Fraud flood leads IRS to halt employer tax credit

Citing scams and abuse of a tax credit for businesses hurt by the pandemic, the IRS put a moratorium on new claims for the potentially valuable subsidy until the end of the year.

The employee retention credit has attracted about 3.6 million claims from employers who continued to pay qualifying wages to some or all workers despite government shutdowns or declining business, but the IRS Criminal Investigation unit has opened 252 probes of $2.8 billion in potentially fraudulent applications and thousands of audits, the agency said last week. In steps praised by the American Institute of Certified Public Accountants, the IRS halted the processing of any more claims through Dec. 31, offered guidance to employers with pending applications for the credit and indicated it expects turnaround times to double.

With "incredibly complex" rules and "extremely lucrative" credits available to eligible employers, groups of promoters have been exploiting a criteria of qualification aimed at businesses closed by government orders due to the pandemic in 2020 or the first three quarters of 2021, according to Devin Tenney, a senior manager with the Washington national tax and executive compensation and employee benefits teams of accounting and advisory firm Baker Tilly. Tax professionals call that provision the suspension test.

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"This test is subjective and facts- and circumstances-based and extremely complex, so this has presented an opportunity for these pop-up shops that I call credit mills to come in and make extremely aggressive interpretations of that guidance — interpretations that have led many of them to say every taxpayer in the country is eligible for this credit," Tenney said in an interview. "We have this potentially extremely lucrative credit paired with less-than-exhaustive guidance that has opened the gates for these ERC mills to come in and make extremely aggressive interpretations, and the two have just resulted in this feeding frenzy."

With more than 600,000 claims awaiting processing, the IRS pushed back its timeline target to 180 days, or about six months, from a previous goal of 90 days. The agency warned employers that many claims will get closer compliance scrutiny and take longer to process. IRS Commissioner Danny Werfel suggested that employers "seek out a trusted tax professional who actually understands the complex ERC rules, not a promoter or marketer hustling to get a hefty contingency fee." He noted that businesses that "receive ERC payments improperly face the daunting prospect of paying those back."

For employers who are trying to get the credit, the agency noted there have been "repeated instances of people improperly citing supply chain issues as a basis," which "will very rarely meet the eligibility criteria." Those employers may withdraw their application or participate in a settlement program slated to be finalized this fall that will enable businesses to repay their claim without penalties or other compliance proceedings, although the IRS is still considering how to deal with taxpayers who have already paid a promoter a contingency fee for the credit.

"The IRS is increasingly alarmed about honest small business owners being scammed by unscrupulous actors, and we could no longer tolerate growing evidence of questionable claims pouring in," Werfel said in a statement. "The further we get from the pandemic, the further we see the good intentions of this important program abused. The continued aggressive marketing of these schemes is harming well-meaning businesses and delaying the payment of legitimate claims, which makes it harder to run the rest of the tax system. This harms all taxpayers, not just ERC applicants."

Tax professionals and the IRS have been raising alarms about abuse of the credit since last year, and the agency gave the claims top billing in 2023 on its annual "Dirty Dozen" list of tax scams. So far, at least 15 of the more than 250 criminal investigations have led to federal charges, with four sentences averaging nearly 2 years. The IRS and the American Institute of CPAs have released guidance on the technical details of the employee retention credit and red flags of potentially abusive sales tactics.

"This latest initiative by the IRS takes a multi-pronged approach to taper ERC fraud by further scrutinizing ERC claims already received, pausing the processing of additional claims and defining processes for taxpayers to handle claims they now feel are in error," AICPA President Barry Melancon said in a statement. 

"While drastic, these measures are necessary to protect small businesses by putting a stranglehold on the unscrupulous ERC practices of credit mills," Melancon continued. "We are pleased with the IRS's announcement of the additional measures they are taking to push back against the dishonest credit mills taking advantage of unsuspecting small businesses. While there are still valid claims to be processed, these bold measures are necessary to combat widespread ERC fraud."

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Depending on the size of the employer, the tax credit claims range from several hundreds of thousands of dollars up to the millions or tens of millions, according to Tenney. Employers who claimed the credit when they were ineligible could be facing a "worst-case scenario" in which they may have paid a contingency fee to a promoter plus the administrative costs of seeking the subsidy by amending tax returns, only to find themselves paying more for audit defense, repayment, interest and any penalties, he said.

"I think, personally, this has the potential to be one of the biggest tax fraud schemes of all time. It is imperative that taxpayers that claimed the ERC consult a trusted tax professional if they haven't already," Tenney said. "Those records need to be documented now, because you will not be able to recreate them. This also then gives you the position and the ability to determine if you have that exposure. If that credit mill did in fact mislead you, what is the extent of that exposure, and what steps can we now take to mitigate the risk so that you don't end up being in the hole, hundreds of thousands, if not millions, of dollars?"