Employee Retention Credit Audits: New Rules, Old Problems

The Shifting Landscape of the Employee Retention Credit

ERC credit audits are a top priority for the IRS. If you claimed the Employee Retention Credit, understanding the current audit landscape is critical. What began as pandemic relief has become a compliance minefield due to aggressive “credit mills” and widespread improper claims. The IRS has responded with audits, a moratorium on new claims, and inclusion of ERC schemes on its “Dirty Dozen” list of tax scams.

Key Facts About ERC Credit Audits:

• Extended Audit Window: The IRS now has six years to audit certain ERC claims for Q3 and Q4 of 2021.
• New Penalties: A 20% penalty applies to erroneous refund claims, on top of potential fraud penalties.
• Retroactive Disallowances: Claims for Q3/Q4 2021 filed after January 31, 2024, are disallowed.
• High Scrutiny: The IRS is targeting claims from aggressive promoters.
• Voluntary Programs: The IRS offered disclosure programs to repay 80-85% of the credit to avoid penalties.

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.

As Attorney Samuel Landis, Managing Partner at Segal, Cohen & Landis, I use my 15+ years of experience, including as a former IRS insider, to help clients steer complex ERC credit audits and defend against aggressive enforcement.

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

The One Big Beautiful Bill Act (OBBBA), signed into law on July 4, 2025, dramatically changed the rules for the Employee Retention Credit. It gives the IRS significantly more power to pursue ERC credit audits and enforcement actions, affecting both your audit risk and potential consequences.

Key Changes to the ERC Under OBBBA

The OBBBA disallows all pending ERC claims for the third and fourth quarters of 2021 that were filed after January 31, 2024. If you submitted a claim for these quarters after that date, it will be rejected.

This rule is specific:

• Claims for Q3/Q4 2021 filed before January 31, 2024, are not affected by this disallowance.
• Claims for 2020 or Q1/Q2 2021 are not affected.

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

The most significant change is the extended statute of limitations. The IRS now has six years—not three—to audit ERC claims for Q3 and Q4 of 2021. This gives the agency twice as long to challenge your claim and assess penalties.

The OBBBA also introduces a new 20% penalty for erroneous ERC claims, which applies to the amount of any improper refund. This penalty, previously used for income tax, now directly targets ERC claims, increasing the financial stakes of an audit. You can find more information in the IRS’s general guidance on false claims.

Here’s how the rules compare:

The OBBBA also imposes new due diligence requirements on ERC promoters, with a $1,000 penalty for each failure to comply. The message is clear: the IRS has more time and more tools to pursue ERC credit audits, fundamentally changing the risk profile for businesses that claimed the credit.

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)

To claim the credit, your business needed to meet one of two main tests during an eligible quarter:

1. Full or Partial Suspension of Operations: A government authority (federal, state, or local) must have issued an order related to COVID-19 that limited commerce, travel, or group meetings. This order must have caused a “more than nominal” suspension of your business operations (generally a 10% or greater impact). General recommendations or voluntary closures do not count.
2. Significant Decline in Gross Receipts: The qualification threshold changed by year.
   • For 2020: Gross receipts for a quarter dropped below 50% of the same quarter in 2019.
   • For 2021: Gross receipts for a quarter were less than 80% of the same quarter in 2019.

A third category, Recovery Startup Business, applied only to Q3 and Q4 of 2021 for businesses started after February 15, 2020, with gross receipts under $1 million and a credit cap of $50,000 per quarter.

Qualified wages (generally W-2 wages plus certain health plan costs) were capped per employee ($10,000 annually for 2020, $10,000 quarterly for 2021). For “large employers” (over 100 employees for 2020 claims, over 500 for 2021), qualified wages were limited to payments made to employees for not providing services. For the latest information, check the most recent IRS guidelines.

Interaction with PPP and Other Relief Programs

This is a common trigger for ERC credit audits. You cannot use the same wages for both the ERC and for Paycheck Protection Program (PPP) loan forgiveness. This “no double-dipping” rule requires meticulous records to show which wages were allocated to each program. Similar restrictions apply to wages used for a Shuttered Venue Operators Grant (SVOG) or a Restaurant Revitalization Grant. For more on PPP, 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 your refund, which incentivizes promoters to inflate claims.
• 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 you’re selected for an ERC credit audit, preparation is your best defense. The burden of proof is on you to verify that every dollar claimed was legitimate and thoroughly documented.

How to Prepare for ERC Credit Audits: A Document Checklist

When you receive an audit notice and an Information Document Request (IDR), you must gather extensive documentation. Be prepared to provide:

• 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 establishing your employee count for 2019 to determine if you were a “large employer.”
• Promoter Correspondence: Any communication with advisors who helped you file the claim.

Our experience with IRS audit defense strategies shows that organized, thorough responses to IDRs are critical for a better outcome.

What to Expect During the Audit

ERC credit audits are a priority for the IRS and often move quickly. The process generally includes:

1. Notification Letter: The IRS will send a letter specifying the tax periods under examination. Do not ignore the response deadline.
2. Information Document Request (IDR): You will receive a comprehensive request for the documents listed above.
3. Initial Interview: An agent will ask about your business, your basis for eligibility, and how you calculated the credit.
4. Document Review: The agent will compare your Form 941-X against the documentation you provide, checking your math and verifying eligibility.

The burden of substantiation is entirely on you. If the agent finds gaps or inconsistencies, expect a longer, more intensive examination. Understanding the basics of what is an audit can help reduce anxiety during this process.

Potential Penalties and Outcomes of ERC Credit Audits

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

• Repayment of the Credit: Any improperly claimed amount must be returned.
• Interest Charges: Interest accrues from the date you received the refund and can be substantial.
• 20% Accuracy-Related Penalty: The OBBBA introduced this penalty specifically for erroneous ERC claims.
• Civil Fraud Penalties: Can reach 75% of the underpayment in cases of intentional misrepresentation.
• Criminal Fraud Penalties: In the most severe cases of willful intent, the IRS may pursue criminal charges, which can lead to fines and imprisonment.

Proactive compliance and expert guidance are the best ways to mitigate these risks. If you owe money after an audit, solutions are available. Our guide on what to do if you owe the IRS but can’t pay outlines potential relief options.

Correcting an Improper ERC Claim: Your Options

If you believe your ERC claim was filed in error, it’s not too late to fix it. The IRS created pathways to correct mistakes and potentially avoid the harsh penalties that come with an ERC credit audit. Acting before the IRS contacts you is always the best strategy.

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.

Participants were generally required to repay 80-85% of the claimed ERC amount. In exchange, the IRS agreed not to assert civil penalties, and participants received a closing agreement that resolved the matter completely. To be eligible, you could not already be under criminal investigation or employment tax examination. While the VDP is closed, filing an amended return is still an option, though it doesn’t offer the same penalty protection. Our team can help you explore all available avenues for “Understanding tax debt relief options“.

Withdrawing an Unprocessed ERC Claim

If you filed an ERC claim that you now believe is incorrect and the IRS has not yet processed it, you may be able to use the ERC claim withdrawal process. This is the best-case scenario for correcting a mistake, as the IRS treats the claim as if it was never filed. You will owe no penalties or interest.

You can use the withdrawal process if:

• You filed your claim on an adjusted return (like Form 941-X).
• 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.

If you have an uncashed check, you must void it and mail it back with your withdrawal request. If you’ve already cashed the check, this option is not available. You would instead need to file a corrected Form 941-X and repay the amount. Taking advantage of the withdrawal process is a straightforward way to correct course before facing an ERC credit audit. If you’re unsure of your options, we can help you steer the complexities of “Resolving back taxes“.

Frequently Asked Questions about ERC Audits

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

While the ERC is not taxable income, it reduces your deductible wage expenses. You must amend your business income tax return (e.g., Form 1120-S, 1065) for the year the qualified wages were paid to reduce your wage deduction by the amount of the credit. This increases your taxable income and can result in a higher tax bill. The OBBBA extended the statute of limitations for making this amendment to six years for certain 2021 claims, aligning it with the new audit period.

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.

Given the new six-year audit window for Q3/Q4 2021 claims, you should keep all ERC-related documentation for at least six years as a best practice. Without solid proof, the IRS will disallow your claim.

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

If you’ve encountered a fraudulent ERC promoter, you can report them to the IRS. Complete and send Form 14242, Report Suspected Abusive Tax Promotions or Preparers. This form allows you to provide details about the promoter and their misleading tactics. For information on significant tax noncompliance, you can also contact the IRS Whistleblower Office. Reporting these schemes helps the IRS protect other business owners.

Conclusion: Securing Your Business’s Financial Future

The Employee Retention Credit, once a lifeline, has become a major compliance risk. The One Big Beautiful Bill Act raised the stakes with a six-year audit window for some claims and new 20% penalties. The IRS has made it clear: ERC credit audits are a top priority.

This is not the time to hope for the best. You must proactively review your claim and ensure your documentation can withstand scrutiny. If you have any doubts about your eligibility or have received an audit notice, do not wait.

The good news is that there are pathways to correct errors. At Segal, Cohen & Landis, our team has over 33 years of experience handling thousands of ERC credit audits, voluntary disclosures, and complex tax disputes. We understand the technical rules and the stress of facing the IRS. Your business’s future doesn’t have to be defined by an ERC claim. Contact us for professional IRS audit representation and let us protect what you’ve built.