The employee retention credit (ERC), as authorized under pandemic-era legislation to assist businesses with the costs of retaining employees, has been claimed by many employers for applicable quarters in 2020 and 2021. This article discusses the requirement to amend income tax returns in connection with an ERC claim and to review the professional responsibility to which all CPAs must adhere in amending these income tax returns.
Note: Legislative changes to the ERC could occur proximate to publication of this article. One such proposal under consideration in Congress as of this writing would retroactively eliminate the credit for any claims filed after Jan. 31, 2024 (see §602 of the Tax Relief for American Families and Workers Act of 2024, H.R. 7024; see also Waggoner, "House OKs $78B Tax Bill With Changes to ERC and Child Tax Credits," The Tax Adviser, Feb. 1, 2024). The proposed legislation would also increase penalties and extend the IRS's statute-of-limitation period on assessment of erroneous ERC refunds to six years with a correlative extension of the statute-of-limitation period for taxpayers to amend income tax returns for wage deductions attributable to ERC claims. In addition, it would enact several additional provisions intended to address unscrupulous ERC promoters.
Claims for the ERC are based on the amount of "qualified wages" paid by eligible employers during applicable quarters. These claims are made by amending employment tax returns (e.g., Form 941-X, Adjusted Employer's Quarterly Federal Tax Return or Claim for Refund). In connection with an ERC refund for 2020 or 2021, the company (and in some cases, its owners) is required to amend corporate and individual income tax returns to reduce related wage or salary expenses the employer could otherwise deduct on its federal income tax return for the applicable tax year. Partnership income tax returns will need to be amended, or the Administrative Adjustment Request (AAR) procedure must be used. While many tax practitioners (and their clients) are familiar with this rule requiring amendment of income tax returns, uncertainty exists as to how it applies, including the timing of making an income tax return amendment and to what extent tax practitioners helping clients file amended income tax returns are required to assess the validity of a client's ERC claim that they did not prepare.
As enacted, the law provides that rules similar to those of Sec. 280C(a) apply for purposes of the ERC (Sec. 3134(e); §2301, Coronavirus Aid, Relief, and Economic Security Act, P.L. 116-136). These rules disallow a deduction for the portion of the employer's wage or salary expense that equals the total credit for the tax year. Because many ERC refund claims are filed well after the income tax return for the same tax year, the employer in these cases must amend its income tax return to pay the additional income taxes resulting from the corresponding wage disallowance (see also Notice 2021-20, Q&A 60, and Notice 2021-49, §IV(C)). With an IRS moratorium in place as of this writing limiting processing of claims, income tax returns will need to be amended before claimed ERC refunds are paid by the IRS to an employer (see IRS News Release IR-2023-169; see also Waggoner, "Moratorium Imposed on New ERC Claim Processing to Curb Abuse," The Tax Adviser, Sept. 15, 2023).
In March 2023, in the wake of mounting publicity on the multitude of ERC claims that were prepared by entities that may not have undertaken a sufficient analysis to determine whether the employer is entitled to the amount of ERC refund claimed, the IRS Office of Professional Responsibility (OPR) issued Alert 2023-02 to detail how Treasury Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10), applies to amended tax returns for the ERC. The alert explains that tax professionals requested guidance regarding the application of Circular 230 to the preparation and signing of "original tax returns, amended returns, or claims for refund relating to these credits." While the alert is not explicit with respect to which federal tax returns it covers, OPR has informally stated that it is instructive with respect to amended federal income as well as employment tax returns.
The alert explains the standards and due diligence that should be undertaken with regard to clients that applied for ERC refunds. The alert concludes that "the practitioner must also follow Circular 230's requirements of (1) due diligence in the practitioner's advice and in preparing and filing returns (including the specific standards in section 10.34); (2) full disclosure to a client of their tax situation; and (3) reasonable reliance on client-provided information and on any advice provided by another tax professional." Applying the guidance in the alert to amending federal income tax returns, it could be read to mean — and OPR has informally agreed with this interpretation — that the income tax return preparer needs to understand the ERC rules and feel comfortable that the employer qualifies for the credit and has properly computed the amount of the credit for which there is a corresponding wage deduction disallowance.
Circular 230 details the required due diligence and standards a practitioner must take with respect to tax returns, stating that a practitioner generally can rely in good faith and without verification on reasonable representations from the client. In relation to preparers of income tax returns, the message of the alert is that good-faith reliance would require a practitioner to make reasonable inquiries of a client to confirm eligibility for the ERC and to determine the correct amount of the credit. The client's responses can be accepted at face value if reasonable, but the practitioner cannot ignore other information the practitioner knows. If the ERC seems incorrect or inconsistent with other facts the practitioner knows, the practitioner must make further inquiries to reconcile the incorrect or inconsistent facts. In reviewing the facts and the law regarding ERC claims, Circular 230 does not permit practitioners to sign a return containing a position that lacks a reasonable basis (Circular 230, §§10.34(d) and (a)(1)(i)(A)).
In addition to Circular 230, AICPA members must follow the AICPA Code of Professional Conduct, and members providing tax services must apply the Statements on Standards for Tax Services (SSTSs). SSTS No. 2, Standards for Members Providing Tax Compliance Services, Including Tax Return Positions, contains standards that apply to members preparing original returns, amended returns, claims for refund, and information returns. These standards generally require the member to follow the taxing authority's written position unless the position being taken by the member has only a realistic possibility of success administratively or in the courts and the taxing authority does not have an applicable written standard. A member may prepare or sign a return when there is a reasonable basis for the tax return position and it is adequately disclosed. This is consistent with Circular 230's requirements.
As with all tax positions, tax preparers review the facts, apply the law, and determine the level of authority with respect to a specific position. Some ERC claims take positions that are not consistent with IRS guidance or public statements but might still be considered to have a realistic possibility of success or a reasonable basis. While percentages are not assigned to the likelihood of success when applying levels of authority, practitioners generally agree that a realistic possibility of success is a 30%–33% likelihood of being upheld in court, and a reasonable-basis position has a 20%–25% likelihood of being upheld in court.
If the tax return preparer determines that the positions taken in calculating the ERC have at least a reasonable basis, the employer's income tax return should be amended to reduce the wage deduction in accordance with the ERC requirements. The practitioner may decide to notify a particular client that, although they are assisting with the income tax return amendment, they did not determine the ERC refund amounts; and the assistance with the amendment is not an endorsement of, or support for, the ERC amounts or basis for the claim.
If the practitioner's analysis results in a conclusion that the ERC does not have a reasonable basis, the practitioner needs to discuss the conclusion with the employer. If the employer understands the practitioner's position that even courts might not uphold the ERC claim but does not want to amend the ERC claim to an amount that is reasonable, the practitioner needs to evaluate whether this employer is a client for whom services (including the filing of an amended income tax return to disallow the wage deduction) should be rendered. For two scenarios in this regard, see the sidebar "Practitioner Responsibility Case Studies."
In its examinations of the ERC, the IRS will generally determine that such a deduction disallowance has been made. For claims filed after the due date of the income tax return, as it processes the ERC claim, the IRS can easily determine if a required amended income tax return has not been filed.
The ERC applies for periods during calendar years 2020 and 2021. The statute of limitation for 2020 income tax returns (such as Forms 1120, U.S. Corporation Income Tax Return) will generally expire in 2024. (This deadline could be extended if pending legislation mentioned above is enacted as currently drafted.) Clients that have not already amended their income tax returns to take into account the ERC loss of tax deduction will need to amend them relatively quickly.
For example, assume a practitioner determines that an ERC claim has a reasonable basis, but the claim has not yet been paid. An amended 2020 income tax return must be filed reflecting the decreased wage deduction, with a payment of additional income tax to the IRS, before the statute of limitation expires in 2024. If the IRS denies the ERC claim after the expiration of the statute of limitation for the income tax return, the wage deduction disallowed on the 2020 amended return is no longer correct (and the employer may have overpaid 2020 taxes). Practitioners need to understand the professional responsibilities they have for amending these tax returns, which can result in difficult discussions with clients.
Case study 1
The client receives a refund of $100,000 related to an ERC claim for 2020. The practitioner knows that the client had only five employees during 2020, one of which was the owner's daughter. With only five employees, four of whom were unrelated to the owner, the maximum ERC claim is $20,000. The practitioner concludes that $80,000 of the $100,000 claim has no reasonable basis.
The practitioner should discuss the claim with the client and evaluate whether to continue to provide services if the client is unwilling to amend the claim and repay the $80,000 — or the entire amount if the employer is found to not be an eligible employer. Note that this client communication should include a discussion of the IRS program for withdrawing unpaid claims, which has no expiration date at this time, and the IRS Voluntary Disclosure Program for ERC claims, which expires March 22, 2024. (See IRS News Release IR-2023-193 and Fact Sheet FS-2023-24 regarding the Withdrawal Program and Announcement 2024-3 regarding the Voluntary Disclosure Program.)
Case study 2
The client, a retailer, used a third-party provider to determine that the client is an eligible employer in 2020 due to a partial suspension of operations as a result of a government mandate on supplier parts and delays in shipping. The third-party provider assisted the client to file a claim for an ERC. The IRS may not agree with the position that a more-than-nominal portion of the employer's business was affected by these government orders.
The tax practitioner acts with due diligence to consider the ERC claim prepared by the third party. The tax practitioner uses her knowledge of the client and the client's business, reviews the report from the third-party provider, applies the statute, evaluates the IRS's position explained in its notices and Generic Legal Advice Memorandum 2023-005, considers the level of authority of the Service's guidance, and determines that the client's position to claim the ERC has more than a reasonable basis. In this case, the income tax return should be amended to disallow the deduction for the amount of the credit claimed, and any additional income tax should be paid with the amended income tax return.
— Deborah Walker, CPA, MBA, is national director, Compensation and Benefits, with Cherry Bekaert LLP in Washington, D.C.; Amber R. Salotto, J.D., is a partner in the U.S. National Tax practice of Andersen in Washington, D.C.; Ligeia Donis, J.D., is a partner at Vialto Partners in Washington, D.C.; and Karen Field, J.D., is senior director with RSM US LLP in Washington, D.C. All are members of the AICPA Employee Benefits Tax Technical Resource Panel. To comment on this article or to suggest an idea for another article, contact Paul Bonner at Paul.Bonner@aicpa-cima.com.