Employee Retention Credit Schemes Are Symptom Of A Dysfunctional Tax System

Lance Wallach is an expert on abusive tax transactions – in a good way.  He warns people about them and then helps the ones who didn’t hear his warnings or did not take the warnings seriously enough.  A couple of weeks ago he called me to encourage me to write about the Employment Retention Credit (ERC).  He told me his phone was ringing off the hook about it,  I thought ERC and the abuse that was going on with it was old news.  That’s mainly because the only # I pay serious attention to is #TaxTwitter.  You may not follow #TaxTwitter, but the IRS clearly does

Even the New York Times is catching on.

New York Times Story

Alan Rappeport has a story about ERC in the New York Times.  It is quite good, even excellent by the standards of New York Times tax coverage.  I love the New York Times.  Brian Moroney, an English teacher at Xavier High School, required us to get it on Sundays and read the literary section. And then there are the obituaries.  Tax coverage not so much.  It comes across in the headline This Little-Known Pandemic-Era Tax Credit Has Become a Magnet for Fraud.  Tax pros have been dealing with the ERC fraud problem for a while.  This is from nearly year ago.

Rappeport’s story closes with the most recent IRS warning – IRS alerts businesses, tax-exempt groups of warning signs for misleading Employee Retention scams; simple steps can avoid improperly filing claims.

How Did We Get Here?

The current batch of scamsters is just another instance of the seemingly irresistible impulse to use the Tax Code as the Swiss Army Knife of social policy while refusing to be serious about funding IRS enforcement.  Throw in a plague, which is how I refer to COVID-19, and we had the worst few tax seasons (2020, 2021 and 2022) in at least a generation.  I’m 71 and started in public accounting at a large local firm in 1979.  I was on the sidelines when this all hit. My partner and I had withdrawn from the boutique practice we had finished up our careers with at the end of 2018.

We were touring the country in our RV.  I was consulting for some CPAs and of course writing, so I was in touch with how hard this was for tax practitioners. The truth is that when I look back on my life and compare notes with my classmates, tax accounting is a pretty soft life.  Most of the stress in it is created by greed and ego, not necessarily the greed and ego of those experiencing the stress.  Those seasons were different.  Tax practitioners were leaned on as a sort of emergency finance corps to direct funds to keep businesses going.  There was even money in the legislation to pay them, but the banks kept that for themselves.

In a May 2021 article in Think Outside The Tax Box, I referred to the Employee Retention Credit as the ugly stepchild of the 2020 CARES Act.  The reason was that the Paycheck Protection Program was much easier to access, once it got properly running and much more broadly applicable.  And initially you could not get both a PPP loan and qualify for ERC.  Then came the Taxpayer Certainty and Disaster Tax Relief Act on December 27, 2020.  Besides boosting ERC for 2021, it retroactively allowed PPP participants to take the credit.

PPP was an SBA loan that you got from a bank. If you spent the proceeds properly you did not have to pay it back and, as clarified by the Certainty Act you could still deduct the expenses. ERC is a credit that was claimed on quarterly payroll tax returns.  That meant that at least for 2020 you hade to amend payroll returns to get the credit.  The other thing about ERC was that you did not get an income tax deduction for wages that you claimed the ERC on.  And you could not use wages on which you took ERC for in claiming PPP loan forgiveness.

For my article I interviewed Jeff Kristoff, Tax Director of Rosen Associates in Westborough Mass.  They put all the pieces together for their clients doing the ERC refund work, making sure it was reflected properly on the income tax returns and coordinated with PPP forgiveness applications.  They also made sure that the clients actually qualified for the ERC in the quarters in which it is claimed.

And Now

I checked back in with Jeff Kristoff to see how it is going with ERC now.  It is no longer a live program, so all the ERC action now involves amending quarterly returns filed for 2020 and 2021,  Quarter by quarter there will be fewer eligible returns within the statute which creates a sense of urgency particularly among the fly by night outfits that are exploiting this situation.

At Jeff’s firm they regularly get emails from clients who have been pitched saying “do I qualify for this?.  As he puts it:

“The story is always the same.  They receive a letter that looks official saying they are eligible for a credit or they spoke with someone that obtained an ERC and in both situations are told it is “risk free, pay only if we find a refund.”  That’s the problem – there were so many programs during COVID that business owners rely on experts to know what they are eligible for.  When a consultant offers them a free analysis, they assume there is no harm.  But there is no analysis, the ERC mill is almost always promoted by a salesman that prior to 2021 was selling some other product and has no tax experience.”

The big complexity in the ERC is not the calculations which can be automated, but whether there was a shutdown order that actually qualifies or sufficient decline in gross income.  And here is what happens

“Usually after the client spoke with a salesperson, they would receive an engagement letter.  Remember, the salesperson is saying “of course you qualify, and we’ll do an analysis.Every engagement letter included language that the business owner determined they qualified and was engaging the consultant to do a calc.”

If the client bites then

“The consultant then takes payroll, sometimes ignoring PPP/ERC optimization, limits wages by employee and tosses it onto a 941.  When a business owner receives the funds they just assume the IRS has approved the refund claim which of course isn’t the case, the IRS has just processed a 941-X and the consultant wants a huge % of the refund.”

Amending the income tax return to remove the deductions is not something the consultant does.  That is left to the stodgy tax preparer who did not tell them that they qualified, which they likely don’t.  And when the IRS comes knocking the consultants will be long gone.

Lance Walach tells me that these scams are different than the ones he has seen before.  They are more broadly applicable and do not require the same level of sophistication to execute.

Just like conservation easements and micro-captives, the IRS given its recent warning will be tougher on taxpayers that make egregious ERC claims.

“Unlike prior scams like 419 welfare benefit or 412i plans which required a large outlay of money the market for ERC plans is much larger,. Similar to syndicated conservation easements, captive insurance, 412i or 419 plans the marketing is the same. If your accountant was educated and not an IRS tax collector you would already be in the plan. Unlike the other schemes I have received a large volume of phone calls from business owners who unfortunately will be audited.”

Reflection

The Employee Retention Credit was a program in effect for less than two years which was subject to multiple rule changes.  It was a serious struggle for tax practitioners who wanted to do it right.  I once did a back of the envelope estimate of how many people make at least part of their living working on income taxes, what I call the tax industry.  I came up with a million, I’m not sure how good the estimate was, but it is within reason.  One thing about the group whatever its true size is is that nobody knows everything.

The other thing about the tax industry is that it tries to deliver to its customers two things that are in tension with one another.  There is helping you to be in reasonable compliance and then there is helping you not pay more than you have to. What adds to the tension between those two is that the IRS is badly broken. There are a lot of issues like basis, at-risk and the passive activity loss rules where if you have somebody who knows what they are doing preparing your return, you will likely pay more than if you have a preparer who doesn’t pay much attention to those issues.

If your return gets audited and the agent figures out the problem you will be billed for the deficiency and interest and likely a 20% penalty, although you will have a you didn’t know any better argument to get out of the latter,  What are the odds that will happen?  Probably less than 1%,  So does it make sense to pay extra for somebody who knows the rules better? Sure it does, if you want extra peace of mind and want to be a good citizen.

Of course it is possible that the more knowledgeable adviser will know about benefits that you are entitled to or better ways of structuring transactions.  And it is possible you have a high audit profile making it prudent to be meticulous in compliance.  Then you will get more than your money’s worth from working with more knowledgeable advisers.  They are still not going to know everything.  And maybe you will hear about something that they didn’t think to mention to you.

That is where the consultants come in.  It never occurred to you that a lot of what you do qualifies for the research and development credit.  Your adviser did not suggest that an engineer could figure out all the various components that are part of your building that can be written off much faster.  Those are among the more respectable ones, although they will sometimes push the envelope.  Other things like monetized installment sales and syndicated conservation easements are, in my mind are beyond the pale.  The Employee Retention Credit is something that might have been missed by regular tax preparers, so there is a logic to alerting people to the credit.  You should however only do refund claims for people who actually qualify, which likely means there would not be that much business.

The cause of simplifying the income tax by using it solely as a way to raise necessary revenue seems hopeless.  Many things are uncertain, but this we can almost guarantee.  The people now promoting bogus ERC refund claims will have something else to promote before the last ERC refund claim is submitted.

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Originally published on Forbes.com.

For great value continuing professional education.  I recommend the Boston Tax Institute

You can register on-line or reach them by phone (561) 268-2269 or email vc@bostontaxinstitute.com.  Mention Your Tax Matters Partner if you contact them.

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For articles oriented toward tax professionals check out Think Outside The Tax Box.