Will ERC trigger an audit?
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Employee Retention Credit Fraud and Potential Audits and Penalties
What is the Employee Retention Credit?
The Employee Retention Credit (ERC) is a refundable tax credit that was authorized by the Coronavirus Aid, Relief, and Economic Security (CARES) Act in March 2020 to help businesses retain employees during the COVID-19 pandemic. The credit initially provided eligible employers with a refundable credit against certain employment taxes equal to 50% of qualified wages paid to employees between March 13, 2020 and December 31, 2020, up to $10,000 in qualified wages per employee for all calendar quarters.
The credit was later expanded and extended by the Taxpayer Certainty and Disaster Tax Relief Act of 2020 and the American Rescue Plan Act of 2021. Key changes included:
Increasing the credit rate to 70% of qualified wages
Expanding the limit on per employee creditable qualified wages from $10,000 for the year to $10,000 per quarter
Extending the credit through December 31, 2021
To be eligible for the ERC, an employer must have experienced a significant decline in gross receipts or a full or partial suspension of operations due to a COVID-19 government order. The credit is generally claimed on an employer’s quarterly payroll tax returns.
ERC Fraud Concerns
With such a generous tax credit available, concerns have arisen around potential abuse and fraudulent claims for the ERC. Some key fraud risks include:
Employers overstating decreases in gross receipts to claim the credit when they did not actually experience a sufficient decline
Employers claiming the credit for quarters when they were not significantly impacted by COVID-19
Employers claiming the credit for employees who did not actually perform services
Employers who received Paycheck Protection Program loans also claiming the ERC for the same payroll expenses
Non-eligible employers like government agencies claiming the credit
Retroactively lowering employee wages to maximize the credit when no actual wage adjustment took place
The IRS has identified claiming the ERC when not eligible as one of the top 2021 compliance issues for large business and international taxpayers. Improper ERC claims can result in substantial lost tax revenue for the federal government.
Potential Audits of ERC Claims
Given the concerns around fraudulent ERC filings, the IRS has indicated that employee retention credits will be a focus area in upcoming audits. Employers claiming substantial credits can expect their filings to be reviewed carefully.
Some red flags that may increase audit risk include:
Industries not especially hard-hit by COVID claiming credits
Businesses posting strong financial results claiming credits
Claiming the maximum $10,000 credit for a large number of employees
Claiming credits for employees who were terminated or not actually working
No documented support for claimed significant declines in gross receipts
The IRS has access to a wide range of taxpayer data which enables them to model audit selection around suspicious filings. Information including payroll tax records, PPP loan data, and gross receipts reported on income tax returns can all be cross-checked when evaluating the legitimacy of an ERC claim.
Best Practices to Avoid ERC Audit Triggers
Businesses can take the following steps to avoid red flags and minimize audit risk:
Maintain detailed documentation supporting the decline in gross receipts calculation
Keep records confirming claimed employees actually performed services and were paid wages
Review that employees claimed for the credit were not also claimed for the PPP loan forgiveness
Correct any overclaimed credits through filing an amended return
Consult with a knowledgeable tax professional
Proactively addressing any erroneous ERC claims can help prevent or resolve an audit. However, if selected for examination, promptly responding to IRS requests and having proper substantiation for the credit should lead to a smooth process.
Penalties for ERC Fraud
Intentionally making false claims for the employee retention tax credit can potentially lead to civil and criminal fraud penalties. The IRS treats ERC fraud seriously with aims to prosecute abusers and claw back improper credits.
Civil Penalties
On the civil side, the IRS can assess the following penalties for fraudulent ERC filings:
Accuracy penalties – A 20% penalty applies for substantial understatements of tax related to claiming excessive credits. This penalty increases to 40% in cases of gross valuation misstatements.
Erroneous refund claim penalty – Taxpayers may face a penalty of 20% of any ERC refund they were not entitled to.
Failure to file correct information returns – Businesses that fail to file accurate Forms 941 and 7200 when claiming the credit may be subject to penalties of $270 per return.
Failure to disclose reportable transactions – Taxpayers who fail to properly disclose participation in reportable transactions like abusive ERC schemes can face penalties up to $200,000 for corporations and $100,000 for individuals.
Frivolous tax submissions – Tax filings taking unreasonable positions around ERC eligibility can potentially be considered frivolous and subject to a penalty of up to $5,000.
Criminal Penalties
In the most egregious cases of intentional ERC fraud and tax evasion, criminal charges may be pursued:
Tax fraud – Knowingly falsifying facts to claim improper ERCs can potentially be prosecuted as criminal tax fraud under Internal Revenue Code Section 7206. This felony charge can result in fines up to $250,000 and imprisonment up to 3 years.
Tax evasion – Willfully attempting to evade assessing proper tax related to fraudulent ERC claims may be charged as felony tax evasion under IRC Section 7201, punishable by fines up to $100,000 and imprisonment up to 5 years.
Theft of government funds – Wrongfully obtaining ERC funds could potentially be charged as theft of government money or property under 18 U.S. Code § 641. Violators can face fines and up to 10 years imprisonment.
Wire fraud and mail fraud – Schemes to defraud the government by claiming false ERCs and using mail, wire communications or electronic transfers may be prosecuted under mail or wire fraud statutes, with penalties up to $1 million fines and 30 years imprisonment.
Money laundering – Individuals involved in processing and concealing proceeds from ERC fraud could be charged with money laundering and face significant fines and up to 20 years imprisonment.
Taxpayers should also be aware that in addition to the above penalties, they will be responsible for repaying any improper ERC credits claimed, plus interest and penalties on the amounts owed.
Examples of ERC Fraud Prosecution
The Department of Justice has ramped up pursuing ERC fraud cases criminally. Some examples of recent prosecutions include:
The CEO of a California-based engineering firm was charged with nine counts of wire fraud and money laundering for allegedly claiming $9 million in false ERCs.
Two owners of a Florida air conditioning company were indicted on wire fraud and illegal monetary transactions related to $1 million in fraudulent ERC and PPP loan claims.
A Texas man was sentenced to over 5 years in prison for involvement in schemes misusing ERC and PPP funds.
The president of a transportation company in New York was charged with PPP and ERC fraud totaling over $7 million.
The DOJ news releases provide many examples of prosecutions for individuals who lied about their company’s eligibility or fabricated payroll expenses. These cases underscore the very real criminal risks associated with trying to abuse COVID relief programs.
Avoiding ERC Fraud Problems
The potential civil penalties and criminal prosecution make fraudulent claims for employee retention tax credits ill-advised. However, businesses struggling during COVID that truthfully qualified for the credit should not be deterred from proper usage of the program.
The IRS does expect to see valid ERC claims on many 2020 and 2021 tax returns. Employers who can demonstrate a genuine reduction in gross receipts along with wage payments to employees performing services should have nothing to fear from claiming the credit as intended by Congress.
Some best practices for avoiding ERC fraud issues include:
Carefully reviewing eligibility criteria before claiming the credit
Maintaining detailed records to support any gross receipts declines
Keeping documentation showing claimed employees actually worked and were compensated
Not claiming credits retroactively for prior quarters unless qualified
Claiming a credit in line with business realities, not inflating amounts
Disclosing and correcting any overclaimed credits
Consulting a professional tax advisor with ERC experience
For most employers impacted by COVID-19 slowdowns who claim ERC in good faith, the credit provided welcome tax relief. By being transparent and having proper substantiation, any IRS review of a legitimate credit claim is likely to go smoothly.
Conclusion
The Employee Retention Credit represented substantial tax savings for employers affected by the pandemic. However, the generous credit also created tempting opportunities for abuse.
The IRS is closely examining ERC claims on tax returns to identify potentially fraudulent filings. Intentionally deceiving the government to wrongfully claim credits can result in steep civil penalties and even criminal prosecution.
Employers should ensure they have adequate documentation to validate any ERC credits claimed. With proper diligence and transparency, valid utilization of this important COVID relief program should withstand any IRS scrutiny. But trying to game or exploit the system carries serious enforcement risks that outweigh any potential tax benefits.