CareNotes

Top 5 IRS Red Flags for Employee Retention Credit Audit Selection

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This is a guest article by Maxwell Burns, CPA, the managing director at EZ-ERC, an OHCA business partner. EZ-ERC will be exhibiting at the OHCA Annual Convention next week at booth 817.

Based on EZ-ERC’s 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 IRS auditor or a computer-generated algorithm to raise a red flag on an organization’s ERC filing.

It is important to note 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 the 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 an organization’s filings can flag a 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 an organization (and its CPA and attorney). Minimize a lot of red flags by working with knowledgeable legal and tax professionals who prepare the filings correctly as well as maintain detailed records of the filings. Investing in and working with a reputable advisor can save time, money, and worry. Most importantly, it is vital to have all substantiation ready should a filing come under scrutiny by the IRS. The further the time that elapses since the filing, the harder it may be to collect the information that was relied upon originally.

Here are some of the ERC red flags experts see the most often:

1. Employee Retention Credit Red Flags

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 an ERC application to screen for mistakes and potential red flags. Especially since the IRS has signaled an increased commitment to fighting ERC fraud.

2. Mathematical Inaccuracies

There are a lot of numbers on tax documents. It’s easy to switch one or miscalculate another, but keep in mind the IRS has all 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 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 can be raised.

Reviewing the employee retention credit application (941-X) and keeping documentation of the calculation is imperative.

3. Company Status

One of the first things an IRS can check to see is if a company is real and registered. Is there a Tax ID (Employee Identification Number or “EIN”)? Are the taxes up to date?

To avoid triggering an audit at this initial stage, ensure the basics of the 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.

4. Specific Red Flag Industries

IRS auditors can 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, marketing firms, technology businesses, and other similar industries where workers can do their jobs and provide services remotely.

That’s not to say accounting firms (and other industries noted above) 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 test. Firms in “red flag” industries should be able to provide detailed evidence for their claim if requested by the IRS. Experienced CPAs and tax attorneys will have a working knowledge of these industries and the intricacies of ERC eligibility regulations.

5. Failure to Amend Income Tax Returns

According to the IRS, an employer receiving an ERC refund does not include the credit into gross income for federal income tax purposes. However, the amount of ERC claimed should reduce the payroll 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, view this resource here.