Employee Retention Credit Audits: New Rules, Old Problems

The Shifting Landscape of the Employee Retention Credit

The IRS continues to review Employee Retention Credit (ERC) claims, including through examinations and review of disallowance responses. Eligibility depends on the employer, wages and quarter involved. The IRS warned about aggressive ERC promotion in its 2023 Dirty Dozen list. A historical processing moratorium should not be confused with the current rules for pending claims, eligibility or filing deadlines.

Key Facts About ERC Credit Audits:

Extended Assessment Period: For amounts attributable to section 3134 ERC claims for Q3/Q4 2021, the assessment period cannot expire before six years after the latest of the original return filing date, its deemed filing date or the credit/refund claim date.
Erroneous-Claim Penalty: Section 6676 generally imposes 20% of an excessive refund or credit claim, subject to reasonable cause and coordination rules; employment-tax coverage applies to claims made after July 4, 2025. It does not stack on a disallowed portion already subject to an accuracy-related or fraud penalty.
Q3/Q4 2021 Cutoff: After the July 4, 2025 enactment, section 3134 credits cannot be allowed or refunded unless the claim was filed on or before January 31, 2024.
High Scrutiny: The IRS is targeting claims from aggressive promoters.
Correction Options: The ERC voluntary disclosure application windows have closed. Eligible employers may request withdrawal of an entire unpaid claim or one paid by an uncashed, undeposited refund check.

Many businesses claimed the credit in good faith, only to find they may not have met the strict eligibility requirements. An improper ERC claim can trigger repayment, penalties, interest, and years of IRS scrutiny.

ERC credit audits: Review the relevant notices, filing history, records, and deadlines before choosing a response. Evaluate professional assistance according to the facts, applicable law, and agreed scope of representation.

The One Big Beautiful Bill Act (OBBBA): What Employers Need to Know

The One Big Beautiful Bill Act (OBBBA), enacted on July 4, 2025 as Public Law 119-21, changed ERC claim restrictions, assessment periods and certain penalties. The particular provision and its effective date matter; not every change applies to every ERC quarter or claim.

Key Changes to the ERC Under OBBBA

The OBBBA provides that, after its enactment, no credit or refund under section 3134 for Q3/Q4 2021 may be allowed or made unless the claim was filed on or before January 31, 2024. Review the filing record and any IRS determination; this cutoff does not establish that a timely claim otherwise qualifies.

This rule is specific:

Claims for Q3/Q4 2021 filed on or before January 31, 2024, are not barred by this particular cutoff, but remain subject to eligibility and other applicable rules.
Claims for 2020 or Q1/Q2 2021 are outside this particular section 3134 cutoff; their own eligibility and limitation rules still apply.

While this change is narrow, the OBBBA’s impact on audits and penalties is broad, reflecting heightened concerns about tax fraud.

New Statute of Limitations and Penalties

For Q3/Q4 2021 section 3134 claims, the assessment limitation now cannot expire before six years after the latest of the original return filing date, the date the return is treated as filed under section 6501(b)(2), or the date the credit/refund claim was made. The earlier section 3134 rule used five years after the later of the first two dates, not a uniform three-year period. The amendment applies to assessments made after July 4, 2025; separate exceptions or extensions may also matter.

Section 6676 now reaches employment-tax refund or credit claims made after July 4, 2025. Its 20% penalty is generally calculated on the excessive claim, even if no refund was paid. Reasonable cause and statutory coordination rules apply, including exclusion of a disallowed portion subject to accuracy-related or fraud penalties. See the IRS’s general guidance on false claims.

Here’s how the rules compare:

Aspect	Rule or Scope	Current Treatment and Conditions
Statute of Limitations	Section 3134 amounts attributable to Q3/Q4 2021 credits; the earlier special period was five years.	At least 6 years from the latest of original filing, deemed filing or claim date; other exceptions or extensions may apply.
Erroneous Claim Penalty	Section 6676 excessive income- or employment-tax refund/credit claims; employment-tax coverage applies to claims made after July 4, 2025.	Generally 20% of the excessive claim, whether paid or unpaid, subject to reasonable cause and coordination with accuracy-related and fraud penalties.
Promoter Penalties	New due-diligence requirement for a statutorily defined COVID-ERTC promoter providing covered assistance after July 4, 2025.	$1,000 per failure to comply with the prescribed due-diligence requirement; the statutory promoter definition and exceptions must be reviewed.
Related Wage-Deduction Refund Period	Income-tax overpayment attributable to a deduction for improperly claimed ERC wages, when an assessment attributable to the section 3134 credit is made.	The related refund/credit limitation cannot expire before the section 3134 assessment period; this is not a blanket six-year deadline to amend every income-tax return.

The new promoter due-diligence penalty is $1,000 for each failure by a statutorily defined COVID-ERTC promoter to comply with the prescribed requirements for covered assistance after July 4, 2025. The definition uses specified fee and gross-receipts tests and includes an exception for certified professional employer organizations. It does not automatically classify every advisor as a promoter.

Are You at Risk? ERC Eligibility and Common Red Flags

Understanding the core ERC eligibility rules is the first step in assessing your audit risk. The IRS is targeting claims that don’t meet its specific criteria, which were often glossed over by aggressive promoters.

Core Eligibility Requirements (2020 vs. 2021)

For 2020 and the first three quarters of 2021, the principal eligibility tests concerned suspension by a governmental order or a qualifying decline in gross receipts. Recovery startup businesses had separate rules for Q3/Q4 2021; only recovery startup businesses remained eligible for Q4 2021. Apply the rules for the particular quarter:

Full or Partial Suspension of Operations: A COVID-19 governmental order must have caused the relevant suspension. For partial suspension, the affected portion or operational modification must satisfy the applicable more-than-nominal rules. The 10% safe harbor for a suspended portion uses that portion’s share of gross receipts or employee service hours in the same 2019 quarter; operational modifications have a separate effect test. Recommendations, voluntary closures and a general 10% revenue loss do not by themselves establish eligibility.
Significant Decline in Gross Receipts: The qualification threshold changed by year.
- For 2020: The significant-decline period generally began with a quarter whose gross receipts were below 50% of the same 2019 quarter; eligibility under this test stopped in the quarter after receipts first exceeded 80% of the comparable 2019 quarter. Special rules and aggregation may affect the comparison.
- For 2021: For the first three quarters, gross receipts generally had to be less than 80% of the same 2019 quarter. An alternative-quarter election can use the immediately preceding quarter; special comparison rules apply to employers not in existence in 2019.

A Recovery Startup Business must have begun carrying on a trade or business after February 15, 2020, and satisfy the average annual gross-receipts limit of $1 million or less for the relevant preceding 3-taxable-year period, with special rules for shorter periods and aggregation. The category applied in Q3/Q4 2021, with a $50,000 credit limit per quarter. For Q3, it also required not otherwise qualifying under the suspension or receipts tests; Q4 eligibility was limited to recovery startup businesses.

Qualified wages include eligible wages and allocable health-plan expenses, subject to exclusions and coordination rules. The wage cap was $10,000 per employee for all of 2020 and $10,000 per employee per eligible 2021 quarter. Large-employer status generally uses the average number of full-time employees in 2019: more than 100 for 2020 and more than 500 for 2021, with aggregation and special rules for newer employers. Large employers generally count wages paid for time employees did not provide services; a separate severely financially distressed employer rule applied in Q3 2021. Related-individual exclusions can also matter. For guidance, check the most recent IRS guidelines.

Interaction with PPP and Other Relief Programs

The same wages cannot support both ERC and Paycheck Protection Program (PPP) loan forgiveness. Keep records showing the allocation. For Q3/Q4 2021 section 3134 credits, coordination also excludes payroll costs taken into account for Shuttered Venue Operators Grants or Restaurant Revitalization Grants; other credit-coordination rules may apply. See the SBA’s Paycheck Protection Program information.

Warning Signs of an Ineligible Claim or Scam

The IRS has warned about misleading tactics from “credit mills.” Be wary if you encountered any of these red flags:

Unsolicited Contact: Aggressive marketing calls, emails, or ads promising massive refunds.
Guaranteed Qualification: Claims you qualify without a detailed review of your government orders, gross receipts, and operations.
Contingency Fees: Fees based on a percentage of the refund are an IRS warning sign. The fee arrangement alone does not prove a claim is invalid, but warrants careful review.
No Documentation Request: The promoter prepared your claim without asking for comprehensive supporting documents.
Supply Chain Claims: Being told you qualify based solely on supply chain disruptions, which the IRS has stated is not sufficient on its own.
High-Pressure Tactics: Being pushed to sign and file immediately with warnings of fake deadlines.

These tactics are common in various tax scams, including those related to clean energy credits. If these signs are familiar, it’s time to review your ERC claim. You can learn more about protecting yourself from such schemes by understanding how to beware of clean energy tax credit scams.

Navigating the IRS ERC Credit Audits Process

If selected for an ERC credit audit, organize evidence supporting eligibility and the amount claimed. Substantiation is important, but the applicable burdens and procedures depend on the issue; an incomplete file does not itself establish fraud.

How to Prepare for ERC Credit Audits: A Document Checklist

Read the audit notice and any Information Document Request (IDR), note the response deadline, and identify the records relevant to the stated issues. Common supporting records include:

Payroll Records: Detailed journals, W-2s, and 941s showing wages paid by employee and pay period.
Gross Receipts Calculations: Financial statements and clear quarter-by-quarter comparisons to your 2019 baseline.
Government Orders: Copies of the specific federal, state, or local orders that suspended your operations.
PPP Loan Forgiveness Documents: Your application and supporting schedules showing how you allocated wages to avoid “double-dipping.”
Health Plan Expenses: Documentation of costs included in your qualified wage calculation.
Full-Time Employee Count: Records supporting the average number of full-time employees in 2019, aggregation and any applicable rule for a newer employer.
Promoter Correspondence: Any communication with advisors who helped you file the claim.

Review the relevant notices, filing history, records, and deadlines before choosing a response. Evaluate professional assistance according to the facts, applicable law, and agreed scope of representation. Related resources: IRS audit defense strategies.

What to Expect During the Audit

The steps and pace of an ERC credit audit depend on the examination. Possible steps include:

Notification Letter: The IRS will send a letter specifying the tax periods under examination. Do not ignore the response deadline.
Information Document Request (IDR): The examiner may request records supporting the issues under review. Check the actual request and response deadline.
Interview: An examiner may ask about business operations, the basis for eligibility and the credit calculation.
Document Review: The agent will compare your Form 941-X against the documentation you provide, checking your math and verifying eligibility.

Keep records supporting the claimed credit and address questions or discrepancies accurately. The applicable burden of proof varies by issue, including special rules for fraud; do not assume every disputed claim is fraudulent. For an overview, see what is an audit.

Potential Penalties and Outcomes of ERC Credit Audits

An unfavorable audit outcome means more than just returning the money. Potential consequences include:

Credit Disallowance or Repayment: An unpaid improper claim may be denied; a credit already received may need to be repaid, depending on the determination and any available review.
Interest: Interest may apply under the relevant tax and penalty rules. Its starting date and amount depend on the type of assessment and circumstances; it does not universally run from the refund date.
20% Erroneous-Claim Penalty: The section 6676 erroneous-claim penalty is distinct from the section 6662 accuracy-related penalty. The 2025 amendment extended section 6676 to employment-tax claims made after July 4, 2025. It generally uses 20% of the excessive claim, subject to reasonable cause and statutory coordination rules.
Civil Fraud Penalty: Section 6663 imposes 75% of the portion of an underpayment attributable to fraud, subject to its proof and allocation rules. An error or disallowed credit alone does not establish fraud.
Criminal Exposure: Deliberately fraudulent claims may lead to criminal investigation or prosecution. Withdrawal does not provide immunity for fraudulent conduct.

Review the determination, deadlines and available challenge or payment options. Eligibility for a payment arrangement or other relief depends on the facts. Our guide on what to do if you owe the IRS but can’t pay discusses possible approaches.

Correcting an Improper ERC Claim: Your Options

If an ERC claim may be incorrect, review its status, the applicable quarter, payment history and any IRS notice before choosing a correction. The ERC voluntary disclosure windows are closed; withdrawal is available only when its requirements are met. A correction does not automatically eliminate every tax, interest or penalty consequence.

The IRS Voluntary Disclosure Program (VDP)

The IRS introduced a Voluntary Disclosure Program (VDP) for the ERC. The application windows for these programs (Announcement 2024-3 and Announcement 2024-30) have now closed. These programs allowed employers to come forward and resolve their liabilities before an audit.

Withdrawing an Unprocessed ERC Claim

The ERC claim withdrawal process may be available for an entire claim that is unpaid or paid by an uncashed, undeposited refund check. A request is effective only when you receive the IRS acceptance letter. An accepted withdrawal is treated as if the claim had not been filed, without interest or penalties on that withdrawn claim, but it does not shield fraudulent conduct from investigation or prosecution.

The withdrawal process requires all of the following conditions:

You claimed ERC on an adjusted employment-tax return, such as Form 941-X, and that return made no adjustments other than the ERC claim.
You want to withdraw the entire ERC amount for a specific period.
The IRS has not yet paid your claim, OR you received a refund check but have not cashed or deposited it.

Follow the IRS procedure for your circumstances. If under audit, send the request to the assigned examiner or follow the audit notice. For an uncashed check, follow the voiding and mailing instructions. An already cashed or deposited check is outside this withdrawal process; correcting a claim may instead require the appropriate adjusted employment-tax return and repayment. Partial corrections or returns containing other adjustments also require a different procedure. Related reading: Resolving back taxes.

Frequently Asked Questions about ERC Audits

How does claiming the ERC impact my business’s income tax return?

The ERC generally reduces the deduction for qualified wages in the year the wages were paid or incurred. IRS guidance permits certain corrections without always amending that year: if a taxpayer received ERC in a later year without previously reducing wage expense, the overstated deduction may generally be included in gross income in the year the credit was received. Different treatment can apply to capitalized wages. If a credit is finally disallowed after wage expense was reduced, the IRS permits an increase in wage expense in the year of final disallowance; an amended return, administrative adjustment request or protective refund claim may instead be appropriate. The OBBBA’s special limitation rule concerns a related wage-deduction overpayment when a section 3134 credit assessment is made; it is not a blanket six-year extension to amend all income-tax returns.

What documentation is required to support an ERC claim and for how long?

For ERC credit audits, documentation is everything. You must keep records proving eligibility and your credit calculation. Key documents include:

Detailed payroll records.
Proof of gross receipts decline (financial statements).
Copies of specific government orders that suspended your business.
PPP loan forgiveness applications showing no “double-dipping” of wages.
Records of qualified health plan expenses.

Keep records through the applicable assessment and refund periods and while an examination, appeal or other dispute remains unresolved. For Q3/Q4 2021 section 3134 claims, calculate the six-year minimum assessment period from the latest of original filing, deemed filing or claim date; exceptions or extensions may require longer retention. Do not treat six years from wage payment as a universal destruction date.

How can I report a fraudulent ERC promoter or illegal activity?

To report suspected abusive ERC promotion or deliberately improper preparation, the IRS directs taxpayers to Form 14242, Report Suspected Abusive Tax Promotions or Preparers, with supporting materials and the current submission instructions. Describe the facts accurately; a suspicion or referral is not itself a finding of fraud.

Conclusion: Securing Your Business’s Financial Future

ERC review requires attention to the quarter-specific eligibility rules, supporting records and claim history. The OBBBA changed the minimum assessment period for Q3/Q4 2021 section 3134 credits and expanded section 6676 to employment-tax claims made after July 4, 2025, subject to its conditions.

Review any disputed claim promptly, preserve the supporting records and note the deadlines in IRS correspondence. Obtain advice on the specific issues when needed; preparation or representation does not guarantee that a claim will be allowed.