IRS Increases Audits of Employee Retention Credits

The Employee Retention Credit (ERC) was established as part of pandemic relief measures to help businesses retain employees. The complexity of the rules, combined with aggressive marketing, led to many improper claims, prompting the Internal Revenue Service (IRS) to increase enforcement. The agency has initiated thousands of audits and hundreds of criminal investigations into potentially fraudulent claims.

In response to the volume of applications, the IRS implemented a moratorium on processing new ERC claims in September 2023. The agency partially lifted this pause in August 2024, resuming the processing of claims filed before the moratorium.

Identifying High-Risk ERC Claims

The IRS may flag a claim for an incorrect determination of eligibility. Businesses qualify through either a significant decline in gross receipts or a full or partial suspension of operations from a government order. For 2020, a gross receipts decline meant a drop of at least 50% in a calendar quarter compared to the same quarter in 2019. For 2021, the threshold was a decline of at least 20% compared to the same quarter in 2019.

A frequent mistake involves misinterpreting what constitutes a qualifying government order. To be eligible, a business must have been subject to a specific federal, state, or local directive that limited commerce, travel, or group meetings. A general recommendation or news report about pandemic-related restrictions does not meet this standard. The order must have directly resulted in more than a nominal portion of the business’s operations being suspended.

Businesses have also improperly claimed the credit based on supply chain disruptions. The rules for this are narrow, requiring proof that a supplier was unable to deliver critical goods because that supplier was subject to its own qualifying government shutdown order. General delays or increased costs in the supply chain are not sufficient grounds for eligibility.

Overstating qualified wages is another common error. Wages paid to majority owners (more than 50% ownership) and their relatives are not eligible for the credit. Additionally, businesses cannot claim the ERC for wages that were used to obtain Paycheck Protection Program (PPP) loan forgiveness. The rules for calculating qualified wages also differ between 2020 and 2021 and between large and small employers.

Documentation to Prepare for an Audit

To substantiate an ERC claim during an audit, a business must have complete records. The primary documents are the employment tax returns filed with the IRS, including the original Form 941 for each period and any amended returns, Form 941-X, used to retroactively claim the credit.

If eligibility was based on a decline in revenue, detailed worksheets showing the calculation are necessary. These records must compare gross receipts for the relevant quarter against the same quarter in 2019. The worksheets should be supported by financial documents, such as profit and loss statements, that verify the gross receipts figures.

For claims based on a suspension of operations, a business must have copies of the specific government orders that caused the shutdown. These documents must be the actual, dated mandates from a government authority. A business should also prepare a written explanation detailing how the directive impacted its ability to operate and to what extent.

Comprehensive payroll records are required to support the amount of qualified wages claimed. This includes reports for the credit periods showing gross wages paid to each employee. If qualified health plan expenses were included in the calculation, the business must have documentation like invoices or payment statements to prove these costs.

The IRS Audit Process

The IRS audit process for the ERC begins when a business receives an official notice in the mail, such as Letter 6612. This letter informs the taxpayer that their claim has been selected for review. It will specify the tax periods under examination and provide instructions and a response deadline.

Following the notice, the IRS will issue an Information Document Request (IDR), which is a formal request for the documents needed to verify the claim. A timely and complete response to the IDR helps the audit proceed smoothly.

An IRS examiner will review the submitted documentation to determine if the business met eligibility requirements and accurately calculated the credit. The examiner may contact the business or its representative with follow-up questions or for additional clarification.

After the examination, the IRS issues its findings. If the claim is valid, the business will receive a “no-change” letter closing the audit. If the claim is improper, the IRS will propose adjustments requiring the business to repay the credit with penalties and interest. The taxpayer has the right to appeal the decision.

Options for Correcting Improper Claims

For businesses that filed an ERC claim but have not yet received payment, the IRS offers a claim withdrawal process. This option allows a taxpayer to retract their entire claim for a tax period. The IRS will then treat the claim as if it were never filed, avoiding future penalties or interest. Specific instructions for submitting a withdrawal request are available on the IRS website.

If a business already received an improper ERC refund, one option was the ERC Voluntary Disclosure Program (ERC-VDP). The program, which closed to applications on November 22, 2024, allowed taxpayers to repay an improper credit at a discount while avoiding penalties. It was available for claims related to 2021 tax periods, and participants were required to repay 85% of the credit received.

To apply for the ERC-VDP, a business filed Form 15434. Eligibility required that the business was not under an employment tax audit, had not been notified of a disallowed credit, and was not under criminal investigation. Accepted applicants signed a closing agreement with the IRS, and installment agreements were considered on a case-by-case basis for those unable to pay at once.