Promoters and tax advisors have extensively marketed the Employee Retention Tax Credit (ERTC) as a way for employers to reclaim Federal Insurance Contributions Act (FICA) payroll taxes paid during the first two years of the COVID-19 pandemic. The rules governing ERTC claims are complex and nuanced, resulting in increased scrutiny by the Internal Revenue Service (IRS). Asserting that many employers have improperly claimed these heavily marketed ERTC refunds, the IRS released two announcements on September 14, 2023, and October 19, 2023, that address ERTC claims. In conjunction with these announcements, the IRS has already named fraudulent ERTC claims as number one on its “Dirty Dozen” tax scams list for 2023.
Specifically, the IRS will now target erroneous ERTC claims with penalties and interest. If a case is deemed fraudulent, the IRS will investigate and may impose civil and criminal penalties. The IRS has also suspended ERTC refund claims and provided a new withdrawal process for potentially fraudulent claims.
Following these announcements, employers should consult their legal and tax advisors to ensure they understand how to respond to previously filed ERTC claims that the IRS may deem aggressive or fraudulent. Employers also should consider filing protective refund claims to preserve their employment and income tax positions.
US Congress enacted the ERTC to help employers retain employees who might otherwise have been terminated or furloughed due to the COVID-19 pandemic. To encourage ongoing employment and reduce expensive claims for extended unemployment, an “eligible employer” that paid “qualified wages” to its employees could potentially claim $26,000 of refundable tax credits per employee ($5,000 per employee for 2020 and $21,000 per employee for 2021).
Many promoters and tax advisors marketed their unique ability to file and recover tax credits for employers, often imposing success fees of 20% or more of the refund amounts received by the employer. Although tens of thousands of valid ERTC claims have been filed, the IRS is now targeting thousands of other ERTC claims that may be considered aggressive, erroneous and even fraudulent.
A WARNING FROM THE IRS
Even though the IRS fully concedes that the ERTC is a legitimate refundable tax credit, it is aggressively targeting ineligible employers who have been encouraged to file refund claims to recoup their FICA taxes. To assess promoters who publicize ERTC refunds, the IRS identified certain red flags, such as any of the following.
Statements that ERTC eligibility can be determined immediately and without any additional knowledge of the employer’s specific situation;
Substantial up-front fees to claim the ERTC;
Contingency fees based on a percentage of the refund amount of the ERTC claimed; or
Preparers refusing to sign the ERTC return.
Even if these red flags are not present and an employer believes its ERTC claims are bona fide, an employer can be forced to repay an erroneous ERTC credit and can face significant corresponding tax penalties and interest. Employers also may be unable to recoup the success fees paid to promoters and corrections of an employer’s tax return could fall outside the statute of limitations period to reverse the ERTC wage deduction disallowance. Furthermore, the IRS warns that the most aggressive ERTC claims may lead to criminal investigations and notes that some individuals have already been tried in federal court and sentenced to prison terms averaging 21 months.
AN OPPORTUNITY TO WITHDRAW
The new IRS guidance outlines a process that allows employers to withdraw pending ERTC refund claims to avoid future ERTC repayment and corresponding tax penalties and interest. The procedures for requesting a withdrawal can vary, so employers should consult with their legal and tax advisors regarding the exact requirements based on the employer’s specific situation.
OBSERVATIONS AND POTENTIAL NEXT STEPS
Although many ERTC claims may be aggressive and even fraudulent, the IRS’s recent announcements arguably fail to consider that the rules governing eligibility and calculation of the ERTC are subjective and complex. In the absence of clear and concise IRS guidance, many employers (and their advisors) are left to interpret the statutory text in a way that is potentially far more expansive than Congress intended.
To combat increasingly aggressive promotion and marketing of the ERTC, the IRS seeks to swing the pendulum in the opposite direction. Many valid ERTC claims soon will be caught up in IRS challenges. The IRS generally has two years to challenge and seek recovery for an erroneous ERTC refund. Given the size of many of these claims, we anticipate both significant ERTC refund challenges by the IRS and significant ERTC litigation with the IRS.
To respond to the new IRS guidance, employers should consider the following.
Consult with trusted legal and tax advisors to review ERTC claims and confirm eligibility;
To avoid penalties and interest, consider amending current ERTC refund claims using regular tax refund procedures or withdrawing the ERTC claims using the new IRS procedure;
To prevent double dipping for the same expense, ensure deduction disallowances associated with the ERTC have been properly applied to federal income tax returns;
Consider suspending success fee payments or placing success funds in escrow until the two-year statute of limitations period on erroneous refunds has expired;
Consider refiling any amended or withdrawn claims as “protective” ERTC employment tax refund claims, which can also be done for employers who were considering ERTC claims but decided against filing; or
File “protective” federal income tax refund claims to address the deduction disallowance on a potential IRS challenge to the ERTC claims.
The last two considerations may seem counterintuitive but are the most important steps an employer can take to respond to the recent IRS announcements and potential audits. Each protective refund claim serves a different purpose. An employment tax protective claim recognizes that some claims deemed aggressive by the IRS might be upheld in federal court. The protective claim also may allow an employer to best leverage its tax position by (i) avoiding penalties and interest, (ii) preserving its ERTC claims and (iii) awaiting the outcome of legal challenges to the IRS’s ERTC positions. Even if a protective employment tax return is not filed, an employer should file a protective income refund tax claim in almost all ERTC situations to avoid paying excess federal income taxes with a disallowed or repaid ERTC.
Employers who have not yet filed ERTC refund claims should consult their legal and tax advisors to understand the complex eligibility rules and potential tax challenges. Based on this advice, employers may need to amend or withdraw their ERTC claims or repay ERTC refunds. Employers also should immediately seek advice on filing protective refund claims to preserve their employment and income tax positions for any ERTC claims.