As IRS audits of Employee Retention Credit (ERC) claims intensify, understanding the risks and potential penalties is crucial for businesses. This guide explores ERC audit processes, common red flags, audit preparation strategies, and penalty abatement options. With proactive planning and expert guidance, businesses can navigate ERC audits more effectively and reduce their audit risk.
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ToggleWhy the IRS is Increasing ERC Audits
The Employee Retention Credit (ERC) was established under the CARES Act to support businesses keeping employees on payroll during the COVID-19 pandemic. Despite this benefit, the IRS has seen an increase in ineligible or erroneous claims, often due to the complex eligibility rules or improper guidance from promoters. As a result, the IRS is intensifying its audit efforts to ensure compliance and verify ERC claims, particularly for businesses that may have claimed credits based on misinterpreted or inflated eligibility.
ERC Audit Risks: What Triggers an ERC Audit?
Several factors can increase a business’s risk of an ERC audit. Understanding these common red flags can help businesses evaluate their audit exposure:
1. Inconsistent or Incomplete Information: Incorrect or incomplete details on filed forms, such as Form 941, can raise IRS concerns.
2. Excessive ERC Claims Relative to Payroll: The IRS is more likely to audit businesses with ERC claims that appear disproportionate to their reported payroll expenses.
3. Use of Ineligible Wages: Claiming ERC for wages paid with funds from other COVID relief programs, such as the Paycheck Protection Program (PPP), can trigger scrutiny.
4. Misinterpretation of Government Shutdowns: Claiming ERC based on shutdowns without a qualifying government mandate can increase audit risk, particularly in industries where operational restrictions varied by region.
Note: Businesses are required to maintain detailed payroll records, revenue statements, and documentation supporting ERC eligibility for at least four years, as the IRS has up to five years to audit these claims.
Preparing for an ERC Audit: Essential Documentation
Being prepared for an ERC audit involves gathering the necessary documentation to demonstrate compliance with ERC eligibility requirements. Here’s what businesses should have ready:
Key Documents for ERC Audit Preparation
•Payroll Records: Documentation of wages paid during qualifying quarters.
•Revenue Records: Monthly and quarterly revenue statements demonstrating compliance with the gross receipts test.
•Government Mandates: Proof of any government orders that affected business operations, such as stay-at-home orders or capacity restrictions.
•Correspondence with Third-Party Advisors: Any communications with tax preparers or ERC consultants involved in calculating the credit.
Maintaining these documents in a systematic, organized manner can expedite the audit process and facilitate easier communication with IRS agents if additional information is requested.
Tip: Keep a checklist of required documents and store them digitally to avoid delays during an audit.
The ERC Audit Process: What to Expect in 4 Steps
Step 1: Notification of Audit
An ERC audit typically begins with a notification letter from the IRS, which details the scope of the audit, the documents required, and a deadline for submission. This initial communication also assigns an IRS agent to the case.
Step 2: Submission of Documentation
The business will need to provide all requested documents, either electronically or through in-person meetings, depending on IRS guidelines. IRS agents may request clarification or additional records during this stage.
Step 3: Examination of Records
The IRS will review submitted documents to verify ERC eligibility, cross-referencing data with payroll records, financial statements, and tax filings. Agents may contact the business for explanations regarding discrepancies or questionable data points.
Step 4: Preliminary Findings and Resolution
Once the IRS completes its review, it issues a preliminary report outlining findings. The business can respond with additional information or corrections if discrepancies are identified. The IRS will finalize its decision based on the response, determining if the ERC claims were valid, partially adjusted, or disallowed.
Penalties Associated with ERC Audits
If an ERC audit results in a disallowed or adjusted claim, the IRS may impose various penalties:
- Accuracy-Related Penalties: For substantial errors or understatements in ERC claims, businesses may face accuracy-related penalties, typically calculated at 20% of the erroneous credit amount.
- Underpayment of Tax: Businesses are responsible for repaying any disallowed ERC funds, along with interest from the original filing date.
- Fraud Penalties: For cases where fraud or intentional misrepresentation is suspected, penalties may be as high as 75% of the disallowed credit, along with potential criminal charges.
Example: If a business claimed $10,000 in ineligible ERC funds, an accuracy-related penalty of $2,000 (20%) may be applied, in addition to repayment and accrued interest.
Penalty Abatement Options: Reducing ERC Penalties
In some cases, businesses can apply for penalty abatement to reduce or eliminate penalties. The IRS may grant relief if the business can demonstrate a reasonable cause for the error, such as reliance on incorrect advice from a third-party ERC consultant.
3 Steps for Requesting Penalty Abatement
1. Prepare a Written Explanation: Detail the circumstances that led to the ERC miscalculation, including any reliance on external advisors.
2. Submit Documentation Supporting Reasonable Cause: Include any documentation showing that the business acted in good faith, such as communications with advisors or consultants.
3. Respond Promptly to IRS Requests: Engage with the IRS as needed, ensuring that all abatement requests and supporting materials are submitted before any deadlines.
Pro Tip: Working with a tax professional can improve the likelihood of a successful abatement request, as they can help tailor the explanation to IRS standards.
Minimizing ERC Audit Risks: Proactive Measures
While no business can fully prevent an ERC audit, taking proactive measures can minimize the likelihood of an audit and improve readiness if one occurs:
Ensure Accurate and Complete Filings: Double-check all ERC claims for accuracy, including payroll calculations, eligible wages, and other supporting data.
Use Reputable ERC Consultants: Working with experienced and IRS-compliant tax professionals reduces the risk of improper claims, as these consultants are knowledgeable about ERC rules.
Review ERC Compliance Regularly: Conduct internal reviews of ERC eligibility and documentation. This is particularly useful for multi-employee businesses that may require periodic updates to reflect payroll changes.
Respond to IRS Inquiries Promptly: If the IRS requests additional documentation before issuing an audit, respond quickly and comprehensively to avoid triggering a full audit.
Recent Developments in ERC Enforcement
The IRS has recently taken significant steps to enforce ERC compliance, including issuing thousands of letters to businesses about ineligible claims and implementing a moratorium on processing new ERC claims due to audit backlog. The agency has also warned against aggressive ERC promoters, listing ERC-related scams in its “Dirty Dozen” tax scams list for 2024. These developments underscore the importance of maintaining accurate ERC records and carefully evaluating eligibility before claiming the credit.
Key Takeaway: Staying informed about the latest IRS guidance and working with qualified advisors can prevent common ERC audit issues.
When to Seek Professional Help
Navigating an ERC audit alone can be challenging, especially given the potential for penalties. At Silver Tax Group, we specialize in IRS audits and tax compliance, and our experienced professionals are here to support you throughout the ERC audit process. We help ensure proper documentation, manage all IRS communications, and provide guidance on penalty abatement options to protect your business.
Professional assistance is especially valuable for businesses that:
- Used Third-Party ERC Consultants: If a business relied on an ERC consultant for their claims, a tax advisor can help ensure compliance and address discrepancies.
- Face Complex Eligibility Issues: Businesses with unique operational structures or varying revenue streams may require additional guidance.
- Received Audit Notification: If the IRS has initiated an ERC audit, working with an experienced professional helps protect the business’s interests.
Final Thoughts: Navigating ERC Audits Successfully
With increasing IRS scrutiny on ERC claims, businesses need to be vigilant about compliance and proactive in maintaining accurate records. By understanding the ERC audit process, preparing necessary documentation, and seeking professional assistance when needed, businesses can mitigate risks, reduce penalties, and navigate IRS examinations with confidence.
Summary: The IRS is actively auditing ERC claims to prevent misuse and ensure eligibility compliance. Staying prepared with the right documentation and expert guidance can help businesses respond effectively to audit inquiries, minimize penalties, and avoid future compliance issues.