Employment tax: Actions to take and documents for an IRS audit

This IRS’ heightened interest is also increasing the scrutiny of ERC refund requests during financial audits and due diligence reviews for mergers and acquisitions.

The IRS’ intensified focus on the ERC leaves many taxpayers wondering what actions to take after being notified they are subject to an IRS employment tax examination. By providing documentation that establishes compliance with computational rules and eligibility for employment tax credits—including the ERC or other credits established by coronavirus relief legislation—you can generally avoid penalties and surprises that would negatively affect your liquidity.

The increase in employment tax examinations

The ERC was valid only during certain quarters of 2020 and 2021 for businesses negatively affected by the pandemic, either through a significant decline in gross receipts or a full or partial suspension of operations due to relevant government orders. To keep threatened workers employed, Congress prioritized distributing relief funds to businesses by using this partially refundable credit obtained by filing an amended Form 941-X.

Fast forward to late 2022. The IRS established the ERC claim examination as a focus and trained approximately 300 agents to conduct the examinations.

Meanwhile, the agency has repeatedly warned taxpayers of bad actors who fraudulently promise businesses substantial ERC refund amounts and generally charge a significant percentage of the credit as their fee. In March 2023, the IRS described these aggressive promoters in its annual Dirty Dozen list of tax scams and egregious arrangements.

In doing so, the IRS reiterated that taxpayers are ultimately responsible for the accuracy of the information on their tax returns. It’s crucial for taxpayers to understand the actions and documentation required for an employment tax audit.

Employment tax: IRS objectives

Although it’s clear the IRS is focused on ERC claims, federal employment tax examinations are not limited to this singular issue.

Employment tax examiners generally look for issues such as employees being treated as independent contractors; or payments to employees improperly excluded from wages, such as reimbursements for personal expenses or taxable fringe benefits.

Adjustments to these items often result in additional employment taxes, such as:

• Income tax withholding
• Federal Insurance Contributions Act (FICA) taxes
• Federal Uninsurance Tax Act (FUTA) taxes

Employers can also be subject to penalties and additions to taxes for underreporting or failing to deposit taxes and for failing to file returns, including information-reporting returns such as Forms W-2 and 1099.

Expectations and documentation for an employment tax examination

If your business claimed the ERC and is facing an IRS employment tax exam, you can expect the revenue agent to request a substantial list of documents to aid in proving the business was eligible to claim the amount of the credit obtained. Those documents must establish that the business experienced more than a nominal impact from government shutdown orders or that its gross receipts declined significantly during specified periods.

Such supporting documents could include:

• Governmental orders that affected your business—or suppliers to your business—and a written explanation of those effects
• General ledgers or other documents that establish quarterly gross receipts for 2019, 2020 and 2021

You will also need to trace the wages claimed under the credit. Supporting documentation could include the following:

• Worksheets attached to Form 941 (the employer’s quarterly federal income tax return) used to calculate ERC eligibility
• Worksheets that tie wages claimed to employees and demonstrate appropriate caps on wage amounts claimed per employee

Large employers—meaning more than 100 full-time employees for 2020 and more than 500 full-time employees for 2021 (measured by 2019 employment numbers)—must show that they paid wages for the nonperformance of services; in other words, they paid employees despite being unable to perform services or provide the pre-pandemic level of services because of the governmental orders.

You must also establish that those wages were not used to support a forgiven Paycheck Protection Program (PPP) loan, a Families First Coronavirus Response Act credit or certain other credits. No overlap or double-dipping is permitted.

As an employer, you likely will need to demonstrate compliance by providing documents that show the following:

• PPP loans received
• Any other employment tax credits taken
• Sufficient wage amounts not covered by PPP loans or other credits that used to claim the ERC

Taxpayer takeaway

As the IRS steps up enforcement actions involving ERC claims, the agency has emphasized that taxpayers are ultimately responsible for the information on their tax returns. At the risk of penalties and additional tax obligations, you must be attentive to details and completeness in providing documentation to support ERC claims and other employment tax compliance matters.

For taxpayers subject to an employment tax exam, including an ERC claim, the IRS has resources online that discuss IRS examinations and taxpayer rights. The IRS recommends reviewing this information before meeting with an examiner. Consulting an experienced advisor can also help you understand the processes and complexities of an audit.