ERC claims from 2020 (and April 15, 2025, for ERC claims from 2021). 
  • Amended Tax Returns. One reminder with the ERC: employers that obtain an ERC refund need to adjust taxable income for the period the wages were earned that generated the ERC. For example, if you filed an ERC claim in 2022 for the second quarter of 2021 but did not receive your ERC refund until 2023, you still need to include the ERC amount in your taxable income for 2021; the year of the ERC claim. Amended income tax returns will be needed to include this ERC in taxable income in 2021. Thus, an employer will need to pay the income tax cost now, for the ERC refund to be received later, or they will be subject to additional interest. 
  • Consult With Advisors. If you take these steps and are diligent in your work, you should consider reviewing your ERC claim with your outside advisors. An advisor should be independent from an ERC provider and should rely on IRS guidance as their justification for stating an employer can or cannot claim the ERC. You may also need to obtain a legal opinion on the ERC, as noted above. 

The ERC continues to present a significant opportunity for employers. It also poses a critical exposure area for others. Caution should be adhered to whether an employer is considering an ERC now or it has previously filed an ERC claim. Take a closer look at your documentation now, as the IRS will likely review it.