The Coronavirus Aid, Relief, and Economic Security (“CARES”) Act of 2020 established the employee retention tax credit (“ERC”) which provided a refundable payroll tax credit to eligible employers designed to assist those employers in retaining and paying employees during the COVID-19 pandemic. Subsequent legislation extended the availability of the ERC into calendar year 2021.

Employers are required to meet specific criteria to qualify for the ERC including:

The amount of the credit for qualifying employers depends on several factors including the number of employees, amount of qualified wages paid to employees, and whether the employer received a Paycheck Protection Program (“PPP”) loan.

IRS Scrutiny of ERC Claims

The ERC became a popular provision and inevitably third-party advisers emerged that prepared ERC claims on behalf of employers without appropriate analysis of the criteria for eligibility and the amount of the credit claimed. Often, these third-party providers charged contingent fees for their services based on the amount of the ERC claim.

In response to this problem, the IRS issued several news releases warning taxpayers about unscrupulous advisers and addressing several factors that taxpayers should consider when determining the validity of an ERC claim. In late 2023, the IRS issued a moratorium on the processing of ERC claims. Although the moratorium was eventually lifted, a long delay still exists in the processing of new claims which leaves the status of thousands of claims currently undetermined. In addition, the IRS has increased examination activity to combat fraudulent and excessive ERC claims and has begun the process of requesting additional information from employers to examine and verify claims.

Income Tax Implications of the ERC

The CARES Act specifies that an employer’s income tax deduction for the qualified wages used in the determination of an ERC claim must be reduced by the amount of that claim. Guidance issued by the IRS clarified that this reduction must be made for the tax year for which the ERC was claimed. This is accomplished by filing an amended income tax return (or an Administrative Adjustments Request (“AAR”) for certain partnership returns) for the tax year the wage deduction was claimed on the employer’s income tax return. Note that the amendment of an income tax return to add back the deduction for qualified wages will usually result in the taxpayer having to pay the additional tax that is attributable to the add back.

An income tax return must be amended before the expiration of the statute of limitations (“SOL”) for that return. Generally, the SOL for an income tax return expires on the earlier of the due date of the return (including extensions, if applicable) or the date on which the return was filed. For a calendar-year taxpayer that claimed the ERC for 2020, the SOL for the corresponding income tax return will expire at some point during 2024, depending on the date the income tax return was filed. Similarly, the SOL for 2021 income tax returns will expire in 2025.

Amended Income Tax Returns and Protective Refund Claims

The interplay of the ERC and the related income tax filing requirements make it very important that a taxpayer file each amended income tax return before the expiration of its respective statute of limitations. Because the filing of an amended income tax return to reduce the previously claimed wage deduction is a required part of filing a valid overall ERC claim, a taxpayer that does not amend its income tax return by the SOL date may risk its qualification for the credit. A taxpayer that previously received an ERC refund but did not timely file a corresponding amended income tax return may be required to repay the full amount of the ERC (including penalties and interest) it received upon a subsequent examination by the IRS. Similarly, a taxpayer with a pending but unpaid ERC claim that does not file an amended income tax return by the statute expiration date possibly risks the IRS declining payment of the pending claim on the basis that the taxpayer did not fulfill all the necessary requirements to qualify for the credit.

Even if the taxpayer timely files an amended income tax return and pays any additional tax to the IRS, a subsequent IRS payroll tax return examination that finds an ERC claim invalid will require the taxpayer to repay all or part of that claim. In certain circumstances, the expiration of the SOL for a taxpayer’s payroll tax returns may expire after the SOL for the related income tax returns. In this case, If the income tax statute has expired when any additional payroll tax is assessed, the taxpayer may be barred by statute from recovering the additional income tax it paid with the amended income tax return. To avoid this potential outcome, a taxpayer may consider filing a “protective refund claim” before the ultimate expiration of the income tax statute. If a proper protective claim is filed, the taxpayer can protect its ability to recover the additional income tax paid with an amended income tax return if an ERC claim is disallowed after the expiration of the income tax SOL.

If a taxpayer that filed an ERC claim subsequently determines that the claim is invalid, it may not be required to file an amended income tax return if it corrects the erroneous claim with the IRS. The IRS has implemented procedures that a taxpayer may use to correct a previously filed ERC claim. A taxpayer that has a pending but unpaid claim can withdraw the full amount of the claim (no partial withdrawals are available) by filing amended 2020 and 2021 payroll tax returns by April 15, 2024, and April 15, 2025, respectively. A taxpayer that previously received an ERC refund may utilize the IRS ERC voluntary disclosure program (“VDP”) through March 22, 2024. If the taxpayer qualifies for the VDP, it must repay 80% of the claim received but will not be subject to additional penalty and interest.

Disclaimer: This tax alert is designed only to provide general information regarding its subject matter and should not be construed as tax, accounting, or legal advice to any specific person or entity.  The statutes, authority, or other law discussed or cited in the alert are subject to change and Whitley Penn assumes no obligation to update the reader of any changes.   Any advice or opinion regarding the application of the subject matter for a specific person or entity should be provided by a competent professional tax advisor based on the application of the appropriate law and authority to the facts and circumstances applicable to that person or entity.