How to Respond to an Employee Retention Credit Disallowance Letter From the IRS

 Posted on August 22, 2024 in Tax Audits

To help businesses address losses experienced due to the COVID-19 pandemic, the Employee Retention Credit (ERC) was available in 2020 and 2021. However, some businesses may have made incorrect ERC claims. In some cases, this has been due to aggressive marketing by tax preparation services that have claimed that the ERC is a grant or government stimulus. The IRS is taking steps to address the large number of claims that have been made, and businesses that have made incorrect claims may be required to repay the credits they have received.

Recently, the IRS announced that it is sending out "disallowance letters" to businesses that have filed ERC claims that are at a high risk of being incorrect. It will also be conducting tax audits of some businesses that have received ERC claims. Employers who have received these disallowance letters or who are concerned about potential penalties related to ERC claims may wish to consult with an attorney to determine their options for addressing these issues.

Reasons the IRS Might Disallow an ERC Claim

The IRS has detailed a number of warning signs that a taxpayer has submitted an incorrect ERC claim. The reasons that a claim may be disallowed include:

• Claims for Too Many Quarters: The ERC was available for businesses that were required to shut down by the government or experienced a significant decline in gross receipts in 2020 or the first three quarters of 2021, as well as businesses that qualified as recovery startup businesses in the last two quarters of 2021. Businesses that claimed credits for all of these quarters are likely to raise red flags, since most taxpayers did not meet the eligibility requirements for every quarter when the ERC was available.

• Claims for Essential Businesses That Remained Open: If a business was not shut down by government order during the pandemic or did not experience a significant decrease in gross receipts, it would not be eligible for the ERC. Claims based on modifications that may have been required but did not significantly affect a business, such as providing masks for employees, may be disallowed by the IRS.

• Claims for Wages Paid to Family Members: Only qualified wages are eligible for the ERC. Credits may not be claimed for wages paid to the business owner’s spouse, children, or other relatives. Claims for unqualified wages may lead to tax audits or the requirement to repay credits that were received.

• Paycheck Protection Program Loan Forgiveness: Many businesses qualified for PPP loans that allowed them to continue paying wages to their employees, and if certain requirements were met, these loans were forgivable. If a business received forgiveness on a PPP loan based on reported payroll costs, it will not be eligible for an Employee Retention Credit for these wages. However, the ERC may be available for wages that exceeded the amount of a forgiven PPP loan. If the IRS disallows a claim based on a PPP loan, a business may need to take steps to demonstrate that the claim was based on wages in excess of the amount that was forgiven.

Steps to Take if You Receive an ERC Disallowance Letter

1. Review the Letter Carefully: It is important to understand the reasons the IRS believes an ERC claim should be disallowed. The letter should provide specific details about the potential issues with the claim, which can help you understand whether the claim may have been incorrect or whether you can demonstrate that the claim was valid.

2. Consider Withdrawing Your Claim: If, after reviewing the letter, you determine that your ERC claim was incorrect, you may choose to withdraw the claim. The IRS has an ERC withdrawal program, and when a withdrawal is submitted, the IRS will treat the claim as if it was never filed. It is recommended that you consult with a tax attorney before taking this step to ensure that withdrawal is the best course of action for your situation.

3. Consider Using the ERC Voluntary Disclosure Program: The IRS is currently allowing employers to disclose and correct invalid ERC claims. Under the current voluntary disclosure program, taxpayers can resolve incorrect claims by repaying 85 percent of the erroneous ERC payments they received, and no penalties or interest will be applied to these amounts. This program only covers claims made for tax periods in 2021, and it will be available until November 22, 2024.

4. Gather Supporting Documentation: If you believe your claim was valid, you will need to provide information to the IRS demonstrating that you should receive a credit. Documents to submit to the IRS may include payroll records, financial statements showing gross receipts, and documentation of government shutdown orders or other evidence showing how the pandemic impacted your business operations.

5. Respond to the IRS: Your response must be submitted within the timeframe detailed in the letter, and it should include a detailed explanation of why you believe the disallowance is incorrect, along with all supporting documentation. A tax lawyer can help you prepare a comprehensive response.

6. Prepare for a Tax Audit: In some cases, the IRS may initiate a tax audit to further investigate your ERC claim. If this happens, it is important to be fully prepared. A tax attorney can help you navigate the audit process, ensuring that you provide all necessary information and respond appropriately to any IRS inquiries.

Contact Our San Jose, CA Tax Audit Attorney

If you have received an ERC disallowance letter from the IRS, you will want to make sure to take steps to avoid potential penalties or ensure that you receive the proper tax credits. At John D. Teter Law Offices, our San Jose tax lawyer can help you determine the best response. We can assist with withdrawing a claim, voluntarily disclosing incorrect credits, handling a tax audit, or addressing tax penalties. Contact our office at 408-866-1810 to discuss your situation in a consultation and get the legal help needed to resolve these issues effectively.