The last major federal COVID-related tax credit program, the Employee Retention Credit (ERC), is still open and providing benefits to employers affected due to disruptions during the COVID pandemic in 2020 and 2021. However, we have found business owners are frequently approached with questionable, sometimes fraudulent, claims made by third-party tax credit firms.

What is ERC? 

The employee retention credit (ERC) is a refundable payroll tax credit designed to help businesses affected during the COVID-19 pandemic by either a government shutdown order or a significant decline in gross receipts. You can read our previous blog post for more specific qualification information. 

Government Shutdown & Supply Chain Disruption

A business could be qualified for ERC even if it did not have a revenue decline. Qualification depends on the full or partial suspension of operations based on governmental orders to a business itself or its supply chain. An order must be from an applicable governmental authority (federal, state, county, or local) that has jurisdiction over the employer’s operations.

As referenced from IRS Notice 2021-20, “the declaration of a State of Emergency by a governmental authority is not sufficient to rise to the level of a governmental order. Further, such a declaration that limits commerce, travel, or group meetings, but does so in a manner that does not affect the employer’s operation of its trade or business does not rise to the level of a governmental order.”

Lutz has found that many third-party credit providers frequently ignore the exceptions to these rules, which can be the difference between qualifying and not qualifying.

More Than Nominal Impact

A full or partial shutdown or supply chain interruption must have disrupted more than a nominal portion of an employer’s business operations. More than nominal is defined as 10 percent of total gross receipts or 10 percent of total employee hours. The comparison period is the same calendar quarter compared to 2019 gross receipts or employee hours.

Qualified Wages

If qualified due to a governmental order, qualified wages are only wages paid during the shutdown period. This is different from revenue decline, which qualifies a business for the entire quarter.

Full or Partial Shutdown

To qualify for a full or partial suspension of operations, the business must have been subject to a government-mandated order. The most affected businesses are restaurants with indoor dining restrictions and healthcare facilities that perform elective surgeries.

Examples of government orders that may qualify:

• Limited hours of operations
• Limited working hours for employees subject to a curfew
• Limited indoor seating for restaurants
• Shutdown for periodic cleaning and disinfecting
• Limited use of physical space for employees who could not perform comparable duties, responsibilities, or services from home

Examples that do not qualify on their own include the following:

• Self-imposed restrictions that were not required due to a government order
• Work-from-home requirements for jobs that could be performed remotely
• Decreased profits due to a lack of demand or increased costs to comply with CDC recommendations
• Lack of customer demand as a result of stay-at-home orders
• Labor shortages or the inability to hire personnel to run the business as normal
• Requirements to wear masks or socially distance

Supply Chain Disruption

This provision shifts the burden to your supplier, subject to full or partial suspension due to government orders which did not allow your business to operate as usual. Please note that most manufacturers were deemed “essential” and were therefore exempt from most government orders.

Third-Party credit companies abuse this supply chain area of the ERC program the most. Supply chain issues in the United States have been obvious, but they don’t necessarily qualify your business for the ERC, as some may argue.

The business must meet all the following criteria to qualify for the ERC based on supply chain disruption:

• The supplier must have been unable to make deliveries of critical goods or materials due to a U.S. governmental order to suspend its operations fully or partially.
• The business could not procure these critical goods or materials from an alternatively affordable supplier.
• The goods or materials not available must be “critical.”
• The supply delays that caused the business to suspend certain operations must have caused more than a nominal impact to the business.

Some examples that do not qualify on their own include:

• Inability to timely receive products due to trucking issues
• Inability to timely receive products due to labor shortage issues
• Inability to receive products from a standard supplier, but the business was able to procure comparable products from an alternative supplier
• General business disruptions due to international supply chain issues

In an IRS memo released on July 21, 2023, the IRS further clarified its position that supply chain disruptions must be rooted in a government order that the supplier was subject to. Without such an order, the business cannot be qualified for ERC based on a supply chain disruption argument. Therefore, qualification for supply chain disruption is a narrow, infrequent reason for qualification. See the five scenarios the IRS laid out that further explain these rules.

ERC Complexities

There are a few complicated areas of the ERC program that deserve special attention when analyzing qualifications and calculating credits. It is important to work with a qualified professional who understands your business and how these rules apply.

Interaction with Other COVID Programs

There is no double dipping of qualified wages allowed among various COVID programs, most notably the first and second rounds of the SBA’s Paycheck Protection Program (PPP), SBA’s Restaurant Revitalization Fund (RRF), IRS’s FFCRA emergency paid sick and family leave, DHHS’s Provider Relief Funds (PRF), and other state programs. Although no double dipping is allowed, interaction among the programs is possible.

Lutz is an expert in each of these areas and provides comprehensive guidance when analyzing ERC. Be aware that third-party providers possibly only consider ERC, which could jeopardize other funding the business received.

Interaction with Commonly Owned Entities & Family Members

Aggregation and affiliation issues arise when individuals and certain relatives have majority ownership in various entities. Control groups, brother-sister organizations, parent subsidiaries, and affiliated service groups are some forms of aggregation that must be considered for the ERC.

Aggregated groups must analyze payroll on a combined basis to be considered for the credit. This is true for employee count to determine if the business is a large employer, revenue decline calculations, and determination of full or partial suspension of operations to the business or its supply chain. Government orders may have disrupted one business in an aggregated group, but the aggregated group will only qualify if it can prove that the shutdown affected more than a nominal portion of the entire aggregated group.

When it comes to calculating the credit, individuals (and attributed family members) that own more than 50 percent are disallowed from receiving credits on their wages.

Income Tax Interaction

When qualifying for the ERC based on revenue decline, revenue must be considered on the tax return basis of accounting, which may differ from what company management typically uses. Many businesses have differences in book/internal and tax revenues.

The ERC is treated like other payroll-related credit programs. Unlike tax-exempt income from PPP forgiveness, the expenses used for the ERC are disallowed deductions on income tax filings, meaning that ERC credits are taxable.

IRS guidance requires taxpayers to amend income tax filings in the year credits pertain to. For example, if a taxpayer files the ERC for 2020 and the income tax returns are already filed, the 2020 income tax filings must be amended to account for the increase in income.

Buyer Beware

ERC applications on Form 941-X don’t require up-front documentation, meaning the IRS pays out credits first and asks questions later during a potential audit. Many credit firms advertise aggressively and guarantee that businesses qualify while loosely interpreting IRS rules. These factors have led to many occurrences of abuse and fraudulent claims.

The government is targeting Paycheck Protection Program (PPP) and Economic Injury Disaster Loan (EIDL) fraud. The IRS has ERC audits on its radar and is providing a new way for people to make anonymous reports concerning third-party credit companies promoting improper ERC claims.

The American Institute of Certified Public Accountants (AICPA) has acknowledged widespread abuse of this program and has shared its thoughts on enforcement with the IRS. The IRS released this announcement on October 19, 2022, detailing widespread abuse. The July 21, 2023 memo further shows the IRS is aware of the abuse of the ERC program and will be allocating more resources towards rooting out fraudulent or inaccurate credit claims.

Extended Statute of Limitations

Payroll tax returns normally have a three-year statute of limitations. However, when making an ERC claim, the statute automatically extends to five years, meaning the IRS has more time to audit credit claims. Ultimately the taxpayer takes on the risk of the audit when working with third-party credit companies, even if they offer audit protection. Most firms do not sign the amended filings as a paid preparer, so it leaves the business exposed to penalties and interest should the IRS disallow the credit claim.

Contingent Fees

Be sure your ERC provider is working as a partner to your business instead of for its own benefit. The rules are complicated and require extensive knowledge of your business. If a third-party provider does not ask the right questions or consider the full picture, it may result in the wrong eligibility determination. Do not ever sign amended returns if you are uncertain about the reasoning for the qualification. Many times, credit companies only communicate with you through salespeople; it is important to understand qualifications directly from the CPA or legal team.

Most third-party credit companies operate on a contingent fee basis, meaning they charge more for their services the more credits they calculate. Most contingent fees range from 10 to 25 percent, meaning a business’s after-tax ERC benefit is 45 to 60 percent.

Lutz does not operate on a contingent fee basis, so we have your best interest in mind throughout the ERC consulting engagement and will be honest if we believe you do not qualify. We are not motivated to inflate your credit or disregard IRS rules.

Processing Timeline

The IRS has a large backlog of amended payroll tax returns that were delayed during COVID-19. It is currently taking 6-12 months to receive refunds from Form 941-X filings. If the quarterly claim is more than $200K, it requires manager approval resulting in even longer processing times.

If your business is still awaiting refunds and Lutz filed as paid preparer, do not use a separate credit company to file again. There are steps to determine where the filing is in the IRS queue.

Lutz Can Help 

Lutz has a team specialized in the ERC that has assisted hundreds of businesses in claiming credits. If you believe you may qualify or have been approached by firms offering to help you apply for the ERC, we recommend you contact us or reach out to your Lutz Representative before proceeding.