Based on our understanding, the IRS uses several methods to select Employee Retention Credit (ERC) applications for audit and, in some cases, random selection. Suspicious conditions can also cause an auditor or a computer-generated algorithm to raise a red flag on your filing.
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 941-X filing to claim ERC. Therefore, the IRS has to sift through the millions of filings using its own approach to detecting improper claims or bad-faith actors. 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.
It would be impossible for IRS auditors to investigate every claim filed, so the IRS has created selection criteria for audit selection — the full set of which has not been released to the public. However, inconsistencies across your filings can flag your return in a computer screening or cause an auditor to dig deeper. The IRS has repeatedly issued warnings on improper ERC claims and ineligible positions and will be examining ERC filings for several years to come.
Proactive planning can save months—even years—for you (and your CPA and attorney). You can minimize most red flags by working with knowledgeable legal and tax professionals to keep detailed records and double-check your filings. Investing in and working with a reputable advisor can save you time, money, and worry. Most importantly, it is vital to have all of your substantiation ready should your filing come under scrutiny by the IRS. The further the time that elapses since your filing, the harder it may be to collect the information you relied upon originally.
Qualifying for ERC funds doesn’t exempt a business from an audit. Even well-intentioned filers can be audited, and good-faith claims can contain mistakes.
That’s why it’s crucial to go over every detail of your ERC application to screen for mistakes and potential red flags. Especially since the IRS has signaled an increased commitment to fighting ERC fraud.
Here are some of the ERC red flags our experts see most often:
There are a lot of numbers on your tax documents. It’s easy to switch one or miscalculate another. But keep in mind that the IRS has all of your originally filed returns on record (e.g., 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 do not line up with historical figures, alarm bells may ring.
If, for example, the wages on Form 941-X that a taxpayer is claiming ERC on are overly inflated as compared to the wages originally reported on the payroll tax returns, a red flag will be raised.
Reviewing your employee retention credit application (941-x) and keeping documentation of your calculation is imperative.
One of the first things an IRS can check to see is if your company is real and registered. Do you have a Tax ID (Employee Identification Number “EIN”)? Are your taxes up to date?
To avoid triggering an audit at this initial stage, ensure the basics of your paperwork are in order. Typos and miscalculations may have consequences with the IRS. Investigators may not assume every typo is a bad-faith application, but they can take a closer look if basic information is not aligning or if EINs are not registered.
IRS auditors often hone in on industries with more risk for fraud or higher instances of suspicious filings. As it concerns the employee retention credit, auditors may look closer at sectors less affected by COVID-19-related shutdowns or social distancing orders, such as businesses without a brick-and-mortar presence or that don’t require in-person activity to maintain business activities.
Some of these industries include accounting firms, law firms, tech businesses, and other similar industries where workers can do their jobs and provide services from home.
That’s not to say accounting firms are disqualified from filing for the ERC under the substantial decline in revenue test. They simply have to make a compelling case if claiming ERC under the full or partial suspension of operations rules. Firms in “red flag” industries should provide detailed evidence for their claim. Experienced CPAs and tax attorneys will have a working knowledge of these industries and the intricacies of ERC eligibility regulations.
According to the IRS, an employer receiving an ERC refund does not include the credit in gross income for federal income tax purposes. However, the amount of ERC claimed should reduce the expenses that an eligible employer could otherwise deduct on its federal income tax return, which, in effect, may result in an increase in federal taxable income. An easy check for the IRS is to see if a taxpayer who received ERC went back and amended their income tax returns for 2020/2021 as a result of the ERC. Taxpayers who fail to remit any back taxes owed as a result may be first in line for an audit. For information about how to account for the ERC following receipt of the funds, please check our helpful article here.
Whether trying to minimize red flags on your ERC claim or defend an ERC audit, diligent documentation and accurate records to support your ERC claim are crucial. Maintaining records increases your chances of a successful claim and a successful audit defense.
Finding expert guidance from CPAs and tax attorneys who stay up-to-date on ERC guidelines is just as critical. An experienced team can help mitigate audit risk and ensure compliance.
Sagemont Tax combines decades of first-in-class, discerning tax advisory experience gained at highly reputable firms such as Deloitte, KPMG, RSM, and Alvarez & Marsal, with legal support from some of the largest, most sophisticated law firms in the world to deliver ERC advisory services that are unparalleled in the complex ERC service industry.
Where many ERC providers offer a one-size-fits-all approach, Sagemont Tax’s experts tailor their service to the needs of each client, whether they’re small, high-net-worth, or institutionally owned businesses.
The experts at Sagemont Tax are confident in their knowledge of the tax code and employee retention credit regulations. Contact one of our advisors today to see if they can help you and your clients optimize their ERC benefit while minimizing their audit risk.