Employee Retention Credit Audits - Defending the ERC

On October 27, 2022, Newport Beach tax attorney Daniel Layton spoke as part of a panel on Employee Retention Credit (ERC) audit issues for the UCLA Tax Controversy Institute. An IRS representative on the panel confirmed the IRS was training over 300 employment tax examiners with an eye towards auditing and compliance issues with the ERC. In addition, the IRS issued a press release on October 19, 2022, warning of solicitations from companies potentially preparing improper ERC (or ERTC) claims, often for large fees or on contingency. Businesses that claimed the credit would be wise to prepare for a potential audit.

The IRS's Warning of Potentially Sketchy ERC Tax Credit Services and Claims

Because of the amount of the credit, how widespread it is available, and the need (and maybe dire in some cases) for relief, any business should be discerning when hiring a tax professional to help with the ERC. There are many companies that are qualified and providing honest services and some which may have popped up opportunistically. Even if you are entitled to the credit, a business should also be cautious to avoid opportunistically inflated fees.

Although certain professions have ethical considerations which prevent charging exorbitant fees, such as attorneys and CPAs, this doesn't apply to non-CPA or non-lawyer tax return preparers. Because of the limitations of its power to oversee tax practitioners, the IRS doesn't have an effective way to regulate fees charged by tax practitioners.

10.27 of Circular 230 (31 USC § 330) covers unconscionable and contingent fees. Paragraph (c)(1) defines a contingent fee as any fee based, in whole or in part, on whether or not a position taken on a return is sustained. But, in Ridgely v. Lew, 55 F.Supp. 3d 89 (D.D.C. 2014), the district court held that the IRS’s authority under Title 31 doesn’t each return preparers (including a CPA) who file refund claims when the original return has not yet been examined by the IRS. (This followed the Federal Circuit case of Loving v. IRS that same year.)

Paying a lot for preparation fees does not necessarily provide additional protection from the IRS. In fact, there is some chance that the IRS use the exorbitant fees against you, arguing that a taxpayer should have been on notice as to the tax preparer's incentive to file an illegitimate claim when the the preparer is being paid so much. (See Canal Corp. v. Comm’r, 135 T.C. 161 (2010): “The Court doubts that any firm would have had such a cavalier approach if the firm was being compensated solely for time devoted to rendering the opinion.”)

ERC Audits Expanding to Income Tax Audits and Vice Versa

One concern that has been raised is the potential for an ERC audit to trigger a tax return audit due to the crossover in the "Gross Receipts" part of the qualification test. Businesses in a regular tax examination are regularly subject to Form 941 expansion is an auditor sees an employee compensation issue. There is no reason to believe, at this time, that the IRS won't expand from a 941 audit to an 1120, 1040, or partnership return audit if a gross receipts understatement issue is identified which may affect income tax.

1099 to W-2 or Employee to Independent Contractor Audits from the ERC

Due to incentives from the pandemic relief, many employers may have transitioned independent contractors from 1099 to W-2. From experience, transitioning back from W-2 to 1099 will cause a business to get attention from the government, the California EDD if not the IRS. With the EDD and IRS leaning towards W-2 classification as a default, a strong defense will have to be mounted even where the business has good reasons for the changes.

Posted on 10/28/2022 by Daniel Layton.