January 29, 2021 – Audits constitute an important and necessary part of the taxation system, both at state and federal levels. That said, it’s never fun. At the same time, claiming the maximum amount of credit benefits can mean the difference between profit and loss, especially during difficult economic times. COVID-19 brought on just such a difficult time, and the Employee Retention Credit (ERC) represents just such a vital credit for affected businesses. What this means is that the tax executives for those businesses now face a challenging task: weighing the potential benefits of ERC claims against the risk of a future audit.
Some companies may desperately need as much tax credit as they can manage to get. Other companies may have more interest in avoiding a surprise audit down the road. The first step in planning the ERC application process involves figuring out where on that spectrum your enterprise lies. Once you know your goal, you can start to assess the risk.
Importantly, however, you must consider not only the possibility of an audit but the potential of financial overexposure or operational overburdening in the pursuit of maximizing your credit. In this sense, a lack of transparency from your tax service provider is one of the largest risks involved. In order to guard against all of the risks combined, it may help to approach ERC claims with a process that includes three risk gates. Prior to going “through” each gate, a risk analysis should be performed.
The 1st Gate: Getting Started
Before even starting to calculate a benefit claim, you should ask a number of questions related to risk.
- Are your areas of eligibility low risk, high risk or both? (See risk breakdown below.)
- Will you apply for credit across all eligibility areas or only the low-risk areas?
- Are you working with a tax credit service partner that operates transparently, uses a proven methodology, provides useful insights and answers every question satisfactorily?
- Alternatively, do you have a capable internal tax assessment team that understands the necessity of inter-departmental collaboration and is experienced with complex credits like ERC?
- Regardless of who implements it, will the methodology significantly impact your business?
- What will the operational impact look like?
The answers to each of these questions will help paint a picture of your assumed risk.
The 2nd Gate: Deciding the Claim
At this stage, you’ve answered the questions above, chosen which areas of eligibility to pursue, implemented the methodology and come up with your claim amounts — but you haven’t yet added them to your return. Before you do, it’s time to perform another risk assessment. Largely, this one will involve cross-analyzing the results to determine accuracy and validity. Has every key assumption that informed the data been uncovered and accounted for?
Another question you will want to ask at this stage regards the efficacy of employee interviews, which for many companies will be an integral part of the methodology itself. Did the interview process inspire confidence? Were interviews consistent, professional and well-documented? Before inputting your claim, you’ll want to answer these kinds of questions in order to re-establish what risks you may be assuming and whether or not they are acceptable.
The 3rd Gate: Delivery
You’ve assessed risk, implemented methodology, derived a benefit calculation, reassessed risk and confirmed the credit amount you’ll pursue. Now it’s time to file your claim and provide all supporting documentation. Of course, it warrants more attention than simply uploading everything stored in your company’s ERC folder.
For instance, you want to ensure that your documentation is consistent with the latest IRS guidance and determine whether it also accounts for the recent changes made to ERC with the introduction of the Consolidated Appropriations Act of 2021. All supporting files should be checked carefully for consistency and freedom from error.
What’s Your Risk Tolerance?
Extracting data and qualifying wage eligibility must be approached with an eye for risk and an open mind. Wages may not simply be “eligible” or “ineligible.” In fact, they fall into a range of categories up and down the risk ladder. Different tax credit service providers may use varied methods of categorizing and analyzing risk, but for a general description, you can reference the patterns outlined here:
Lower risk categories include wages such as those attached to a COVID payroll code, especially where the employee provided no correlating services to the company, or those not attached to a COVID payroll code but clearly tied to other documented company policies.
Higher risk categories include wages whose eligibility cannot be clearly determined by codes or policies but which are clearly correlated with a decline in productivity metrics or performance indicators. Wages qualified through employee interviews or via statistical sampling represent the highest rung on the risk ladder.
Arguably, the risk of an IRS audit in the near future is lower than in most years, as governmental organizations are strained and a temporary sympathy toward businesses is observed. Meanwhile, the CARES Act COVID-19 Employee Retention Credit (ERC) represents an excellent opportunity for businesses to shore up financial weak spots resulting from a global recession.
Companies can minimize their risks involved with ERC claims and simultaneously maximize those claims if they proactively perform risk assessments, choose service providers carefully and approach the situation from a long-term, goal-oriented standpoint.