The IRS is cracking down on a popular small business tax break that could lead to a costly audit

A cottage industry of specialist firms has sprung up to help business owners claim the Employee Retention Credit (ERC), a governmental tax incentive intended for companies stressed by the pandemic. But businesses need to be careful not to get hoodwinked. 

There are strict eligibility requirements for the ERC — one way it can be claimed is for wages paid during pandemic periods when gross receipts declined — and many owners may not really understand the criteria. This means they could inadvertently gloss over the opportunity and lose out on credit of up to $26,000 per employee. Or, they could easily be duped by dodgy providers into improperly seeking money they aren’t entitled to — with a hefty fee attached, of course — and likely ramifications down the road.

The problem is particularly pervasive given how easy it is to file for the credit and dupe small businesses in the process, said Donald N. Hoffman, a partner with Eisner Advisory Group. “Every business owner is getting dozens of emails and mail and being bombarded by television ads,” he said.

To be sure, the IRS warned business owners last October to be on the lookout for third parties promoting improper ERC claims. It renewed that warning in March of this year given what it said in a release “continue to be promoters who aggressively mislead people and businesses into thinking they can claim these credits.”

The IRS went so far as to add fraudulent claims involving the ERC to its annual “Dirty Dozen” list of tax scams. 

“The aggressive marketing of these credits is deeply troubling and a major concern,” said IRS Commissioner Danny Werfel in a release. “There are very specific guidelines around these pandemic-era credits; they are not available to just anyone.” 

These promotions may rely on inaccurate information about eligibility or how the credit is calculated, the IRS said. What’s more, some of these advertisements are designed to collect a taxpayer’s sensitive information, which is then used for identity theft purposes, the IRS said.

Here are important things owners need to know about the ERC to avoid issues, including in the worst-case scenario, an audit.

Start by understanding the basic ERC claim requirements

Start by knowing the basics so you can understand whether your business may qualify for a credit.

Eligible taxpayers can claim the ERC on an original or amended employment tax return for qualified wages paid between March 13, 2020, and Dec. 31, 2021, according to the IRS. Businesses can be eligible if they sustained a full or partial suspension of operations due to a pandemic-related government-ordered shutdown during applicable time periods. A business can also be eligible if it experienced a decline in gross receipts during the first three quarters of 2021, or a significant decline in gross receipts during 2020. Another way to be eligible is if the company qualified as a “recovery startup business” — a business started during the pandemic — for the third or fourth quarters of 2021.

Businesses can still be eligible for the credit if they received PPP loan forgiveness, which some owners may not realize, said Gina Perrone, a senior tax manager at accounting, tax and advisory firm Sax LLP. When the ERC was first created this was not allowed, but it was later revised. There are however, restrictions on double-dipping, which a tax professional can help ensure doesn’t happen.

Consult a CPA before signing with an ERC specialist

It’s very confusing for small businesses because of the various requirements, so it is advisable to consult with a CPA firm that is familiar with the ERC rules — even if a third party suggests the business automatically qualifies. There are many definitions and particulars that need to be sorted out to ensure that a business is, in fact, eligible. 

For instance, the definition of gross receipts for credit purposes is the one used by the Small Business Administration, and it refers to the figure reported on your tax return, Hoffman said.

Certainly, don’t sign an agreement with a third party before consulting with a trusted and reputable financial professional.

Learn to spot the ERC red flags to avoid an audit

Even though a provider may make it sound “super simple,” there are many complicated factors in determining eligibility, said Jenn McCabe, partner at accounting and consulting firm Armanino. Be wary of any firm that uses pressure tactics to encourage businesses to act quickly, she said. These firms sometimes charge hefty upfront fees or a fee that is contingent on the refund amount.

Another red flag is when a third party doesn’t ask for documentation to ensure a business owner qualifies, Perrone said. Businesses don’t have to provide that documentation to the IRS, but they should nonetheless ensure they are entitled to the credit to avoid costly headaches later on. If the business wasn’t really eligible, but received the credit and is later audited, it will owe the money back with penalties and interest, Perrone said. This can occur several years later, and meanwhile, the business has already paid the third party and is unlikely to recover those funds, Perrone said. 

To help avoid an audit, “make sure you can substantiate your claim and your eligibility requirements,” Perrone said.

If your business does qualify, next steps with tax return

Once the business ascertains it qualifies, the next step is to file Form 941-X, an amended quarterly payroll tax return, for each quarter for which the business seeks credit. For 2020, businesses have until April 15, 2024 to file; for 2021, they have until April 15, 2025, Perrone said. 

Businesses that file for the credit also need to amend their applicable tax returns to account for the additional income based on the year they qualified for the credit. “They cannot just report the income in the year they received the cash,” Hoffman said.

Also know that professional standards prohibit CPAs from charging contingency fees for preparing original or amended returns — a necessary step in receiving the credit.