Employee Retention Credit Risk

The Employee Retention Credit (ERC) program was originally established as part of the Coronavirus, Relief and Economic Security Act of 2020 to provide financial assistance to businesses in response to the pandemic.  The ERC was designed to provide government grant type assistance to qualifying employers in the form of refundable payroll for certain periods.  The qualifying periods for the ERC were 2020 and 2021.  While most businesses applied for and received these funds primarily during 2022, some received their money in 2023, which makes the funds received a 2023 financial statement and tax reporting issue.

While previously, the IRS processed the ERC almost without exception, in 2022 the IRS began to question the validity of the credits being processed and began to inspect submitted applications with more scrutiny. This scrutiny resulted in an increased number of rejected applications.  These days, attorneys that work on defending ERC claims agree that claims filed for Q3 2021 will most likely not qualify for credit. Therefore, for companies that received ERC funds in 2023 for this specific period management needs to evaluate the potential risks associated with recognizing the credit as income.

From an accounting standpoint, an ERC credit cannot be recognized as income until either the barrier of eligibility is substantially met, or the statute of limitations expires and the recipient is no longer required to return the funds. The criteria of “substantially met” is generally backed by a written legal opinion confirming a high probability (90% or more) that the ERC credit criteria have been satisfied.   The IRS can challenge the ERC credit prior to the statute of limitation expiration dates, as follows:  April 15, 2024 for 2020 ERC claims, and April21, 2025 for 2021 ERC claims.  However, the IRS adopted a five-year statute of limitations for all Q3 2021 claims.

If, after having received the ERC credit, management believes that an ERC claim has been mistakenly filed and returns the funds to the IRS, no punitive penalty will be imposed on for the incorrect filing.  However, if the ERC funds received are not returned and the IRS finds the claim erroneous, the IRS may assess an accuracy penalty from 25% to 75% of the claim value.  For example, if the IRS determined that the recipient’s claim for $1,000,000 was erroneous, the total payback could be between$1,250,000 to $1,750,000.

Therefore, from a risk mitigation standpoint, it is essential for management to review the sufficiency of its internal documentation related to the ERC claim to ensure a good faith effort to comply with the ERC filing requirements.  This would mean not only retaining the documentation provided by the accounting or consulting firm that processed the ERC claim, but also giving consideration to obtaining a legal opinion to determine whether substantive authority for the ERC claim exists.

If, after performing this analysis, management believes substantive authority has not been met, then rather than recognize the ERC credit in income, management could elect to record the ERC credit as a liability and wait for the statute of limitations period to expire.   You need to engage with legal counsel and senior management to properly assess your risk and establish a viable contingency plan in the event of an IRS audit.

If after performing an in-depth analysis of the ERC credit, management determines they were ineligible, the IRS currently has a program whereby they will only require an 80% return of the improperly filed claim without penalty.  Recipients have until March 22, 2024 to apply for this program, which is done through the submission of IRS Form 15434.

The recognition of the ERC credit is a complex matter which requires that adequate analysis and research be done to mitigate risk, and the possibility of loss from any potential IRS adverse determinations.

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