The IRS continues to focus on combating perceived fraudulent claims relating to the COVID-19 pandemic-era Employee Retention Credits (ERCs). On Oct. 19, the IRS announced a special process allowing taxpayers to withdraw certain previously filed ERC claims. That announcement follows enhanced IRS scrutiny of potentially fraudulent ERC claims that resulted in the IRS suspending processing new ERC claims at least through the end of 2023. It is expected that the IRS will continue its focus on this front and issue additional guidance in an effort to combat such perceived fraud. The uncertainty concerning ERC claims is highlighted in the context of M&A transactions, especially if the parties are otherwise generally relying on representation and warranty insurance (RWI) rather than an indemnity from the sellers.
What Are ERCs and Why Are They Still Relevant?
The ERC is a refundable payroll tax credit that was originally created by the CARES Act in 2020 for the benefit of certain businesses that continued paying qualified wages during the COVID-19 pandemic between March 13, 2020, and Sept. 30, 2021 (or Dec. 31, 2021, in the case of certain startup businesses, which are beyond the scope of this alert). The refundable credit is payable to qualifying taxpayers in cash. Generally speaking, a business is eligible for ERCs with respect to qualified wages if its business operations were fully or partially suspended by order of a governmental authority due to COVID-19, or if it had a significant decline in gross receipts during the eligibility periods (as determined in accordance with highly technical ERC guidance).1 ERCs that were not claimed by businesses contemporaneously may be claimed by filing an amended payroll tax return, which is typically due on the later of three years after the initial payroll tax return was filed or two years from the date the payroll tax was paid. Therefore, even though new ERCs are no longer being generated, some employers are still applying for ERC refunds by amending their 2020 and 2021 tax returns. Others have applied for ERCs but face significant delays in receiving refund payments.
The statute of limitations with respect to assessments attributable to ERCs is generally five years from the filing of the relevant tax return in the case of ERCs claimed for the third and fourth calendar quarters of 2021, and three years from the filing for ERCs in respect of other quarters. However, that might change soon, as the current administration's fiscal year 2024 budget includes a proposal to make all quarters in which the ERC is available subject to a five-year statute of limitations. In the case of a false or fraudulent return with the intent to evade tax, there is no statute of limitations for assessment. The IRS has announced that, as of mid-September 2023, thousands of ERC cases have been referred for audit, and the process can be extensive once an audit has been initiated.
The IRS' Increasing Scrutiny of ERCs
Over the past few years, the IRS has increased its scrutiny of perceived aggressive marketing tactics by third-party promoters targeting businesses that may not in fact be eligible for ERCs. Following several IRS press releases warning businesses about ERC-related fraud, ERC scams were included in the 2023 "Dirty Dozen," the IRS' annual list of "the worst of the worst" tax scams.2 The press releases describe aggressive promoters preying on innocent businesses that are ineligible for ERCs with misleading advertisements in broadcast, via direct mail and online. The promoters earn significant fees (up to 25% of the ERC refund) filing invalid ERC claims on behalf of unwitting businesses that are then left holding the bag when the ERCs are subsequently disallowed and interest and penalties may be imposed.
On Sept. 14, the IRS imposed an immediate moratorium on processing any new ERC claims at least through the end of 2023 (and the lengthening of time for processing previously filed ERC claims from 90 days to 180 days).3 These steps came in response to growing concerns that a substantial share of new claims for the ERC were fraudulent as a result of aggressive promoters convincing ineligible taxpayers to submit refund applications. According to the IRS, from the beginning of the program through mid-September 2023, approximately 3.6 million ERC claims had been submitted and an estimated $230 billion has been paid out.4 The volume of such claims has led the IRS to enact stricter compliance reviews and devote more resources to the processing of claims.
Most recently, on Oct. 19, the IRS announced a withdrawal process for certain businesses that filed for the ERC and are concerned about the accuracy and legitimacy of their filing.5 The withdrawal process is only available for taxpayers that can satisfy all the following requirements: (1) They made the claim on an adjusted employment tax return, (2) no other adjustments were made on such return, (3) they withdraw their entire ERC claim, and (4) either the IRS has not yet paid the claim or the IRS has paid the claim but the refund check has not been cashed or deposited. Employers that do not meet these requirements may still be able to file another adjusted return where they can reduce the amount of their ERC claim or make other adjustments.
In addition to the withdrawal process and moratorium, the IRS is developing new initiatives to help businesses that were targeted by ERC scams, including a settlement program for repayments of improperly received ERCs. The details of the program have not been announced yet, but it would allow businesses to repay ERC claims and avoid penalties and future compliance action.6
Considerations for M&A Transactions
Given the heightened scrutiny and the scope of perceived fraudulent claims, several considerations arise in connection with M&A transactions involving companies that submitted ERC claims.
Although a wide variety of tax items are relevant in connection with business transactions, ERCs are different in several key respects. Outside of the ERC context, parties often rely on RWI to address pre-closing tax risks without an indemnity by the sellers. However, the market has largely developed to exclude ERCs and other pandemic-era tax measures from RWI coverage. On the other hand, the scope of the due diligence performed with respect to ERC claims is often limited due to the highly factual and detailed nature of such claims. Accordingly, unless a specific concern regarding an ERC has been identified, it may prove challenging for a potential buyer to successfully demand the creation of a special indemnity that is supported by an escrow or similar mechanism.
The IRS' continuing focus requires the parties to further consider whether the IRS' new withdrawal process is available and appropriate and, if not, the possibility of an amended return or participation in the IRS' upcoming settlement program. Such determinations may be challenging in light of the due diligence shortcomings described above.
In addition, acquirers in M&A transactions may also need to address the potential impact of ERC claims on the income tax returns of the target. Adjustments are needed for federal and often state income tax purposes, as the wages that were originally used to claim the ERC are no longer able to be taken as a deduction. Depending on the circumstances involved, it appears that often taxpayers take the approach of reflecting the net income tax effect relating to such adjustments on the income tax return for the year in which the ERC claim is made (or the refund is received) rather than through an amendment to the income tax return for the earlier period to which such ERC claim relates.
In light of the IRS' heightened attention to issues of ERC fraud, the parties need to further consider the manner in which they diligence and allocate the risks associated with such ERC claims.
1. For an earlier alert addressing tax provisions of the CARES Act, see "Tax-Related Provisions of the CARES Act," available at https://www.kramerlevin.com/en/perspectives-search/covid-19-update-tax-related-provisions-of-the-cares-act.html. For an earlier alert addressing some of the details of the aggregation rules affecting the ERC, see "Aggregation Rules May Prevent Private Equity Portfolio Companies From Taking Full Advantage of the New Employee Retention Credit Under the CARES Act," available at https://www.kramerlevin.com/en/perspectives-search/aggregation-rules-may-prevent-private-equity-portfolio-companies-from-taking-full-advantage-of-the-new-employee-retention-credit-under-the-cares-act.html.
2. IRS News Release, IRS opens 2023 Dirty Dozen with warning about Employee Retention Credit claims; increased scrutiny follows aggressive promoters making offers too good to be true (Mar. 30, 2023), https://www.irs.gov/newsroom/irs-opens-2023-dirty-dozen-with-warning-about-employee-retention-credit-claims-increased-scrutiny-follows-aggressive-promoters-making-offers-too-good-to-be-true.
3. IRS News Release, To protect taxpayers from scams, IRS orders immediate stop to new Employee Retention Credit processing amid surge of questionable claims; concerns from tax pros (Sept. 14, 2023), https://www.irs.gov/newsroom/to-protect-taxpayers-from-scams-irs-orders-immediate-stop-to-new-employee-retention-credit-processing-amid-surge-of-questionable-claims-from-tax-pros.
4. Julie Zauzmer Weil, IRS halts processing claims for pandemic tax credit tied to fraud, The Washington Post (Sept. 14, 2023), https://www.washingtonpost.com/busines/2023/09/14/erc-irs-employee-retention-credit/.
5. IRS News Release, IRS announces withdrawal process for Employee Retention Credit claims; special initiative aimed at helping businesses concerned about an ineligible claim amid aggressive marketing, scams (Oct. 19, 2023), https://www.irs.gov/newsroom/irs-announces-withdrawal-process-for-employee-retention-credit-claims-special-initiative-aimed-at-helping-businesses-concerned-about-an-ineligible-claim-amid-aggressive-marketing-scams
6. The IRS recently issued memorandum AM 2023-007 providing guidance on what constitutes a "government order" for purposes of the ERC, Internal Revenue Service Memorandum, No. AM 2023-007 (Oct. 18, 2023), https://www.irs.gov/pub/lanoa/am-2023-007.pdf.
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