Employee Retention Credit (ERC) claims by employers are once again being processed by the IRS after a moratorium period for any credits filed after September 14, 2023. During this period, the IRS performed a large study on a group of ERC claims to help determine the next steps on remaining claims and essentially develop an audit strategy for filed claims and ERC audit risks.
Post-moratorium included issuance of 28,000 disallowance letters and focus on processing only low-risk claims. The IRS has other initiatives focused on claim withdrawals, ERC promoter investigations, criminal investigations, and the initiation of thousands of ERC claim audits, emphasizing ERC audit risks for high-risk claims.
The question I would answer for your business is where your claim falls in the risk for audit and then take the proper next steps to secure your position in the event of audit or potentially enter the ERC Withdrawal Program that is available if you determine your claim to be erroneous. Knowing the ERC audit risks will help you make informed decisions.
The IRS has listed various warning signs that present high risks for ERC claims. Many of these dealt with the calculation of the credit and centered around claiming too many quarters, too many employees, and the calculation of eligible employee wages. If you worked with a reputable firm in completing your credit, this shouldn’t present much of a risk, but the pop-up promoter firms were working to maximize a credit as many of their fees were contingency based, creating heightened ERC audit risks due to potentially overlooked diligence in preparing the actual credit.
The risks that I’d like to focus on in this article are those around the actual qualification for the credit. ERC qualification really came down to two qualification methods, one based on declines in gross receipts, and the other on impact from a government order.
The gross-receipts test is fairly straightforward, and as long as the decline in gross receipts at the proper percentage was present, the quarter would qualify for ERC. Another provision in the legislation opened the door for the subsequent adjacent quarter to also qualify. This qualification method would seemingly be low-risk in the eyes of the IRS. The government order test, however, is where the IRS is observing the most erroneous claims. Either by non-conforming government orders or by taking qualification on government orders that didn’t impact the business. I.E., government orders largely didn’t impact companies employing essential workers.
The government order’s qualification is also the focus on the IRS’s five new warning signs of a higher risk claim. More detail can be found on these five new warning signs at: https://www.irs.gov/newsroom/irs-shares-more-warning-signs-of-incorrect-claims-for-the-employee-retention-credit-urges-businesses-to-proactively-resolve-erroneous-claims-to-avoid-penalties-interest-audit.
Overall, the IRS’s new and old warning signs prevalently call out the qualification of government orders, citing of supply chain issues, and essential businesses that didn’t experience a decline in gross receipts. If your business qualified under the government order, be ready to defend how the order fully or partially suspended business operations. A general reference to orders that were in place is not going to be enough of a defense, and businesses are going to have to prove, through a combination of quantitative and qualitative measures, how the government order suspended more than a nominal portion of the business operations.
What does nominal portion mean? The IRS has addressed this to an extent, stating at least 10 percent of your business based on gross receipts or the total hours your employees spent working in that part of the business. Even if you had to modify how your business operated, the more than nominal test presides and you have to prove more than a 10% reduction in ability to provide goods or services in the normal course of business.
After reviewing your own business’s qualification, I recommend making sure your audit file has robustly defended your position by addressing the specific factors the IRS calls out in new guidance.