Navigating the murky waters of the Employee Retention Credit

By H.T. Astrov, JD, CPA (inactive), LLM, tax attorney at Zaino, Hall & Farrin

On March 20, in IR-2023-49, the IRS kicked off its 2023 Dirty Dozen list of schemes and scams by issuing a very pointed warning to employers about improper claims for the ERC which, when properly claimed, may result in an eligible employer receiving a refundable tax credit of up to $26,000 per eligible employee. The IRS warning spotlighted, in very direct language, the “blatant attempts by promoters to con ineligible people to claim the credit” and restated that false claims promising tax savings that are too good to be true generate significant risk to employers. These third-party promoters often charge a percentage fee that is contingent on the amount of the refund. Also, many promoters do not make it clear to employers that they will need to amend their business’s federal income tax return for the corresponding period because any wages used in the computation of the credit are no longer deductible.  

The IRS reminded employers that there are very specific guidelines that address eligibility for this credit and admonished that, contrary to what some promoters are saying in advertising and unsolicited phone calls and emails, the ERC is not available to just anyone. And because employers are always responsible for the accuracy of the information reported on their tax returns, the IRS emphasized that improperly claiming the ERC could result in employers having to repay not only the credit, but also penalties and interest. 

Including improper ERC claims on the 2023 Dirty Dozen came as no surprise to those who have been following the IRS’s ERC-related announcements closely. On March 7,  the IRS issued IR-2023-40 to renew its Oct. 19, 2022 warning (IR-2022-183) about third parties aggressively promoting false ERC claims on radio and online, and in many circumstances, misleading employers about eligibility for the ERC and its complexities. Unusual is both the fact that the IRS is warning in very strong terms about a tax credit of relative broad applicability to business taxpayers (as opposed to individual taxpayers), and that many of the perceived abuses arise from advice provided by established specialty tax consulting firms working under similar contingent fee arrangements to those used by newly-created “credit mills.”[2] 

In its Dirty Dozen announcement, the IRS advised that—unlike tax professionals who are carefully and competently advising clients on the complexities of the ERC— “third-party promoters of the ERC often don’t accurately explain eligibility for and computation of the credit” and the promoters “may make broad arguments suggesting that all employers are eligible without evaluating an employer’s individual circumstances.” We described some of our concerns about how the ERC should be approached in November 2022. The IRS encouraged the tax professional community to continue to advise clients not to file ERC claims when the tax professional does not believe that the employer has an appropriate basis for filing such claim. 

Now what? How to tell if an ERC claim may be improper 

When approached with diligent attention to its rules, the ERC provides a benefit to certain employers whose business operations were negatively impacted by the COVID-19 pandemic. However, there is also a spectrum of dubious ERC advice and eligibility determinations being provided by some promoters (or advisors).[3] This spectrum of advice ranges from flat-out “cons, schemes and scams” (all words used by the IRS) which take minimal account of IRS guidance, to extreme interpretations of the ERC guidelines by more technically savvy tax practitioners. All of which the IRS may challenge if the claims are audited. As a starting point, apart from situations where an employer qualifies for the ERC because of a decline in gross receipts, we believe the critical prerequisite for ERC eligibility requires the employer to be able to determine how a governmental order caused a full or partial suspension of trade or business operations. These rules are provided in Notice 2021-20.[4] However, Notice 2021-20 for the most part does not articulate simple bright-line standards and leaves significant room for interpretation as to whether a governmental order caused a “full or partial suspension of business operations.”[5] Thus, there is no “one size fits all” test that enables a business employer to readily assess whether their ERC claim may fall within the range of abuses the IRS is warning about. Nonetheless, here are some of the questions we believe employers should ask as they consider the strength of their ERC claims: 

1. How much time did the advisor spend talking to the employer about the facts and circumstances of the employer’s business operations? Except in instances where the employer is eligible because of the decline in gross receipts, we would expect there to be an actual interview to understand how the employer’s business operated before the pandemic and then during each quarter of the pandemic (particularly in each of the first three quarters of 2021 where the wage limits are applied on a quarterly basis). We believe that this interview process should be more than a “quick” phone call. 

2. Based on the interview and other information gathered, did the advisor prepare a written narrative that both identified the specific state or local government orders the business was subject to and described their impact on the employer’s business operations? As a general matter, we would expect this written narrative to be comprehensive enough to explain to an IRS examiner what provisions in the governmental order applied to the employer’s business operations and how these provisions caused the business operations to be suspended in whole or part.[6] In this regard, we believe that the ensuing narrative should describe with specificity the fundamental changes the employer had to make to operations at the core of its business. In contrast, we would be concerned when the written narrative looks like a “cookie cutter” analysis and does not describe and analyze the employer’s actual business operations in a particularized manner. 

This written narrative should also discuss when these modifications ended as governmental orders (and actual behavior) evolved during 2020 and 2021. We would also expect the advisor to share a draft of this written narrative with the client in order for the client to review its factual accuracy. Obviously, the final copy of the written narrative (as well as other supporting documents) should be provided to the client so it is readily available for review by their auditors or the IRS. 

To read the rest of the questions employers should ask and what you should do if you've already filed your ERC claim, read more here.