What CPAs Need to Know About Employee Retention Credit Audits

As most CPAs already know, the Employee Retention Credit (ERC) is a federal payroll tax credit paid to businesses that were able to retain and pay employees during the COVID-19 pandemic. Think of it as a reward for keeping your employees during significant pandemic-related hardships.

However, because of the complicated nature of ERC rules and regulations as well as the proliferation of bad actors in the space (known as “ERC mills”) that are coercing vulnerable clients into taking improper positions, the Internal Revenue Service (IRS) intends to crack down on fraudulent ERC claims, including them in their annual “Dirty Dozen” list.

In July 2023, IRS Commissioner Danny Werfel spoke publicly about the increased scrutiny with which auditors will consider ERC claims. Fortunately, you don’t have to wait until the IRS initiates an audit and sends your client an IDR to prepare. Gathering the potentially required information for an audit during (or following) the application process can make the whole process easier.  An IDR from the IRS isn’t the end of the world; it simply means you need to provide more documentation. If you follow the guide below, you should be prepared before the letter ever gets to your mailbox.

It is important to note that the supporting information for an ERC claim, including eligibility substantiation, is not submitted (nor is required to be) with the IRS in tandem with the Form 941-X filing to claim ERC. Therefore, the IRS has to sift through the millions of filings using their own approach to detect improper claims or bad-faith actors. Note, an IRS inquiry or audit doesn’t necessarily mean your claim is automatically incorrect, but rather, is just being looked at more closely and may require the taxpayer to produce supporting information in order to substantiate the filing.

Download Sagemont Tax’s Practical Guide to Navigating an Employee Retention Credit Audit

Overview of the ERC Audit Process

We got our first look into the IRS’s ERC-specific audit process in December 2022 when it published a “training manual” for ERC auditors. Most tax practitioners, including our team at Sagemont Tax, noted there were no significant changes from previous ERC filing guidance.

The IRS also signaled they would use the same guidelines in its audits as employers and their advisers used to file for the ERC. It’s easier for everyone when filers and auditors navigate from the same road map.

The training manual and guidelines aren’t a complete picture of the ERC audit process, but they serve as a helpful guide to traverse the filing and audit process.

In this article, we’ll take a closer look at the audit process and cover some strategies for making a potential audit easier and more efficient.

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Common Triggers and Risk Factors for IRS Audits

If you file a poorly prepared or fraudulent ERC claim, there is a greater chance the IRS can flag it for audit.

The IRS uses several methods in selecting businesses for audit:

• Mathematical inaccuracies: The IRS has all of your originally filed returns on record (e.g., historical income tax and payroll tax returns). Therefore, the IRS is aware of the wages paid and revenue earned historically. If the numbers on the Form 941-X are not lining up with historical figures, there may be alarms rung.
• Industry: The IRS may pursue audits based on the industry or associations of an organization. Auditors may select a particular industry vertical because of industry-specific tax regulations or increased potential for fraudulent activity. For example, it’s a lot harder to prove a partial suspension of operations for a marketing firm that was able to function remotely as compared to a restaurant.
• ERC provider: An auditor may pursue all filings from ERC advisors with suspicious activity or past transgressions. The IRS has undoubtedly made clear its feelings about ERC mills.
• Random audits / computer screening: The IRS uses screening programs and computer algorithms to select random businesses for audit.

The ERC Audit Process Step-by-Step

The ERC audit process begins with an inquiry into an organization’s ERC claim, via the IDR; but don’t panic. The letter is simply a request for additional or clarifying evidence.

The IDR asks an employer to substantiate one or more of the “tests” required to prove eligibility during the application phase (i.e., governmental orders or a significant decline in gross receipts), which includes providing a handful of supporting documentation (e.g., tax returns, P&Ls, government orders in place, etc.).

After providing the information, the IDR or inquiry may be closed if the filing business can provide adequate evidence for its claim. However, at this point, the IRS may ask for further evidence (via another IDR) or pursue a complete examination.

A full audit may involve meetings to discuss qualifications and could take three to six months to conclude (or more). And the IRS doesn’t compensate companies for time lost to audit defense—no matter how successful—so preparation is a matter of fiscal responsibility.

Understanding the Documentation and Records Required for Audits

Since the ERC is a relatively new program and the number of completed ERC audits is so low, there are only a few examples available to study. Here are some examples of the language you might see on an ERC IDR:

• Documentation that the operations were fully or partially suspended due to orders from an appropriate government authority limiting commerce, travel, or group meetings (for commercial, social, religious, or other purposes) due to COVID-19;
• Documentation that the taxpayer experienced a significant decline in gross receipts during the calendar quarter for which the Employee Retention Credit was claimed; and
• Documentation to show how the Eligible Employer determined the amount of qualified wages and health plan expenses that the Eligible Employer allocated to wages (if applicable).

Here’s what Sagemont Tax CEO Kenneth Dettman, CPA, said on the Grow Money podcast:

“There is not much in terms of formal guidance or inferences we can take from documented audits, given the short history of the ERC program. There’s certainly no case law out there. Therefore, we must rely on anecdotal evidence based on what we hear from other providers. If you are audited, the IRS sends you something called an information document request, or IDR, which is their standard list of what they want you to provide and prove with respect to your claim. We are carefully watching the evolution of how that IDR is becoming more and more specific, particularly in regards to partial suspension.”

ERC IDRs typically ask for additional evidence as it pertains to:

• Governmental orders affecting your business during COVID-19;
• Significant decline in gross receipts (P&Ls, tax returns);
• Wage records / payroll register; and
• Allocable health plan expenses

How to Prepare for an Employee Retention Credit Audit

Here’s the good news: documenting your ERC application process can minimize your client’s chances of being audited and likely increase their chances of receiving the money they qualify for.

The ERC guidance provides a number of qualification tests an employer can meet in order to receive the credit. Since the ERC auditor training manual follows those same guidelines, simply tracking all relevant receipts and documentation referenced in the claim will give you a head-start in satisfying any potential inquiries.

The experts at Sagemont Tax recommend drafting a thorough eligibility report for your clients before filing for the ERC. This way, you are already prepared for the IDR if your client gets scrutinized.

Strategies for Mitigating Audit Risks

Seek proactive third-party legal guidance on your client’s filing, especially on ERC filings related to the “full or partial suspension of operations.”

Here’s another quote from Kenny’s Grow Money appearance that pertains to risk mitigation:

“Based on what we have seen to date, audits are happening but not on a large scale. The two primary areas of focus we’re hearing about are the partial suspension of operations reliance and large employer credits, which allows large companies to take the credit only on wages paid to people while they weren’t working. The latter credit has been subject to quite a bit of abuse, but we are hearing a lot of the auditors admit that this is new to them too. As these things are taking a while to evolve, we’re not really clear on what type of hard lines are going to be drawn.”

Consider reaching out to an ERC expert to review your client’s filing. Taking a second look at your ERC application with qualified legal and tax experts increases your chances of optimizing your clients’ benefits while decreasing their chances of encountering IRS penalties.

Wrapping Up ERC Audits

The consequences of a failed audit defense can be significant for you and your clients. But with careful preparation, diligent record keeping, and the help of qualified ERC advisors, you can successfully defend an audit of your client’s ERC claim.  Accordingly, we recommend undertaking the following:

• Prepare for the audit during the application phase;
• Revisit the qualifications tests and compile substantiating evidence;
• Prepare an eligibility statement;
• Collect and maintain all supporting documentation up-front;
• Stay up to date with changing ERC guidelines; and
• Address any income tax implications

Refer Your Clients to Someone You Can Trust

For CPAs with several ERC-eligible clients, Sagemont Tax offers a referral program.

ERC services should indisputably be provided by a firm composed of experienced, credentialed, and licensed tax, accounting, and legal professionals. This is why Referral Partners come to Sagemont Tax.

Sagemont Tax’s executive leadership team is composed of CPAs and/or attorneys with big firm experience (Big Four, Big Law, and Top 25 global consulting firms) with decades of experience in both advising taxpayers on complex tax transactions and tax positions, as well as representing clients in front of the IRS.

Can We Help You with Your Employee Retention Credit Claims?

The experts at Sagemont Tax are confident in their knowledge of the tax code and ERC rules. Contact one of our advisors today to see if they can help you and your clients claim their full ERC benefit while minimizing their audit risk.