5 IRS “Warning Signs” of an Improper ERC Claim

Oct 24

Warning sign on a road indicating caution for icy conditions ahead, symbolic of IRS warnings about Employee Retention Credit risks.

You might be one of the millions who have filed or intend to file an Employee Retention Credit (ERC) claim, drawn in by the substantial tax relief this credit offers. However, while the ERC gained popularity quickly and countless firms emerged to help businesses navigate the process, the IRS is now scrutinizing these claims more carefully. Recent IRS guidance highlights the growing number of improper claims, offering important insights on how to avoid errors and misinformation from aggressive ERC promoters. In this article, we’ll walk you through the IRS’s “warning signs” and common mistakes to ensure your ERC claim is accurate and compliant.

ERC Background

The ERC is a refundable tax credit designed to help eligible businesses and tax-exempt organizations retain employees during the Covid-19 pandemic. It was created to support businesses that either shut down due to the pandemic or experienced a significant drop in revenue in 2020 or 2021. With an estimated 3.5 million claims already processed by the IRS as of September 2023 and 1.4 million still pending as of June 2024, the ERC remains highly popular. The program will officially end in April 2025, when the final claims for 2021 wages must be submitted.

Due to the overwhelming volume of claims and widespread fraud driven by promoters encouraging ineligible filings for a fee, the IRS has tightened its review process. Many claims have been found to be improper, either from genuine mistakes or deliberate fraud. In response, the IRS introduced options for businesses to correct their filings, including withdrawing unprocessed claims and a voluntary disclosure program for those needing to repay improperly received credits. Recently, the IRS also issued key warning signs to help taxpayers avoid these pitfalls, which we’ll cover below.

Five newly announced warning signs of an incorrect ERC claim
(from IR-2024-198, July 26, 2024)

Essential Businesses Without Suspension in Operation or Decline in Revenue Are Not Eligible. Promoters convinced many essential businesses to claim the ERC when, in many instances, essential businesses weren’t eligible because their operations weren’t fully or even partially suspended by a qualifying government order. Modifications that didn’t affect an employer’s ability to operate, like requiring employees to wash hands or wear masks, doesn’t mean the business operations were suspended. The IRS urges essential businesses to review eligibility rules and examples related to government orders.

Visibility Comments: The government order may be at the local, state or federal level. Examples of governmental orders include:

An order from the city's mayor stating that all non-essential businesses must close for a specified time period;
A state's emergency proclamation that residents must shelter in place for a specified period, except for essential workers;
An order from a local official imposing a curfew on residents that impacted the operating hours of your trade or business for a specified time period;
An order from a local health department mandating a workplace closure for cleaning and disinfecting

Lack of Documentation of How a Government Order Fully/Partially Suspended Business Operations. Whether a business was fully or partially suspended depends on its specific situation. When asked for proof on how the government order suspended more than a nominal portion of their business operations, many businesses haven’t provided enough information to confirm eligibility.

Visibility Comments: Being subject to a Covid-19 governmental order alone is not enough to be eligible; you must be able to demonstrate that it also resulted in more than a nominal portion of your trade or business being suspended. The IRS considers "more than nominal" to be at least 10% of your business based on either the gross receipts from that part of the business or the total hours your employees spent working in that part of the business. Make sure you have records of the period you were shut down, records of the reduction in employee hours, financials showing the decrease in revenue, or any other records supporting this element.

Reporting Family Members’ Wages. If business owners claimed the ERC using wages paid to related individuals, those claims are likely for the wrong amount or ineligible. Wages paid to related individuals aren’t qualified wages for the ERC. This is an important one to watch out for. Generally, related individuals are the majority owner of the business and their:

Spouse.
Child or a descendant of a child.
Brother, sister, stepbrother or stepsister.
Father, mother or an ancestor of either.
Stepfather or stepmother.
Niece or nephew.
Aunt or uncle.
Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law or sister-in-law.
Household member, meaning an individual who, for the taxable year of the taxpayer, has the same principal place of abode as the taxpayer and is a member of the taxpayer’s household.

Using PPP Wages for ERC Claim. The U.S. Small Business Administration offered the Paycheck Protection Program (PPP), which provided SBA-backed loans that helped businesses keep their workforce employed during the pandemic. The PPP ended May 31, 2021, but borrowers could still apply for PPP loan forgiveness.

If SBA forgave the loan, businesses can’t claim the ERC on wages that they reported as payroll costs to get PPP loan forgiveness. Participating in the PPP affects the amount of qualified wages used to calculate the ERC. Payroll costs up to the amount SBA forgave aren’t eligible for ERC. Taxpayers can use the rest of their qualified wages to figure their credit. Make sure there is no double dipping.
Large Employers Claiming Wages for Active Employees. Special rules applied to large eligible employers, which are those that averaged (i) more than 100 full-time employees in 2019 and claimed ERC for 2020 tax periods, and/or (ii) more than 500 full-time employees in 2019 and claimed ERC for 2021 tax periods.

Large eligible employers can only claim wages paid to employees who were not providing services. Many large employers’ claims incorrectly included wages for employees who were providing services during these periods.

These recently issued “warning signs” are just the latest guidance to be published by the IRS regarding the ERC (see link below for previously issued signs of an incorrect ERC claim). However, this article provides just a high level summary, and the predominant recommendation by the IRS is for taxpayers to work with a trusted tax professional who understands the complex ERC rules and can help businesses recheck their claims and discuss next steps. This is especially important for those who used a promoter to file claims instead of a tax professional.

If your business plans to file a claim by the April 15, 2025 deadline related to wages paid in 2021 or if you have questions about the eligibility of a previously filed claim, Visibility can assist you with preparing your claim and ensuring accuracy and compliance with the eligibility requirements. Please click the link to set up a call today.