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7 Reasons Your ERC Tax Credit Will be Flagged by the IRS

Posted on April 23, 2024

By Michele Roletter

May 25, 2024

The pandemic was a tough financial time for employers. To alleviate a portion of the financial burden, the government passed the Employee Retention Tax Credit (ERC). The ERC allows employers to claim a refund for qualifying wages and healthcare costs paid during 2020 and 2021. Despite good intentions, the IRS has uncovered high levels of fraud in credit claims, noting billions of dollars fraudulently paid out. As a result, the IRS is increasing audit efforts, meaning your claim might be investigated further. Here are seven reasons why your ERC tax credit might be flagged by the IRS.

#1: Claiming Too Many Quarters

The first factor that raises IRS suspicion is claiming too many quarters. Certain ERC promoters encouraged business owners to claim the credit for all available quarters. However, 2020 claims had different eligibility requirements compared to 2021 claims.

To be eligible to claim the credit in 2020, employers needed to have a 50% decline in gross receipts from the same quarter in 2019 or sustained full or partial suspension of operations due to government orders. The credit qualifications were more lenient in 2021, with only a 20% decline in gross receipts required. Businesses that claimed all quarters are more likely to be on the IRS’ radar.

#2: Incorrect ERC Tax Credit Claim Calculations

ERC claims that obvious errors in the calculation will more likely than not be flagged by the IRS. For example, 70% of qualifying wages up to $10,000 were eligible for the credit per employee in 2021. However, 2020 ERC tax credit claims are limited to only 50% of qualifying wages up to $10,000 per employee.

If your 2020 credit claim applies 70% of qualifying wages toward the credit computation, your claim will be flagged. Obvious misstatements, like incorrectly footed line items, can also increase your audit risk.

#3: Citing Supply Chain Issues as Qualifying Factor

Another factor that can raise red flags at the IRS and flag your ERC tax credit is citing supply chain issues as a qualifying factor. To use the government order qualification to claim the credit, operations needed to be impacted. An impact on your industry’s supply chain but no direct negative correlation to your business from government orders means your business is ineligible for the credit.

Businesses that substantiate their credit claim based on communications from the Occupational Safety and Health Administration will be flagged. Additionally, if you voluntarily suspended your operations, that does not qualify under the government order requirement.

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#4: Overclaiming the ERC Tax Credit

Businesses can only use wages for ERC tax credit claims during periods of suspended operations. If your business claims the ERC using wages for an entire quarter, the IRS may investigate you for overclaiming the credit.

For example, if your business had to shut down operations mid-quarter due to government restrictions, wages paid from the date of the shutdown to the end of the quarter would be qualifying. Wages paid prior to the shutdown order are ineligible. The same is true for healthcare costs.

#5: Neglecting to Factor in PPP Loans

Another pandemic tax break passed for business owners came in the form of Paycheck Protection Program Loan forgiveness. To be eligible for forgiveness, your business needed to use qualifying wages. The IRS does not allow business owners to double dip on wages used for PPP Loan forgiveness and claim the ERC.

Let’s say that your employee had $5,000 of qualifying wages for a quarter in 2021. When you submitted PPP Loan forgiveness, you used $1,500 of these wages. These wages must be subtracted out when claiming your ERC, meaning the qualifying wages for the quarter would only be $3,500.

Businesses that neglected to subtract out wages used for PPP loan forgiveness increase their risk of being flagged by the IRS. You should have clear documentation of the wages used for PPP Loan forgiveness and the ones used to claim the ERC tax credit.

#6: Misreporting Tax Return Items

The ERC tax credit isn’t necessarily “free” money. Instead, the IRS requires employers to reduce wages by the amounts used to claim the ERC in the year the credit is claimed. This means if you used $50,000 of employee wages in 2021 to claim the ERC, you would need to reduce the wages reported on your tax return by $50,000.

The reduction of wages increases your taxable income. However, when you receive your ERC refunds, the amounts are tax-free. This stipulation may require you to go back and amend previously filed tax returns. If the IRS does not see any reduction of wages on your filed tax return, your ERC claim might be flagged for review.

#7: No Wages Paid

A less common reason that your ERC tax credit claim might be audited is if the IRS doesn’t have any record of you paying wages for the period the ERC is claimed. For example, if you used $20,000 of wages to claim the ERC, but there is no money paid in for Federal withholding or FICA taxes, the IRS may flag your claim.

Additionally, if you file an amended 941-X to claim the credit, but the original 941 is not on file with the IRS, your claim could also be audited. Ensuring all payroll forms are filed with the IRS is the easiest way to eliminate the risk of this audit claim. If the IRS finds out that the wages were fictitious, you could face severe penalties, fines, and other legal implications.

Handling IRS Letters

In December 2023, the IRS reported sending out over 20,000 letters disallowing ERC tax credit claims. With more agents being trained in ERC auditing, the number of disallowances is expected to increase. Even if your business has an accurate ERC claim, you may receive a letter from the IRS requesting more information.

This makes it important to take a proactive approach. For one, be sure you have supporting documentation for your claim ready to go. This includes payroll reports, healthcare costs, and how you determined your eligibility. The IRS will request some type of timely response, so be sure you respond to any correspondence right away.

Bolstering your ERC claim can also be done with the help of a tax accounting professional. They can correspond with the IRS on your behalf and ensure that all documentation is submitted timely. Contact our tax professionals at KDG to help you get started!

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Michele is an accomplished Accountant, bringing a wealth of knowledge and expertise to her current CPA role at KDG. Experienced in Sage Products, Tax Preparation, GAAP, Financial Accounting and Managerial Accounting. Michele has spent her career overseeing tax preparation and accounting services at a multitude of organizations, even owning her own successful CPA firm.

Want to learn more? Book a meeting with us today!

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