Note from editor: This blog post was written and published prior to the IRS guidance released September 2023. NATP recommends all tax professionals to refer to the IRS’ Employee Retention Credit Eligibility Checklist when determining if clients qualify for this complex credit.

The IRS is cracking down on ineligible businesses claiming the employee retention credit (ERC). In recent months, many Information Document Requests (IDRs) have been issued, requesting further information from business owners who claimed the ERC. As a tax preparer, if your clients have claimed the ERC, now is the time to ensure they have proper documentation in case the IRS comes knocking.

What is an ERC audit?

An ERC audit happens when the IRS decides to examine tax returns for businesses that have claimed the ERC. It means they’ll take a closer look at Forms 941 (Employer’s QUARTERLY Federal Tax Return, and Forms 944, Employer’s ANNUAL Federal Tax Return, filed in previous years, as well as the amended versions 941-X and 944-X. If your clients are selected for an audit, they will need to provide documentation of their eligibility to claim this tax credit.

Why is the IRS auditing ERC claims?

The IRS is auditing claims related to the ERC due to widespread abuse. The ERC is valued at up to $26,000 per employee, and some businesses claimed the credit even though they weren’t eligible. As a tax professional, you can review your clients’ claims and advise on necessary actions to prepare for possible audits.

How long does the IRS have to audit ERC claims?

The IRS has extended the statute of limitations on payroll tax returns for the last two quarters of 2021 from three to five years. The statute of limitations for most returns starts on the later of the due date or the date of filing. This extension allows the IRS until at least April 2027 to audit these returns.

What to expect from an ERC audit

First, your client will receive an Information Document Request (IDR) or audit notice from the IRS for their ERC claim. The IRS agent will request documentation to support the claim and will review the documentation to ensure compliance with eligibility requirements.

The audit can be conducted through correspondence, phone discussions, or in-person visits. Interviews may also be conducted to gather additional information. The IRS will also review your client’s recordkeeping practices.

The IRS will then inform the taxpayer of the audit results, which can include adjustments or acceptance of the claim. Taxpayers have the right to appeal the findings if they disagree.

How to prepare for an ERC audit

It’s always smart to be proactive, even if you don’t think there is a reason for the IRS to audit your clients’ businesses.

Questions to ask your clients to prepare for an ERC audit:

• Do they have the necessary calculations of the wages used for ERC?
• Did they identify a governmental order that limited the business’s commerce, travel or group meetings due to COVID-19?
• Did they determine whether the effect on the business was more than nominal?
• Did the ERC filing exclude Paycheck Protection Program (PPP) wages and qualifying wages for self-employed individuals, greater-than-50% owners and related individuals?

What documents do you need for an ERC audit?

• Proof of eligibility. Business owners must provide at least one of three different types of documentation. The first type shows a full or partial business cessation due to a COVID-19 order. The second type demonstrates a significant decline in revenue using quarterly income statements. The third type involves documentation for recovery startup businesses, including proof of business activity and average annualized gross receipts under $1 million.
• Proof of qualifying wages. The IRS can request copies of the filed Forms 941, computation worksheets, reconciliation documents for the ERC and associated adjustments on Forms 941-X, and state unemployment tax returns.
• Additional payroll details. For aggregated group businesses, the IRS requires related entity consolidated employment tax returns and W-2 forms to review and verify ERC claims and adjustments.
• COVID-19 government orders. Taxpayers claiming full or partial suspension will need to provide local and state COVID-19 government orders that impacted the business.

What if clients fail the ERC audit?

Failing an ERC audit can result in penalties and fees similar to other IRS audits. These include accuracy-related penalties, tax fraud penalties (civil and potentially criminal), and failure-to-pay penalties. Failing an ERC audit can lead to additional financial consequences. ERC credits can impact business income tax returns, and adjustments may be required, potentially affecting tax liabilities and penalties.

Be prepared with a trusted ERC provider

Tax professionals specializing in the ERC possess extensive knowledge of ERC guidelines, eligibility requirements and documentation criteria. If your clients have not yet claimed the ERC, advise them to choose a provider that properly factors eligibility, follows IRS notices and revenue procedures, and excludes PPP and other ineligible wages. The ERC provider should supply audit-ready substantiation packages that include proper documentation. Being prepared from the start will save you time and effort while maximizing your client’s chances of a successful outcome.

To learn more about preparing for an ERC audit, NATP is hosting a free webinar for all tax preparers on Aug. 25, 2023, or on demand.