What You Might Not Know About the Employee Retention Credit

Executive Summary

• Aggressive marketing and direct solicitations of third party companies are using the “suspension” test to qualify for the Employee Retention Credit.
• Taxpayers may make improper evaluations, where guidance is complex and unclear.
• Contingent fees from certain companies are generally due before the credit is received, which may take six to eighteen months or longer.
• Amending prior year returns and/or filing Administrative Adjustment Requests (AARs) is required.
• Cumulative costs of ERC credit claims are not fully considered with respect to (1)claiming the credit (2) audit representation (3) audit failure.

K2N is receiving many inquiries relative to the Employee Retention Credit and the influx of marketing claims and direct solicitations which may be making aggressive claims and should give you some pause in order to address certain considerations that need to be taken into account when engaging these companies.  The IRS will be increasing examinations in this area and is warning taxpayers to take appropriate steps to avoid unnecessary risks. Many third party “credit firms” are utilizing publicly available information to determine your employee counts and Paycheck Protection Program (PPP) loans to estimate “maximum” potential credits without any analysis.

There are two primary tests that apply to most companies with respect to the ERC:

• Gross Receipts Decline (GRD) - revenues decreased by the applicable statutory percentage.
• Business Suspension Test  (BST) - government order or “more-than-nominal” business impact.

Which Test Should I Use?

GRD - All companies should consider analyzing whether or not they qualify under the GRD.  Generally this test is very straightforward and if your company was able to operate without interruption and you lost revenue, you can generally determine available credits by using the services from your books and records, PPP Forgiveness application, as well as from your payroll company.  Using a third party that bases its fees on contingency may not be the most economical option when claiming under GRD, especially if you have excellent substantiation for your claim.  For detailed information on the thresholds for each year, you should review the IRS page on ERC.

BST - If certain quarters do not qualify under GRD, you can consider the BST, but things can get tricky.  Two conditions must be met:

• You must be mandatorily subject to a government order in effect.
• A “more-than-nominal impact” impacted business operations due to “suspension” or “modification”.

It is important to be cautious with liberal interpretation of what would cause a company to be “subject to” a government order or experiencing a “more-than-nominal” impact.  Specialized knowledge may be necessary to make these determinations as well as what periods may be applicable.  The IRS has provided some guidance, but generally competent legal analysis should be sought when considering the BST and a full understanding of all potential costs.

Considering All Costs and Assessing Risks

While it is different for everyone, the potential amount for an ERC may be substantial even if you received wage-offsetting PPP funds.  However, costs and risks are not always fully considered before pulling the trigger.  Here are just a few questions you should ask and things to consider.

• How long has the third party credit company been in business?
• What is the level of audit protection offered?
• When is the contingency fee due and is it reversible if the credit does not survive audit?
• Are audit defense representation costs covered by the third party fee?
• Are penalties and interest related to erroneous claims and audit adjustment, including underpayments of payroll taxes which can be substantially covered by the third party fee?
• Have professional costs, penalties and interest related to amendments been considered as well as AARs for partnerships?
• Are there downstream amendment and AAR costs directly to owners of pass-through entities and tiered ownership structures?
• Taxes on the credit income is due prior to receiving the credit proceeds.
• What is the risk of not having available funds to repay the credit?
• Will statutes be in place to permit re-amendment should the Company not survive audit?

Amendments and AARs

When a company claims the ERC, the tax treatment of the credit is treated as a reduction in the amount of payroll tax deduction claimed by the filer and as a result tied to the year with which the credit is associated.  Presently the IRS requires amendments to either or both 2020 and 2021 tax years.  AARs impact partnership filings subject to the Centralized Partnership Audit Regime.  These are complicated and generally impact the year in which they are filed, while calculating the tax, interest and applicable penalty will be considered back to the impacted year.

Audit Failure Costs

The potential of not surviving always exists.  As listed above companies should evaluate not just refunding the credit and potential penalties, interest, defense and amendment costs, but timing risk also exists.  Congress extended the statute of limitation for assessment of payroll tax returns on which the ERC is claimed to five years (Sec. 3134(l)).  It is possible that an audit may occur while the statute of limitations for amending a return runs out.  As a result another unanticipated audit costs is having to be stuck with the additional tax paid on income created by claiming the credit in the first place.

Final Thoughts

All considerations mentioned above are important but we strongly advise that companies utilize any resources they can to make an informed decision and consider all risks and costs when using the BST test to justify an ERC claim.  In addition, not all guidance  may be final at the time of this writing or at the time of your claim, so it is important to stay current with changes in this area at the time of your analysis and through the statute of limitations period.