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CPAs: Here's What You Need to Know About Employee Retention Credit Audits

The COVID-19 pandemic forced many businesses to cease or dramatically change operations due to government mandates.

Posted: 30th October 2023 by Finance Monthly
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In response, Congress passed programs as part of the CARES Act to provide financial assistance to companies affected by the pandemic. One of these programs was the Employee Retention Credit (ERC)—a tax credit that most CPAs are at least somewhat familiar with.

In short, the ERC gives eligible employers payroll tax credits for wages and health insurance paid to employees during the pandemic. Unfortunately, many businesses did not take advantage of the program due to confusion surrounding qualifications. Since the IRS (Internal Revenue Service) issued guidance related to eligibility in 2021, the confusion around ERC qualifications has decreased, and business owners have become more aware of the tax credit. However, misconceptions about the ERC remain and have made the filing process difficult to navigate without qualified assistance. 

ERC scams have become such an issue that the IRS has issued multiple warnings for businesses to carefully choose who prepares their ERC application and added ERC mills to the Dirty Dozen list. Given the high amount of fraud surrounding the ERC, it comes as no surprise that the IRS has begun scrutinizing ERC applications more closely—meaning audits are more likely.

Here's what CPAs need to know about ERC audits and how qualified advisors can support clients’ ERC claims. 

The Employee Retention Credit Audit Process

If the IRS flags your ERC claim, it will perform a preliminary inquiry into your claim rather than a full audit. Typically, the preliminary audit will happen before your credit has even been issued, or they may deny your claim instead of performing a full audit. 

If the IRS decides to pursue an audit for your claim, you will receive an audit notice. The notice will explain the type of audit, the issues being audited, and potential next steps. Here are the main types of ERC audits:

  • Correspondence. You mail the auditor documents that back up the details on your payroll tax return. The majority of this type of audit is conducted via mail. 
  • Desk. The audit notice instructs you to schedule a phone meeting with the auditor. You then send in the requested supporting documents.
  • Field. The auditor comes to your place of business to conduct the audit. This is a rare occurrence with ERC audits but possible.

Often, the notice will include an Information Document Request (IDR). The IDR outlines the documents you need to provide and tells you where to send them—an audit is essentially a way to obtain more documentation. The IRS may have no more questions after the initial investigation, or the audit could be over.

Supporting information for an ERC claim, such as eligibility substantiation, is not required to be submitted to the IRS in conjunction with the 941-X filing to claim the tax credit. Using its approach, the IRS has to sift through millions of filings to detect illegitimate claims or fraudulent actors. So, an IRS inquiry or audit doesn’t mean your claim is automatically incorrect; it just means that your claim is being reviewed and may require supporting information to substantiate the filing.

For most ERC audits, backing up the information on your tax filings should be easy if you’ve kept accurate records and receipts. Unfortunately, this can be a bit more challenging with an ERC audit because you may not have all the details you need in your records. Here are some common supporting documents:

  • Government orders affecting your business during COVID-19. 
  • P&Ls and Tax returns that demonstrate a decline in gross receipts. 
  • Wage records and payroll register.

Failing an audit can lead to penalties on your client’s account. If the IRS has reason to believe that you were negligent in following the tax laws, it may apply a 20% accuracy-related penalty. This is 20% of the underreported tax. In cases of fraud, the penalty is 75% of the tax. The IRS can also bring criminal tax fraud charges against people who attempt to defraud the government by illegitimately claiming false tax credits. This is rare, but the consequences are hefty—prison time and up to a $100,000 fine for individuals and a $500,000 fine for corporations. 

ERC Red Flags for Auditors

White-collar crime and Wall Street scandals have been a catalyst for random audits—especially for tax programs that are more susceptible to fraud, like the Employee Retention Credit. While random audits are unavoidable, there are a few factors that may put businesses at a higher risk of being audited after they apply for the Employee Retention Credit.

Mathematical Inaccuracies. Simple miscalculations can lead to discrepancies between your claimed employee retention credit amount and other financial or tax-related information, such as payroll records, financial statements, and other tax filings.

Industry. Certain industries are at a higher risk of being audited based on how sales and tax regulations impact their business. The more complex the tax rules, the higher the chance that errors occur. 

Provider. The IRS warns consumers about exploitative promoters and other third parties, sometimes called “ERC mills,” which use advertisements to promote ERC refunds. Filing false claims—even unknowingly—can lead to audits, credit repayment, interest and financial penalties, and criminal liability. 

Partner with a Trusted ERC Expert

Because the consequences of being audited are so high, it's important to partner with Employee Retention Credit experts. An ERC expert will be prepared for an audit before your client even submits their claim. 

To ensure your claim is accurate and that your client is protected in the event of an audit, your organization should choose to work with ERC experts who understand the ERC from end to end. 

The right ERC partner should be on board with a proactive approach to the Employee Retention Credit process, from gathering documentation for the application to full-scale audit support. 

Here are some key indicators of proactive ERC service providers:

  • Start-to-finish assistance. Assistance should be available throughout the entire process of filing for the ERC, including calculations, documentation, submitting the application, and audit support. 
  • Tax insurance experience. ERC experts should have strong, well-established relationships with insurance brokerages that can identify tax insurance policies.
  • IRS experience. Experience in dealing with and proactively preparing for IRS audits is imperative to ERC's success.
  • Law firm relationships. Access to tax and legal professionals is an important part of mitigating the risk of an audit. Attorneys can help ensure compliance with ERC eligibility requirements and provide peace of mind.
  • Thorough reporting. Thorough documentation capabilities and the ability to anticipate potential questions from the IRS during audits should be a top priority for ERC applicants.

Employee Retention Credit expert and CEO of EZ-ERC Kenneth Dettman weighs in on the lack of transparency surrounding the tax credit audits:

“Based on what we have seen to date, audits are happening but not on a large scale. The two primary areas of focus we’re hearing about are the partial suspension of operations reliance and large employer credit, which allows large companies to take credit only on wages paid to people while they weren't working. The latter credit has been subject to quite a bit of abuse, but we are hearing a lot of the auditors admit that this is new to them too. As these things are taking a while to evolve, we're not clear on what type of hard lines are going to be drawn.” 

Consulting with experienced, qualified tax and legal professionals is the first step to determining ERC eligibility and filing a legitimate claim for the credit. Expert ERC firms are led by certified public accountants and tax attorneys with extensive experience in the legal test related to the ERC, as well as navigating IRS audits. You can set your clients up for ERC success by partnering with a qualified advisor.

Want more help from qualified Employee Retention Credit experts? Refer to this practical audit guide created by ERC experts at EZ-ERC.

Interested in partnering with qualified experts to help your clients? Check out their CPA referral program

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