False Employee Retention Credit Claims Can Mean Big Problems Later

by | Apr 4, 2023 | Uncategorized

If you are a business person relaxing at home after a long day’s work, watching TV and a commercial comes on claiming you can get a tax refund of thousands of dollars by filing for the Employee Retention Credit (ERC), it gets your attention, right? What those ads fail to mention is you must meet certain stringent qualifications to be eligible for the credit.

The IRS has issued several warnings urging people to carefully review the Employee Retention Credit (ERC) guidelines before trying to claim the credit as promoters continue pushing ineligible people to file.

The ERC is a refundable tax credit designed for businesses who continued paying employees while shut down due to the COVID-19 pandemic or who had significant declines in gross receipts from March 13, 2020, to Dec. 31, 2021. Eligible taxpayers can claim the ERC on an original or amended employment tax return for a period within those dates.

The credit amount for 2020 is 50% of qualified wages, up to a maximum wage of $10,000 per employee. Thus, $5,000 is the maximum credit for qualified wages paid for any employee for 2020. The 2021 credit is 70% of qualified wages, up to a maximum wage of $10,000 per employee per quarter. Thus, the per-employee maximum per quarter is $7,000 for each of quarters 1, 2 and 3 in 2021. A separate rule applies only for “recovery start-up businesses” in the 4th quarter of 2021.

To be eligible for the ERC, employers must have had one or a combination of the following three occurrences:

  1. Business Operations Curtailed – Sustained a full or partial suspension of operations due to orders from an appropriate governmental authority limiting commerce, travel or group meetings due to COVID-19 during 2020 or the first three quarters of 2021,
  2. Significant Decline in Gross Receipts,
    – For 2020, employers that have gross receipts that are less than 50% of their gross receipts for the same quarter in 2019 are also eligible. The significant decline in gross receipts ends with the first calendar quarter that follows the first calendar quarter for which the employer’s 2020 gross receipts for the quarter are greater than 80% of its gross receipts for the same calendar quarter during 2019. This cutoff of eligibility upon return to 80% of a comparable 2019 quarter’s gross receipts is removed for 2021,
    – For 2021, a significant decline is defined as gross receipts being 80% or less than the gross receipts for the same calendar quarter in 2019 (i.e., there’s a 20% decline in gross receipts). The employer has the option to elect to satisfy the gross receipts test by using the immediately preceding calendar quarter and comparing that quarter to the corresponding quarter in 2019. If an employer was not in existence as of the beginning of the same calendar quarter in calendar year 2019, substitute ‘2020’ for ‘2019’
  3. Qualified as a Recovery Startup Business for the third or fourth quarters of 2021.

The IRS and tax professionals continue to see third parties aggressively promoting these ERC schemes on TV, radio and online. These promoters charge large upfront fees or a fee that is contingent on the amount of the refund.

In fact here are a few issues that you should be aware of when amending payroll returns to claim the credit that promoters may not inform taxpayers about:

  • The wage deductions claimed on the business’ federal income tax return (partnership, S corporation or 1040 Schedule C) must be reduced by the amount of the credit.
  • That will generally also require amending the personal return since reducing the wages on the business return will increase profit or decrease loss that flows through to the personal return, generally causing an increase in the 1040 tax.
  • The ERC cannot be claimed for wages that were part of a PPP (Paycheck Protection Program) loan forgiveness.
  • For a self-employed person this could mean an increase in self-employment tax because the payroll expense deduction will be reduced.  

So, there is more to the process than just filing amended payroll tax Forms 941 to claim the credit; the business and personal income tax returns must also be amended.

Tax Trap For Those Amending For Employee Retention Credit

A vast number of employers have been amending their past payroll returns to claim the Employee Retention Credit (ERC). Some are valid claims, some are filed by abusive ERC mills while others are just fraudulent.  So here is where taxpayers can experience financial trouble. It is impossible to predict an outcome of an ERC audit, but here is the worst-case scenario step by step:  

  1. Promoter amends the business’s payroll filings for 2020 and/or 2021 to claim the ERC.
  2. The IRS refunds the ERC amount claimed.
  3. The promoter takes his cut, usually 30%.
  4. The preparer of the business return is engaged to amend the business returns to reduce the claimed wages by the amount of the credit, thus increasing the net profit or reducing a net loss that flows through to the business owner’s 2020 and/or 2021 individual returns.
  5. The preparer of the business owner’s individual returns is engaged to amend the 1040 returns for 2020 and/or 2021 and determine the additional tax resulting from the increased flow-through income from the business. The business owner of course pays that tax.
  6. At this point, the business has received 70% of the credit, and paid to have the business return amended. In addition, the business owner has paid to have the 1040 returns amended and paid the additional 1040 tax.
  7. Now the waiting game begins.
  8. The IRS generally has 5 years to audit a payroll tax filing. If the IRS audits the filings and reduces the credit, or worst case, disallows it altogether, the business will be required to repay a portion or all the credit plus interest. And, in most cases the business owner would have engaged a CPA or EA to deal with the audit.
  9. The promoter can’t be found to return his 30% cut.
  10. If the business owner wants to recover a portion of the tax paid with the prior amended 1040, the business returns need to be amended again and the wages increased by the amount of the credit that is disallowed in the audit. That reduces the net profit or increases the net loss that flows through to the business owner’s 2020 and/or 2021 individual returns.
  11. The business owner’s individual 1040 returns for 2020 and/or 2021 are again amended to determine the tax refund resulting from the reduced flow-through income from the business.  
  12. However, the statutory period for claiming refunds for individual returns is generally 3 years.  So if the IRS audits the payroll filings after the 1040 refund statute expires, the business owner won’t get the refund.

As you can see, those that claim the credit but are not qualified for it can end up with considerable financial liability.