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ERC And The Dangers Of An IRS Examination

  • August 22, 2023

Jessica Ledingham, J.D., LL.M.


I strive to alleviate stress by analyzing and clarifying the tax code.

The Basics of ERC

A recurring concept in the media is the Employee Retention Credit. The ERC is a refundable payroll tax credit that can be as high as $5,000 per employee in 2020, and even as high as $21,000 per employee in 2021. Employers qualify as an eligible employer under three circumstances: (i) Recovery Startup Businesses, (ii) employers that experienced a qualifying decline in quarterly gross receipts; or (iii) business operations suspended under governmental orders. Businesses have until April 15, 2024, to retroactively file to claim ERC for 2020 and 2021 and until April 15, 2025, for 2021. This is a very lucrative proposition; however, filing for the ERC should come with some precautions.

The Dangers Of An ERC Audit

First, the IRS listed the ERC as one of its top audit priorities. The IRS will have a team of specialists that focuses on auditing ERC claims for at least five more years. Although this is intimidating, this does not indicate that businesses should not rightfully claim the ERC, it means that they should only do so as educated consumers. An examination does not mean that the ERC claim was erroneous; however, it means that the organization must provide documentation to substantiate the claim. This includes computations, governmental orders, records used to calculate a “significant decline in gross receipts”, records of employees’ qualified wages, and an explanation of how the governmental orders affected the organization. The IRS has until April 2027 to audit the last two quarters of 2021 and proposes to increase the statute of limitations to audit all 2020 ERC claims until April 15, 2026.

The IRS requires tax return wage deductions in the year associated with the ERC claim to be reduced to avoid double benefits. Unfortunately, with the current statutes if an IRS disallowance of an ERC claim in year 4 or 5 of the IRS audit statute occurs then the taxpayer will have to pay back the credits and not be able to amend its tax returns (due to expired 3-year statutes) to reclaim the lost deductions. Hopefully, the IRS will proactively address this issue.

A Protective Refund Claim

In order to protect themselves taxpayers can file a protective claim for their 2020 and 2021 taxes. A protective claim is not in the Code or regulations; but rather established by US case law. See e.g., United States v. Kales, 314 U.S. 186, 194 (1941). Protective claims are filed to preserve the taxpayer’s right to claim a refund when the taxpayer’s right to the refund is contingent on future events and may not be determinable until after the statute of limitations expires. A valid protective claim need not state a particular dollar amount or demand an immediate refund; however, the claim must have a written component, must identify and describe the contingencies affecting the claim; must be sufficiently clear and definite to alert the Service as to the essential nature of the claim; and must identify a specific year or years for which a refund is sought. See, e.g., Kales, 314 U.S. at 194. It is important to file before statute of limitations for the refund runs.

An ERC examination is a great risk to business because they will have to pay penalties, interest, and possibly lose the ability to deduct wages. In order to preserve the opportunity to request a refund it is important that all businesses file a Protective Refund Claim. I strongly encourage all taxpayers that claimed the ERC to ask a tax professional about protecting them with a Protective Refund Claim.

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