The Employee Retention Credit: Understanding IRS Audit Risks

The COVID-19 pandemic brought immense economic challenges for businesses across the country. To help employers retain staff and stay operational, the CARES Act introduced the Employee Retention Credit (ERC) – a refundable tax credit to offset certain employment costs. However, complex ERC qualification rules also pose IRS audit risks if the credit is improperly claimed.

This article will examine ERC eligibility requirements, common errors that increase audit risk, and best practices employers should follow to substantiate credits and minimize IRS scrutiny.

Overview of the Employee Retention Credit

The ERC is a refundable payroll tax credit introduced by the CARES Act in March 2020, which was later expanded and extended through 2021 by subsequent relief bills. It enables both for-profit and tax-exempt entities to claim credits on qualified wages, up to prescribed limits, for retaining full-time staff during COVID-19 disruption.

Key provisions include:

  • Applies to qualified wages from March 13, 2020, through December 31, 2021.
  • Equals 50% of up to $10,000 in wages per employee per calendar quarter. The credit increases to 70% of wages for Q3 and Q4 2021.
  • Eligibility based on experiencing more than a 20% decline in gross receipts or full/partial suspension of operations due to COVID-19 governmental orders.
  • Employers who received Paycheck Protection Program (PPP) loans can still qualify after loan forgiveness.
  • Refundable credit claimed against the employer’s share of Social Security payroll taxes. Excess credits are received as refunds.
  • Credit also applies to certain qualified health plan expenses allocable to eligible wages.

While the ERC offered crucial relief, complex rules for calculating, qualifying, and claiming credits increase the risk of IRS challenges if errors are made.

Understanding Key Eligibility Requirements

The ERC has specific parameters regarding which employers qualify, how to determine a sufficient decline in gross receipts, what constitutes qualified wages, and how the credit coordinates with PPP loan forgiveness. Falling afoul of any requirements can invalidate credits.

Qualifying Employers

The ERC is broadly available to both tax-exempt organizations and for-profit entities of any size. This includes tax-paying C corporations and pass-through S corporations, partnerships, sole proprietors, trusts, and estates.

Certain government employers do not qualify, including the federal government, states, local municipalities, and any entities receiving assistance through Medicaid. Tribal businesses are eligible for the ERC, however, as the IRS clarified in guidance.

Gross Receipts Decline

Eligibility hinges on satisfying one of two COVID-19 impact criteria:

  1. Experiencing a decline in gross receipts of more than 20% compared to the same calendar quarter in 2019. The decline thresholds phased down in Q4 2020 and Q1/Q2 2021.
  2. Full or partial suspension of operations during any 2020 or 2021 calendar quarter due to orders from a governmental authority limiting commerce, travel, gatherings, or attendance due to COVID-19.

Employers must compute gross receipts consistently and include all forms of income. Failure to properly determine and document revenue declines that meet threshold requirements is a common ERC audit trigger.

Qualified Wages

The amount of the ERC centers on qualified wages paid to employees during eligible quarters. For employers over 100 full-time (FT) staff, it only applies to wages paid to employees not providing services. Smaller employers with 100 or fewer FT staff can claim credits for wages paid to all employees during suspension periods, regardless of hours worked.

Errors in computing qualified wages based on employer size and periods of employment suspension are frequently cited in ERC audits.

Coordination with PPP Loans

Originally, employers could not claim ERC for wages paid with forgiven PPP funds. However, later legislation enabled employers to claim credits retroactively for qualified wages not included in their loan forgiveness amount.

Amending returns just to coordinate ERCs with PPP forgiveness introduces further complexity. Unsubstantiated amendments to capture additional credits are likely to trigger IRS scrutiny.

Common Audit Triggers

Given the intricacies of ERC eligibility rules, several issues commonly arise that may lead the IRS to flag claims for further review. Key areas for employers to avoid include:

  • Failing to accurately determine that gross receipts declined by more than 20% for a quarter compared to 2019 levels. Errors can include using inconsistent accounting methods, incorrect calculation periods, or inadequate documentation.
  • Claiming the credit despite not experiencing an eligible decline in gross receipts or COVID-19-related shutdown. Some employers may assert eligibility without understanding thresholds.
  • Claiming credits for non-qualified wages, such as amounts exceeding prescribed limits per employee, bonuses/tips, or wages to family members.
  • Improperly claiming credits for employees who worked full hours, contrary to qualified wage rules based on employer size.
  • Failing to exclude wages paid with PPP loan funds from ERC calculations or improperly amending returns to claim additional credits after receiving forgiveness.
  • Claiming newly retroactive credits long after original filing without sufficient documentation to support re-filing.

Best Practices to Substantiate Credits and Avoid Audits

The IRS has warned that ERC claims will be closely scrutinized on audit. However, employers can take proactive steps to confirm eligibility and validate credits in preparation for potential reviews. Recommended compliance practices include:

  • Thoroughly reviewing ERC requirements to ensure your business qualifies based on operations, suspensions, revenue declines, wage payments, and coordination of PPP loan forgiveness.
  • Comparing gross receipts quarterly to determine accurate thresholds were met. Retain detailed calculations, accounting records, quarterly financial statements, and other corroborating documentation.
  • For quarters with revenue declines, maintaining evidence of COVID-19 impacts, such as mandated closures or customer loss.
  • Keeping records of all credit computations, including wages per employee, exclusions for hours worked, and qualified health expenses.
  • Documenting methodology for determining FTE employees.
  • Providing evidence that amended returns reconcile ERC claims with PPP loan forgiveness amounts and original filings.
  • Instituting robust change management controls regarding claiming of credits, filing processes, and record retention.
  • Ensuring clear communication of ERC qualification and claiming protocols to payroll, finance, tax, and accounting functions.

By proactively managing ERC compliance risks and keeping proper substantiation, employers can effectively claim these valuable credits while mitigating potential IRS audit challenges.

Conclusion

The wide-ranging business impacts of COVID-19 prompted Congress to enact crucial tax relief through the Employee Retention Credit. This refundable credit enables employers to offset payroll costs for retaining staff during mandated shutdowns or revenue declines.

However, the intricacies of ERC eligibility conditions, calculations, and coordination with PPP loans present IRS audit risks if errors are made or credits are improperly claimed. Employers can significantly reduce exposure by thoroughly understanding qualification rules, computing credits correctly, maintaining detailed documentation, and instituting strong claiming protocols.

With careful compliance and substantiation, companies can fully capitalize on ERC benefits to ease financial burdens, while avoiding troublesome IRS examinations. The ERC provides vital support for navigating COVID-19 disruptions, but only if claimed properly with adherence to all applicable guidelines.

Frequently Asked Questions

Q: Who qualifies for the Employee Retention Credit?

A: Most for-profit and tax-exempt employers are eligible, except for the federal government, state/local governments, and Medicaid-funded entities.

Q: How is the credit amount calculated?

A: It equals 50% of qualified wages up to $10,000 per employee for 2020. The credit increased to 70% of wages up to $10,000 per quarter in 2021.

Q: What are considered qualified wages?

A: Rules differ based on employer size. Small employers with 100 or fewer FTEs can claim wages paid to all employees during eligible periods, regardless of hours worked. Large employers can only claim wages paid to employees not providing services.

Q: Can I claim the credit if I received a PPP loan?

A: Yes, but credits cannot be claimed on wages paid with forgiven PPP funds. Coordination complexities increase IRS audit risk.

Q: How long are ERC credits available?

A: Eligible wages paid from March 13, 2020, through December 31, 2021, qualify for credits.

Q: When does the credit expire?

A: Unused ERC credits from 2020/2021 can still be claimed on tax returns through 2026.

Helpful Resources

  • IRS Instructions for Form 7200 – Advance payment of employer credits
  • IRS Notice 2021-20 – Additional guidance on Employee Retention Credits
  • IRS FAQs on Employee Retention Credits and PPP Loan Coordination
  • Small Business Administration ERC Fact Sheet
  • AICPA Calculator for Employee Retention Credits
  • Guide to substantiating and documenting credits (U.S. Chamber of Commerce)

The ERC offers substantial benefits but also complex compliance obligations. Employers should consult with their tax advisors and accounting professionals regarding qualifying for, calculating, and claiming these valuable credits. Careful adherence to all program rules is essential to leverage ERC support while avoiding IRS audit scrutiny.

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