Selling Your Business? Be Prepared for ERC Review

By Christopher Migliaccio, JD, Partner and Robert Morisseau, JD, LLM, Manager

Employee Retention Credit (ERC) applications and refunds are becoming increasingly subject to IRS scrutiny. The IRS Commissioner believes up to 95% of all recent claims are fraudulent, including many of those for which refunds have been issued. Given the heightened IRS scrutiny, it is no surprise that potential acquirers and investors, in turn, are taking a closer look at target companies that have either claimed or received ERCs. They are concerned about the potential lingering liability from an IRS audit on the target’s ERC claim. Sellers should act accordingly and be prepared to defend the validity of their ERCs.

Initially, and certainly before sitting at the negotiation table, sellers should take an honest assessment of where they stand in respect to their company’s ERC qualification and documentation. Questions they should ask themselves include:

• Did your company qualify based on a government-mandated shutdown or a significant decline in gross receipts?
• Do you have a memo that documents qualification in a way that would meet IRS scrutiny?
• Do you have support for the amount of your ERC?

ERC Basics

The ERC is a refundable payroll tax credit that was available for employers on “qualified wages” paid in parts of 2020 and 2021 during the height of the COVID-19 pandemic. Businesses were eligible if they were closed (fully or partially) because of a government order related to COVID-19 or had experienced a significant decline in gross receipts (by comparing quarters in 2020 or 2021 to those in 2019). Qualification under the gross receipts test is for full quarters; qualification under the government order test is for the length of the government order (and thus the dates of operative government orders are significant).

The credits were a maximum of $5,000 per employee in 2020, and a maximum of $7,000 per employee per eligible quarter (up to three for most businesses) in 2021, creating a maximum credit of $26,000 per employee. The significant credits available spawned an explosion of marketing campaigns that you likely have seen, heard or read through various communication platforms (i.e., email blasts, letters, radio and TV ads).

So aggressive and misleading were their tactics that in March 2023, promotion claims regarding ERC services topped the “2023 Dirty Dozen,” an annual list compiled by the IRS of the “worst of the worst” tax scams. The IRS indicated concerns with “blatant attempts by promoters to con ineligible people to claim the credit.” These companies took exceptionally aggressive positions that companies who were not subject to qualifying government restrictions were eligible through the end of the third quarter of 2021 and thus could claim their maximum credit. Clients of these firms were often left with memos that do not support qualification and calculations of the credit (sometimes in PDF) that do not show how the amounts were computed.

Why Are Buyers Concerned?

Although the ERC relates to periods prior to a transaction, and indeed, the money may have already been received, improper claims could still generate issues for buyers. Buyers have multi-faceted concerns over inheriting payroll tax liabilities, valuation issues and uncertainty.

Certain tax liabilities will succeed for buyers regardless of transaction structure. While income tax liability generally remains with sellers in the event of an asset sale, payroll tax liabilities will follow the buyer subsequent to a stock or an asset acquisition. Put plainly, if you acquire a company through a stock or asset sale, you will inherit any potential ERC liability since it’s ultimately a payroll tax credit.

Another potential area of concern relates to the valuation of the target company. If a target has applied for but has not yet received an ERC refund, how much confidence can be placed on the corresponding receivable? Buyers will likely insist on reviewing a company’s supporting documentation before crediting any receivable recorded for an ERC claim. Failure to provide adequate support could potentially result in a reduced evaluation and reduction in purchase price. At a minimum, the buyer will put a reserve on the valuation for the uncertainty and future inherent risk of the ERC claim.

Moreover, even if a company has received and deposited its ERC refund, the IRS can still conduct an audit and disallow the ERC. At a minimum, this can result in a company having to return its ERC refund and, in the worst case scenario, could result in an assessment of interest and significant penalties. Currently, the statute of limitations is the latter of three years from the date of filing (five years for refunds related to Q3 2021) or two years from the date of refund. There is currently a proposed bill to extend the five-year statute of limitations to all quarters and not limit it to Q3 2021.

Further, in cases of fraud, there is no statute of limitations, and the IRS can perform an audit at any time. Given the prevalence of and the IRS attention on ERC mills, the IRS could assert that nearly all ERC claims coming from those that worked with ERC mills involve some level of fraud.

What Can a Seller Do to Be Prepared?

First, review your documentation. How do you know if you don’t have support?

Regarding qualification based on a government order, though this language seems simple on its face, IRS guidance and publications have introduced some complicating nuances to this analysis. For example, deciding to follow CDC (Centers for Disease Control and Prevention) or OSHA (Occupational Safety and Health Administration) guidelines does not create qualification on its own. The qualifying government order must be a mandate. Moreover, the government mandate must have caused a significant and measurable disruption (according to IRS guidance, at least a 10% disruption in the ability to deliver goods or services) to business operations. As such, companies that were able to seamlessly (or relatively seamlessly) transition to a remote work environment without a significant decline in the ability to deliver goods or services do not qualify. Even if your business struggled, you must be able to tie those struggles to a government order and quantify those limits.

ERC mills frequently ignored IRS guidance or provided memos that did not actually analyze the facts of the business in comparison to the IRS guidance, thus claiming qualification where the business should not have qualified. Many ERC credit mills used supply chain disruptions as justification as well when qualification under a supply chain disruption was very limited. Interestingly, some companies on review will find that they actually did qualify for the ERC, but that their support was lacking because of poor work product from an ERC mill.

Companies that applied for ERCs based on a significant decline in gross receipts face more of an evidentiary rather than interpretive challenge. Sellers must be in possession of the necessary documentation to prove their company experienced a qualifying decline in gross receipts to the satisfaction of prospective buyers. The level of documentation required to do so will vary with each potential buyer’s level of risk aversion but, as a safeguard, sellers should be prepared to validate their ERCs to potential buyers with no appetite for risk.

Substantiation Documents

After this initial review of your company’s underlying qualification, the next task is to ensure you are in possession of the documents required to substantiate the expenses claimed as an ERC. The below list is a good start but is certainly not exhaustive.

• A copy of the ERC calculation and paid sick and family leave for eligible quarters, which includes evidence that no wages used for the ERC were also used for Paycheck Protection Program (PPP) forgiveness (if applicable).
• Copies of PPP Loan Forgiveness Applications and Forgiveness Letters.
• A listing of employees, dates and amounts for those who were paid sick and family leave and were eligible for the ERC.
• Copies of paid sick and family leave required statements provided by employees for the requested leave, written support and statement that the employee is unable to work due to a COVID-19 related reason.
• Copies of documentation to show how qualified health plan expenses were allocated to wages.
• Documentation that operations were fully or partially suspended due to governmental orders.
• Copies of income tax returns, employment tax returns and W-2s for related entities if the taxpayer is part of an aggregated group.
• Copies of W-2s, Form 941s and Form 941-X filings.

Your company may be in possession of some or all of the above documents; however, many companies either outsource their payroll administration to third-parties or engaged a third-party to conduct an ERC study and even submit applications on their behalf. Some third-party payroll service providers file jointly on behalf of several companies and obtaining records specific to one company may be challenging. Earlier review also avoids the potential of key documents being lost as employees leave or memories of government order impacts being lost.

ERC Indemnity

If a seller can’t provide support, a buyer could treat ERC (whether received or not) as a liability and will likely ask for specific indemnities relating to ERC liability from the seller. In extreme cases, if the size of the ERC is large, it could imperil a buyer’s willingness to complete the sale. If sellers find that they lack sufficient documentation and have not yet received their ERC check, they could consider withdrawing some or all of the quarterly returns.

Closing

Even as ERC claims recede further into the past, they remain significant issues for tax diligence. Getting ahead and reviewing your ERC claim in advance can make your due diligence process much simpler, as well as provide peace of mind – a knowledgeable and prepared seller can be a confident one.

Contact Us

PKF O’Connor Davies has helped hundreds of companies across a number of industries determine their ERC qualification, calculate their credit and help them file amended payroll tax returns.

If you have questions about the employee retention credit, contact your PKF O’Connor Davies client service team or:

Christopher Migliaccio, JD
Partner
ERC Services Leader and Transaction Advisory Tax Leader
cmigliaccio@pkfod.com

Robert Morisseau, JD, LLM
Manager, Transaction Advisory
rmorisseau@pkfod.com