The 'wild west' of tax preparation: Understanding widespread ERC issues

The Employee Retention Credit (ERC) was a critical lifeline for businesses during the COVID-19 pandemic, designed to help them keep employees on the payroll. However, this well-intentioned program has been plagued by widespread issues, largely due to a lack of oversight in the tax preparation industry.

The root of the problem, as tax expert James Creech from Baker Tilly points out, predates the pandemic. “Tax preparation is kind of the Wild West,” he states, noting the absence of federal laws that set specific requirements for preparers or prohibit them from charging contingency fees.

This unregulated environment wasn't a major concern in normal times. But when the pandemic hit, the IRS was suddenly tasked with administering massive benefit programs like the ERC, creating a perfect storm for opportunists.

The mechanics of a crisis

Initially, eligible employers claimed the ERC, a refundable credit against certain employment taxes, using Form 941, the standard quarterly federal tax return. After the credit expired, businesses could still retroactively file for it using Form 941-X, an adjusted return or claim for refund.

The fact that these amended returns could only be filed on paper contributed significantly to a massive backlog at the IRS, creating long delays and reducing immediate oversight.

This situation opened the door for a new cottage industry of "ERC mills." These operations began aggressively marketing their services to businesses, often making bold promises about eligibility and large refunds.

The core issue was the incentive structure. As Creech explained, the focus shifted from a well-meaning effort to keep people employed to a numbers game. With minimal oversight and the promise of a hefty contingency fee—sometimes up to 25% of the refund—promoters were motivated to file as many claims as possible, regardless of their legitimacy.

The rise of aggressive ERC promoters

Starting in 2022, the IRS began issuing increasingly urgent warnings about third-party promoters pushing businesses to claim the ERC, even when they didn't qualify. These warnings grew in frequency, and by 2023, questionable ERC claims had earned a top spot on the IRS's annual "Dirty Dozen" list of tax scams.

The situation escalated to the point that in September 2023, the IRS announced an immediate moratorium on processing new ERC claims. The agency pointed directly to the flood of questionable applications driven by promoters who stood to gain significant fees.

This wasn't just a matter of a few bad apples. The scale of the problem was enormous. As of September 30, 2023, the IRS Criminal Investigation (CI) division had initiated 301 investigations into potentially fraudulent ERC claims totaling more than $3.4 billion.

In a further crackdown, the IRS began sending out over 20,000 letters in December 2023 to notify taxpayers that their ERC claims had been disallowed.

Shifting goalposts and official guidance

As time passed, the justifications for claiming the credit became more and more tenuous. Creech noted that while early claims were often "slam dunk" cases related to government-mandated shutdowns, later claims stretched the rules to their breaking point.

One common but dubious tactic involved using Occupational Safety and Health Administration (OSHA) guidance as a basis for eligibility. Promoters would argue that following general safety recommendations constituted a partial suspension of business operations.

The IRS squarely addressed this, issuing legal advice that explicitly states taxpayers cannot rely on OSHA guidance to qualify for the ERC. Similarly, the agency has clarified that simply following guidelines from the CDC or DHS does not make an employer eligible.

Creech hopes that Congress will take action to prevent a repeat of this situation. He suggests that one of the most effective steps the IRS could take after the moratorium is to simply require more documentation upfront. "On the 941-xs that are filed, you claim the ERC and it’s just a couple of lines," he says, arguing that requiring more supporting information would be a welcome step for tax administration.

What businesses can do to protect themselves

For any business that has claimed the ERC or is considering it, the advice is clear: proceed with extreme caution. Get a second opinion: "I think I’d want a second opinion, to tell you the truth,” Creech admits. He emphasizes that it's never too late to review a claim, especially with the programs the IRS has made available.

The IRS has established a special process that allows taxpayers to withdraw an ERC claim if they have second thoughts about their eligibility. If the claim is withdrawn before it is processed and paid, the business can avoid penalties and interest entirely. This, Creech suggests, is a "golden opportunity to sleep easy at night."

When seeking a review, it's critical to work with an independent subject matter expert. Many business owners, lured by promises of easy money, don't fully grasp the risks involved. If a business is audited and the ERC claim is denied or reduced, the consequences can be severe.

This includes a potential accuracy-related penalty of 20% of the underpaid tax. When you factor in a contingency fee that has already been paid to a promoter, a seemingly lucrative refund "can really turn into a net loser very quickly."

The clock is ticking for these claims. The statute of limitations allows businesses to file for the ERC until April 15, 2024, for 2020 claims, and April 15, 2025, for 2021 claims. However, with recent IRS guidance closing the door on many popular justifications, many who thought they had a safe claim may find themselves on shaky ground. Despite the IRS's efforts, the fight against questionable claims is far from over. As Creech concludes, "It’s hard to compete when there’s advertisements on every baseball, football, basketball game you watch.”