It’s time to have a conversation about audits, specifically the Internal Revenue Service employment tax audit and the Small Business Administration PPP loan forgiveness audit. Regardless of what industry or sector includes your organization, the COVID-19 pandemic forced all employers, big and small, to deal with new employment issues. Fortunately, government-backed relief quickly became available, and many employers took advantage of one or even all of the following: the SBA’s Paycheck Protection Program (PPP),1 the Employee Retention Tax Credit (ERTC),2 the employee/employer Social Security tax deferral,3 and the paid sick and family leave credits under the Families First Coronavirus Response Act (FFCRA), the Coronavirus Aid, Relief, and Economic Security Act (CARES), and the Consolidated Appropriations Act (CAA), including extensions under the American Rescue Plan Act of 2021 (ARPA).4
These payroll tax benefits, which hinge on qualified wages and health plan expenses, presented much-needed injections of cash to keep employers operating and employees earning wages. How will the government perform its due diligence to ensure that those payroll funds and credits are doled out properly? How will penalties and tax be assessed on bad actors?
Enter the employment tax audit.
Without going too deeply into the multiple types of relief, this article aims to inform employers about the interplay of these benefits, the required documentation each employer should maintain, and the likelihood of an IRS or SBA audit.
The IRS provides guidance, in Notice 2021-20, on eligibility for the ERTC, including the interplay among FFCRA credits, the ERTC, and the PPP loan forgiveness program.5 One commonality among these payroll tax benefits is that no double-dipping can occur on the same wages. That is, an employer cannot claim PPP loan forgiveness on the same funds used to pay qualifying wages when the employer also received the FFCRA or ERTC credit.
That said, if an employer reports wage expenses on the forgiveness application for a PPP loan and that loan is not forgiven, the employer can then use those wages for the ERTC. Employers must track wages for each employee and the benefit or credits being applied to those wages. Employers need to track information such as:
- orders issued by a government authority, and the period covered, to suspend operations, commerce, travel, or group meetings due fully or partially to COVID-19;
- any records (such as quarterly financial statements) the employer used to determine that it had experienced a significant decline in gross receipts for 2019–2021;
- the number of full-time employees working and not working, for large employers with over 500 (formerly 100) full-time employees;
- documentation that a government shutdown had more than a nominal effect on business operations when compared with 2019; that is, either 1) more than ten percent of gross receipts were affected or 2) ten percent of total hours of business operations were affected; and
- documentation for determining whether the employer is a member of an aggregate group treated as a single employer for ERTC purposes.
Also, large employers, those with more than 500 (formerly 100) full-time employees, should take care to adhere to the thirty-day rule applicable for 2020. That is, qualified wages paid to an employee may not exceed what the employee would have been paid for working an equivalent duration during the thirty days immediately prior to the start of the government-ordered suspension of operations or the first day of the calendar quarter in which the employer experienced a significant decline in gross receipts.6 An employer should be ready to support and defend:
- proof of employee wages paid for mandatory and elective sick/family leave;
- proof of eligibility for a PPP loan (including what the loan proceeds were used for); and
- proof of qualified wages under the ERTC.
Clearly, employers must maintain copies of Form 7200 (Advance Payment of Employer Credits Due to COVID-19), Form 941 (Employer’s Quarterly Federal Tax Return), and Form 941X (Adjusted Employer’s Quarterly Federal Tax Return), along with documentation supporting the credits claimed. But employers should also be prepared to show how they determined the amount of qualified health plan expenses they allocated to wages and how they determined the amount of paid sick leave to eligible employees, including records of work, telework, and paid sick leave. The IRS has also issued FAQs on what records should be maintained.7
The PPP loan forgiveness program requires borrowers to retain supporting wage reports and records demonstrating compliance for six years after the loan is forgiven. Employers are required to maintain all documentation related to employee and family sick leave for four years, regardless of whether leave is granted or denied.8 Documentation for the ERTC should also be retained for four years. However, assuming the employer took full advantage of all benefits, due to the interplay with PPP, an employer should consider maintaining all records demonstrating compliance with payroll credits for six years as well.
Here’s what we know about employment tax audits: they are a standalone process within the IRS, independent of a typical federal income tax examination, and employment tax exams can bring in significant revenue streams for the IRS. In 2017 the Government Accountability Office (GAO) published results from a national research program that analyzed IRS employment tax audits conducted between 2010 and 2013, to identify compliance issues relating to the tax gap. It turns out that twenty percent of the tax gap, an estimated $77 billion, relates to unpaid employment taxes.9 The results of this analysis led to the specific hiring and training of IRS employment tax agents and helped to establish the information document request (IDR) methodology for prospective employment tax examinations.10 Within the IRS, employment tax specialists sit in two groups, in either 1) the Small Business/Self-Employed Division or 2) the Tax-Exempt and Government Entities Division.11
Still, just how likely is an IRS employment tax audit? The IRS picks who will get examined in several ways. For example, some industries are more fraught with abuse than others and may be picked for audit based on the high likelihood of error, such as where the lines between independent contractors and employees are blurred. Sometimes an employee within the organization knows of an area of risk and divulges this information through the anonymous whistle-blower program.
Often IRS employment tax specialists can determine if the taxpayer is ripe for examination simply by reviewing a company’s Form 941. An “unofficial audit” can occur where an amended Form 941X requests a significantly large refund and a specialist sends a notice requesting additional support for the amended return. This scenario could be problematic for the many employers who had no choice but to file an amended Form 941X to request the ERTC after Congress retroactively changed the rule to allow employers who received PPP loans to also receive ERTCs. Also, in the past, employment audit specialists have chosen topical areas, called campaigns, where abuse or misunderstanding of the Code occurs frequently. It’s possible that an employment tax campaign could be designed to review the interplay of wage benefits assigned to the PPP, the FFCRA, paid sick and family leave credits, and the ERTC to ensure there is no double-dipping on the same wages.
Currently, the IRS is stretched incredibly thin in terms of resources. IRS employment is down twenty-two percent over the last decade, from nearly 95,000 employees in 2010 to under 75,000 employees in 2019.12 Much of this attrition is due to retirements, but a significant amount is due to lack of funding and resources; the IRS’ budget was cut by twenty percent over that same ten-year period.13 That said, the IRS continues to request budget increases to beef up its enforcement efforts. Recently US Treasury Secretary Janet Yellen stated that, under President Joe Biden’s fiscal 2022 budget request, an IRS budget increase of $1.2 billion would include $900 million for added enforcement.14
Enter the SBA PPP loan forgiveness audit.
We were all excited to learn that PPP loans are not includible in gross income, qualifying expenses are fully deductible, and the PPP loan is forgivable. However, larger companies are likely to see an SBA audit before anything is forgiven. On April 28, 2020, then-Treasury Secretary Steven Mnuchin announced that every company that received a loan of $2,000,000 or more would be audited to ensure that loans met the eligibility requirements and were used for intended purposes. And, each for-profit organization that received at least $2,000,000 is required to complete a loan necessity questionnaire.15 Although a safe harbor exists for companies receiving less than $2,000,000 in PPP, every company was required to certify, in a good-faith statement, that the loan was necessary to support the ongoing operations of the organization. Mnuchin warned that the SBA would be likely to perform spot checks.
Furthermore, the IRS criminal investigation unit has stepped up its enforcement and investigation activities for COVID-19-related fraud, including fraudulently obtained PPP loans, employee retention credits, and economic impact payments.16
With millions of dollars in tax benefits relating to payroll being dispensed and credited, payroll departments should prepare for and keep documentation substantiating their company’s eligibility for the proceeds they receive and for the credits they take in advance of an IRS employment tax audit or an SBA audit. The employment tax department of an organization should ensure that the correct amount of tax is submitted and take proper steps to minimize audit risk. If areas of risk exist within the employment tax function, the organization should create a governance committee to take action to identify and correct the exposure. Employment tax underpayment and late payment penalties can be significant.
Shannon Christensen, JD, MBT, is a tax and accounting specialist editor with Thomson Reuters Checkpoint.
- Paycheck Protection Program Flexibility Act of 2020,
L. 116-142 (June 5, 2020), as extended by the COVID-related Tax Relief Act, P.L. 116-230 (December 27, 2020).
- Coronavirus Aid, Relief and Economic Security (CARES) Act, P.L. 116-136 (March 27, 2020), as extended and modified by the Consolidated Appropriations Act (CAA), P.L. 116-136 (December 27, 2020), and the American Rescue Plan Act (ARPA), P.L. 117-2 (March 11, 2021).
- Consolidated Appropriations Act (CAA), P.L. 116-136 (December 27, 2020), Notice 2020-65.
- American Rescue Plan Act (ARPA), P.L. 117-2 (March 11, 2021).
- Notice 2021-20.
- Notice 2021-20 (March 1, 2021), Q&A 35.
- “How Should an Employer Substantiate Eligibility for Tax Credits for Qualified Leave Wages?” Internal Revenue Service, January 28, 2021, irs.gov/newsroom/how-should-an-employer-substantiate-eligibility-for-tax-credits-for-qualified-leave-wages.
- 29 CFR 826.100.
- IRS Publication 5365, Tax Gap Estimates for Tax Years 2011–2013, Internal Revenue Service, revised September 2019, irs.gov/pub/irs-pdf/p5365.pdf.
- “Employment Taxes: Timely Use of National Research Program Results Would Help IRS Improve Compliance and Tax Gap Estimates” (GAO-17-371), US Government Accountability Office, May 18, 2017, gao.gov/products/gao-17-371.
- Internal Revenue Manual 1.1.16 Small Business/Self-Employed Division.
- “Stretched to Its Breaking Point, the IRS Needs Multiyear, Sustained Funding to Efficiently Administer the Tax Laws and Provide Quality Service for Taxpayers,” National Taxpayer Advocate (NTA blog), March 17, 2021, taxpayeradvocate.irs.gov/news/stretched-to-its-breaking-point-the-irs-needs-multiyear-sustained-funding-to-efficiently-administer-the-tax-laws-and-provide-quality-service-for-taxpayers/.
- David Lawder, “Biden Budget Would Beef Up IRS Tax Enforcement: Yellen,” Reuters, April 9, 2021, reuters.com/world/us/biden-budget-would-beef-up-irs-tax-enforcement-yellen-2021-04-09/.
- PPP Loan Necessity Questionnaire (For-Profit Borrowers), Form 3509, Small Business Administration, December 31, 2020, sba.gov/document/sba-form-3509-ppp-loan-necessity-questionnaire-profit-borrowers.
- “IRS Criminal Investigation (CI) Pledges Continued Commitment to Investigating COVID-19 Fraud as CARES Act Reaches One-Year Anniversary” (IR-2021-65), Internal Revenue Service, March 25, 2021, irs.gov/newsroom/irs-criminal-investigation-ci-pledges-continued-commitment-to-investigating-covid-19-fraud-as-cares-act-reaches-one-year-anniversary.