IRS ERC Audit Risk Guide: Statute of Limitations, Penalties & More!

Although employee retention tax credits (ERTC) were designed to encourage businesses to retain their employees during COVID-19 pandemic and were a much-needed intervention, many businesses are now facing potential ERC IRS audits.

So, do you really understand the ERTC well enough to handle an audit?

And what do you do when faced with an ERC audit?

That’s where we come in.

Firstly, will the ERC be audited?

Yes, the ERC tax credit could be audited. The IRS may conduct an ERC audit to verify that an employer has accurately calculated and claimed the credit in accordance with the provisions of the CARES Act and subsequent legislation.

However, claiming the ERTC does not automatically trigger an audit.

Instead, the IRS may carry out ERC tax credit audits if they suspect businesses have made errors or misrepresentations in their claims, including if they're suspected of fraud or noncompliance.

An ERTC audit may also be triggered by: 

• Incorrect or incomplete information reported on your tax returns, such as the Form 941 or Form 8974. 
• Inconsistencies or discrepancies between your claimed ERTC amount and other financial or tax-related information—payroll records, financial statements, and tax filings.
• Excessive or unreasonable ERTC claims that aren't supported by the eligible wages, number of employees, and other qualifying criteria states in the CARES Act.
• Prior non-compliance with tax laws or regulations, which may increase the likelihood of an ERTC audit.

Employers should maintain accurate and detailed records to support their ERTC claims and be prepared to provide documentation and respond to any inquiries from the IRS during an audit.

Businesses should take care to ensure that they are accurately calculating the credit and meeting the eligibility requirements. Any errors or discrepancies in their ERTC claim may increase the risk of an audit.

Interaction between the ERTC and the IRS

Employers must report the ERTC on Form 941, the quarterly payroll tax return. These forms are reviewed by the IRS to ensure businesses are claiming the credit accurately and meeting the eligibility requirements. 

The IRS has also provided guidance on the ERTC and updates the guidelines regularly. Businesses are responsible for understanding and following these guidelines to ensure they are eligible for the credit.

In addition, the IRS may request additional documentation to verify eligibility:

• Financial statements
• Payroll records 
• Invoices
• Receipts

These documents are used to verify that you've experienced a significant decline in gross receipts or that you were subject to a government shutdown order. 

You should also be aware of “qualified wages”, which are wages paid to employees during the applicable period. The applicable period is the period from March 13, 2023, to December 31, 2023, with the definition of qualified wages varying depending on the business size: 

• 500 or less employees: All wages paid during the applicable period qualify. 
• More than 500 employees: Only wages paid to employees who aren't providing services qualify.

Additionally, the ERTC can be used in conjunction with other relief programs, such as the Paycheck Protection Program (PPP) and the Shuttered Venue Operators Grant (SVOG). 

However, there are certain restrictions on how the ERTC can be used in combination with these programs. For example, a business cannot claim the ERTC for wages that were paid using PPP loan proceeds that were forgiven.

To claim the ERTC, a business must maintain documentation to support the credit, including records of the number of employees and their wages.

Keep these documents for at least 4 years after the date the tax becomes due or is paid, whichever is later.

(Additional reading: is the employee retention credit taxable income?)

What are the chances of an ERC audit?

The chances of an ERC audit depend on various factors, including your business's eligibility, how you calculated the credit, and the documentation you have to support your claim. The key to avoid an audit is to ensure your claim is legitimate and that all your tax affairs are in order.

Let's look at audit prevention in more detail to give you some steps to follow...

How to prevent IRS ERC audits: Reducing ERC audit risk

Unfortunately, there’s no full-proof method of avoiding IRS ERC audits.

However, we recommend you do these things to lower ERC audit risk:

1. Review the IRS guidelines

While this might sound the most obvious thing to do, you’ll be surprised at how many people don’t check the most recent IRS guidelines.

They’re updated regularly, but I totally understand that you either don’t have the time to check them or need more clarification on what exactly the guidelines mean.

Nevertheless, just a glance through them might trigger you to question whether you’re compliant or not.

2. Use a reputable tax professional

Working with a reputable tax professional, like the team here at Brotman Law, ensures you’re accurately claiming the credit and meeting the eligibility requirements, which are two big factors for being flagged for an employee retention credit audit.

In addition, we can also help businesses navigate any potential ERTC audits or IRS requests for documentation.

3. Document ERTC calculations

Having all documentation to hand may just prevent them from needing to complete a full ERC tax credit audit. 

And, even if an audit still occurs, the documentation will help clarify any inconsistencies and ensure the process is less painful than it needs to be.

4. Double-check ERTC calculations

As a responsible person in your business, you should double-check ERTC calculations to ensure their accuracy. Any errors or discrepancies in their claim may increase the risk of an audit.

5. Respond to any IRS requests promptly

If the IRS requests additional documentation to verify your ERTC claim, respond promptly and provide the requested documentation. Delaying or ignoring an IRS request could significantly increase the risk of an audit.

ERC Statute of limitations: What is the ERC audit period?

The ERTC statute of limitations is 3 years from the date the tax return was filed or the due date of the return, whichever is later.

However, if you've filed an amended return, the ERC audit statute of limitations starts from the amended return file date.

On top of that, the statute of limitations for auditing the ERC depends on various factors:

• Type of tax return filed
• Whether you’ve filed an amended return
• Audit circumstances

If fraud or intentional misrepresentation is suspected, the IRS can audit the business at any time, regardless of any statute of limitations.

How do I prepare for an ERC Audit?

To prepare for an ERC audit, take the following steps:

1. Review the notification letter

The IRS will typically send a notification letter to inform you that your business will be audited.

The letter will provide details on the scope of the audit, the IRS contact person, and the timeframe.

Review the letter carefully and take note of any deadlines or requirements.

2. Gather all relevant documents

Ensure all relevant documents related to the ERC are in order, such as payroll records, tax returns, and other supporting documentation.

You'll need these to respond to the IRS's requests and to demonstrate that the business is eligible for the credit.

Here are some tips on how to maintain your documents in case of an IRS audit:

• Organized records: Keep your tax-related documents organized and easily accessible. Consider using a spreadsheet or software program to help organize your records. 
• Proof of deductions: If you claim deductions on your tax return, make sure you have the proper supporting documentation. This includes receipts for charitable donations, medical expenses, and business expenses. 
• Employment records: Keep detailed records of your employees' wages, taxes withheld, and benefits provided. This includes payroll records, W-2 forms, and other employment-related documents. 
• Communication records: Retain any communication with the IRS, including letters, emails, and phone calls. This will help you keep track of any requests for information or other correspondence related to the audit. 

Remember that the burden of proof is on you, the taxpayer, to provide documentation to support your tax return filings.

By maintaining organized and accurate records, you can help make the audit process go more smoothly and increase your chances of a favorable outcome.

3. Cooperate with the IRS

It’s really essential that you fully cooperate with the IRS and provide all requested information promptly.

Failure to cooperate with the IRS can result in penalties and additional scrutiny (more on penalties coming up!)

4. Appeal the decision, if necessary

You may have the right to appeal the decision through the IRS's appeals process or through litigation in court.

However, this can be lengthy and may require additional time, cost and effort on your part. Naturally, this can be worth it.

With the above in mind, you really need to be aware of the employee retention credit scams around, which coax you into either giving sensitive information or pretending that you're eligible for an ERC claim when you aren't!

Is ERC subject to single audit?

The ERC isn't subject to Single Audit. Single audits, also known as Uniform Guidance audits, are specific types of audits required for entities that expend federal awards, grants, or financial assistance from the U.S. federal government. The ERC is a federal tax credit, NOT one of these.

ERC audit penalty guidance: 

An ERC audit penalty can result in additional tax liabilities, interest charges, and potential legal consequences:

• Underpayment of taxes: Businesses may be required to pay back the erroneously claimed ERC amount, resulting in additional tax liabilities.
• Accuracy-related penalties: In cases where the IRS deems that the errors were due to negligence, disregard of tax rules, or substantial understatement of income, accuracy-related penalties may be imposed. These penalties are calculated as a percentage of the underpaid taxes.
• Interest charges: The IRS may assess interest charges on the underpaid taxes from the due date of the tax return until the date of payment.
• Potential legal consequences: In cases of intentional fraud or willful misconduct, businesses may face criminal charges, including fines and imprisonment.

What is the penalty for false ERC claims?

The penalty for false ERC claims is 20% of the excessive amount claimed. For example, if your ERC claim is $6,000 but, in actuality, your eligible amount was only $5,000, the excessive amount is $1,000 and your penalty is $200 (20% of $1,000).

In addition, the IRS may apply an "accuracy-related penalty if there is not a reasonable cause." Moreover, interest on any ERC penalty could be applied

Note that this penalty isn't specific to the ERC but is the IRS' general guidance on false credit claims.

Mitigating the Risk of ERC Audit Penalties:

To minimize the risk of ERC audit penalties, it's essential for businesses to:

• Maintain accurate documentation: Keep thorough records and documentation supporting the eligibility criteria for the ERC, including evidence of qualified wages and the impact of the COVID-19 pandemic on your business operations.
• Seek professional assistance: Consider working with experienced tax attorneys or tax professionals, such as Brotman Law, which specializes in ERC matters and can provide guidance and ensure compliance with IRS regulations.
• Conduct internal reviews: Regularly review and reconcile your ERC claims to identify any potential errors or inconsistencies proactively. This can help address issues before they become a cause for concern during an audit.

Key takeaways on an IRS ERC audit

There are undoubtedly certain things you can do to mitigate the chance of the IRS auditing your ERC claims.

However, this doesn’t guarantee that you’ll totally avoid the audit from occurring. And, even if you do get audited, all isn’t lost.

Keeping all calculations and documentation updated and to hand will greatly help you. And, if you’re still stuck, you can always get in touch with the team here at Brotman Law so we can see how we can help.