It’s the season for employee retention credit (ERC) audits—yes, right during tax season when you have nothing better to do. Hopefully, you and your clients have heeded all the warnings and lifelines that the IRS has provided.

Let’s start by reiterating CPAs’ responsibility when it comes to the ERC. In March 2023, the IRS’ Office of Professional Responsibility (OPR) released Bulletin 2023-02, which highlighted that practitioners were obligated to meet the provisions of Circular 230 whether or not a third party was used for ERC calculations. Specifically, Section 10.22(a) requires “diligence as to accuracy.” This means that practitioners must:

• Perform reasonable inquiry to confirm a client’s ERC eligibility (If a practitioner can’t reasonably conclude a client’s eligibility, they shouldn’t prepare the return).
• Seek further inquiry if the information from their client appears to be incorrect, incomplete, or inconsistent.
• Inform their client of penalties for noncompliance.

According to IRS OPR Director Sharyn Fisk, there’s not a one-size-fits-all answer to what due diligence looks like, and the agency will be evaluating the facts and circumstances of each situation. “Not asking questions of a client or the third party who handled the ERC claim isn’t exercising due diligence,” Fisk said in an interview with Tax Notes, emphasizing the importance of documentation as a way for tax practitioners to protect themselves and their clients.

Overall, when preparing for an ERC audit, CPAs should be ready to answer these six questions.

1. Did the ERC provider start operating during the pandemic or have “ERC” in their name?

If yes to either, watch out! The IRS has been explicit about there being heavier scrutiny on these businesses.

2. Has the taxpayer’s income tax return been amended to add back payroll expenses pursuant to Internal Revenue Code 280C?

If not, yikes! ERC mills haven’t been properly advising clients that this requirement is mandatory. In fact, we’re hearing many stories about providers who don’t even realize this is a requirement.

3. Is the taxpayer part of a controlled group?

This is a huge factor many providers are missing. You may be asking yourself, “Why does the IRS need this?” Well, for the ERC calculation, you must aggregate all entities that are part of a controlled group.

For example, to qualify for the ERC in 2020, an eligible small employer must have fewer than 100 full-time employees (FTEs) on average in 2019. Let’s say that in 2019, entity A is part of a controlled group with entities B and C. Entity A has 90 FTEs, entity B has 20, and entity C has 20. Looking solely at each entity, they each have fewer than 100 FTEs in 2019, so you may initially think they’re eligible to claim the ERC in 2020. However, when you aggregate the FTE count, it totals 130 FTEs in 2019. Therefore, they’re most likely not eligible for the ERC in 2020, outside of some limited circumstances.

Similarly, when determining whether a business qualifies under the revenue decline test, you should measure 2020 or 2021 gross receipts against 2019 gross receipts in the relevant quarter. If an entity is part of a controlled group, you must aggregate all the gross receipts when performing this analysis.

4. Is there proof of the government order and full or partial shutdown for each relevant quarter?

The IRS will ask for not just the number of the government order, but a copy of the actual order. These typically come from the websites of each state, city, or county. It needs to be clear that the order is a mandate and not merely guidance (i.e., does the order say you “shall” do something or that you “should” do something?). In addition to retrieving a copy of the order, a detailed explanation of how the order applied to the taxpayer should be provided, specifying exact dates and other proof of the full shutdown. Some examples of proof include data showing hours clocked in/out during the closure period, emails, or contemporaneous announcements that clearly indicate a closure.

For a partial shutdown, the IRS will request detailed information that shows how a governmental order resulted in more than a nominal effect to business operations (i.e., an impact of more than 10% on business operations).

Importantly, a narrative alone won’t suffice. For example, we had a situation where a nursing home came to us for help after their ERC claim was disallowed. They tried to show that their business was more than nominally impacted, citing that COVID-19 policies affected their day-to-day operations in how they delivered care, merely mentioning that certain offerings were no longer provided, such as physical therapy. The IRS agent didn’t buy it. However, we were able to help demonstrate a quantifiable impact to the business of more than 10%. The IRS reversed its denial and allowed the credit in full.

5. Is part of the ERC claim due to a supply chain disruption?

The IRS is intensifying its approach toward taxpayers who claimed the ERC due to a supply chain disruption. According to Notice 2021-20, a taxpayer can claim the ERC if their supplier’s operations were fully or partially halted due to a governmental order, and as a result, their business operations were also suspended due to the lack of critical goods.

The IRS has requested various details from these taxpayers, including: 1) copies of governmental orders that led to the suspension of the supplier’s operations during the relevant quarters; 2) evidence that the supplier experienced a full or partial suspension of operations with specific operational data from the supplier; 3) clarification on which goods were delayed and why they were critical; and 4) evidence that the inability to source these critical goods had a significant impact on the taxpayer’s business.

6. Did the taxpayer apply for a PPP loan and later have it forgiven?

If the taxpayer applied for a Paycheck Protection Program (PPP) loan and later had it forgiven, they can’t use those same wages to calculate their ERC. That’s considered double dipping and can get them in double trouble.

In these cases, the IRS will ask to see the following: 1) loan application; 2) loan forgiveness application; 3) documentation submitted with the forgiveness application that itemizes payroll and non-payroll expenses; and 4) calculations proving that there was no double dipping between the PPP loan and ERC.

Additional Reminders

In response to rampant ERC claim fraud, the IRS has issued multiple warnings to taxpayers and practitioners and is taking further action.

In December 2023, the IRS announced it was sending out an initial round of more than 20,000 letters to taxpayers, notifying them of disallowed ERC claims. From what we’ve seen, these letters are only for 2020 claims. We assuredly anticipate that 2021 disallowances are coming. Of course, we also suspect the IRS will establish automated system that’ll flag things like whether a business claimed all available quarters, automatically claimed $26,000 per employee, claimed PPP loans but didn’t account for them, or if state and federal wage numbers didn’t match.

Also in December 2023, the IRS outlined the details of the new ERC Voluntary Disclosure Program (VDP) for businesses that claimed and received ERC refunds but weren’t eligible. This program is only available through March 22, 2024. If taxpayers meet the qualifications for this program, the benefits include:

• Needing to repay only 80% of the ERC received.
• The IRS won’t charge penalties or interest.
• No need to report the 20% of the ERC retained as income.
• No need to amend income tax returns to reduce wage expenses.

Of course, it’s not a guarantee that every taxpayer acting on the VDP will be approved for relief. It’s important to note that taxpayers will be precluded from VDP relief if they’ve been contacted by the IRS regarding their ERC claims or if an ERC mill has already provided their names during the course of a promoter exam.

In our experience, speaking with a trusted advisor is the best strategy to avoid penalties. Remember, it’s a CPA’s responsibility to perform due diligence and protect their clients—don’t say we didn’t warn you.