Treasury and IRS Finalize Regulations Permitting Underpayment Penalty Assessments on Employee Retention Credit Refund Claims
On July 24, the U.S. Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) published final regulations (T.D. 9978) that treat the erroneous refund of employee retention credits (ERCs) – a COVID-era benefit that taxpayers continue to claim on amended employment tax returns – as "underpayments" of the relevant employment tax subject to underpayment penalties and administrative collection procedures. The final regulations are effective as of their issuance and follow corresponding proposed and temporary regulations published in 2021.1
The final regulations come at a time when the IRS has identified claims for the ERC as a potential source of fraud, and has repeated warned taxpayers about making inappropriate claims, going as far to list certain ERC-related scams first on its 2023 "dirty dozen" list of the "worst of the worst" tax scams. While it is true that unscrupulous promoters are advertising that they can "get" ERCs for their clients while misleading them as to the complicated and onerous rules regarding the credit, it is also the case that hundreds of thousands of businesses suffered during the COVID-19 pandemic and have been (and are continuing to) legitimately claim the ERC. The now-finalized penalty rules should cause taxpayers to double check that they qualify for the ERC before submitting a claim.
The ERC in a Nutshell
Most employers in the U.S. are required to pay over to the government under section 31112 an amount equal to (1) 6.2 percent of wages paid to fund social security and (2) 1.45 percent of wages paid to fund Medicare. Railroads have a similar payment obligation on under section 3221(a).
As the country shut down in March 2020 due to the COVID-19 crisis, Congress enacted the first iteration of the ERC in section 2301 of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, which allowed for a credit for wages paid in the first two quarters of 2020.3 In December, a lame-duck Congress both extended the ERC through the first two quarters of 2021 and modified the ERC as part of the Consolidated Appropriations Act, 2021 (CAA).4 Neither of these statutes codified the ERC into the Internal Revenue Code; this would happen as part of the American Rescue Plan (ARP). The ARP created what was technically a new credit, codified in section 3134 of the Internal Revenue Code, which originally applied for the last two quarters of 2021. Congress later restricted the section 3134 ERC to the third quarter of 2021, except for certain "recovery startup businesses."5 Credits for 2020 and the first two quarters of 2021 came under the CARES Act, as modified by the CAA.
The basic idea of the ERC, under both the CARES Act and section 3134, is that an "eligible employer" is allowed a credit against its "applicable employment taxes" in an amount equal to 50 or 70 percent of the "qualified wages" with respect to each employee for the relevant quarters. "Applicable employment taxes" refer to the 1.45 percent Medicare tax (section 3111(b)) and the corresponding railroad taxes (section 3221(a)).6 Significantly, the ERC is fully refundable – to the extent it exceeds applicable employment taxes, it is treated as an overpayment of such taxes.
An eligible employer is an employer carrying on a trade or business during the quarter at issue for which either (1) the operation of its trade or business was fully or partially suspended during the calendar quarter due to orders from an appropriate government authority limiting commerce, travel, or group meetings (for commercial, social, religious, or other purposes) due to COVID-19 (a COVID Shutdown Order) or (2) the gross receipts (within the meaning of section 448(c)) of such employer for such calendar quarter are less than 80 percent of the gross receipts of such employer for the same calendar quarter in calendar year 2019 (a Gross Receipts Reduction).7
The definition of "qualified wages" varies depending on the size of the employer. In cases where the eligible employer for which the average number of full-time employees was greater than 500 (100 during calendar quarters ending in 2020), wages will count as qualified wages only if they were paid by the eligible employer to an employee that is "not providing services" due to either a COVID Shutdown Order or a Gross Receipts Reduction." For other employers, "qualified wages" means all wages paid with respect to employees during the period of the COVID Shutdown Order or Gross Receipts Reduction, regardless of whether the employees were providing services or not.8
The IRS's Challenge
The ERC is attractive to taxpayers whose businesses suffered during the COVID-19 crisis. The refundable nature of the credit means for each quarter for each employee the taxpayer may claim up to 50 or 70 percent of that employee's quarterly wages (up to $10,000) as a refundable credit. Further, under the general limitations rules for claiming a refund or credit (section 6511), taxpayers may claim the credit retroactively. Because section 6513(c) treats applicable employment taxes as being filed of the following year for refund claim purposes, taxpayers generally have until April 15, 2024, to submit retroactive ERC claims for 2020, and until April 15, 2025, for claims for 2021.
Given the attractive nature of the credit and the long period for claiming it, the IRS is concerned about fraudulent and otherwise unsupportable claims. As noted the ERC was number one on the IRS's list of "dirty dozen" tax scams for 2023 and IRS Commissioner Danny Werfel has waxed lyrically about the IRS's continuing to field "more and more questionable claims coming in following the onslaught of misleading marketing from promoters pushing businesses to apply." The Commissioner stated in the same remarks that the IRS is not only working diligently to clear backlogged claims but also intensifying its compliance work and putting additional procedures in place to address fraud in the program. The IRS recognizes that many ERC claims are legitimate and has been working diligently to review claims and pay them.
Congress designed the ERC as a refundable credit and that so many claims are being made on amended returns (generating overpayments with respect to both the "refundable" piece that exceeds applicable employment taxes as well as the "nonrefundable piece" which simply represents a refund of employment taxes already paid) presents special challenges for the IRS. Normally, claims for a refund of overpaid tax are not subject to the civil underpayment penalties of sections 6662 (e.g., for negligence or disregard of rules and regulations) and 6663 (for fraud). This is the case because these penalties apply to "underpayments," generally at a rate of 20 percent or 75 percent, respectively, and a refund claim does not present an underpayment because the taxpayer has already paid the tax in full. Section 6676 provides that an "excessive" claim for refund that lacks "reasonable cause" is subject to a 20 percent penalty, but this rule applies only to claims for refunds of overpaid (or deemed overpaid) income taxes, which does not include the ERC.
To complicate matters further, the IRS's general authority to assess tax liabilities – section 6201(a)) – generally does not provide for the assessment of the refundable portion of a tax credit like the ERC, which means that the primary way for the IRS to recover such amounts is through a cumbersome erroneous refund action under section 7405.
The most significant impact of the final regulations is to address both issues. First, Treas. Reg. §§ 31.3134-1(a), 31.3111-6(b), and 31.3221-5(b) provide that any amount of ERCs under section 3134 and 2301 of the CARES Act that is treated as an overpayment and refunded or credit to a taxpayer under section 6402(a) that the taxpayer is not entitled to is treated as an underpayment of applicable employment taxes. This means that erroneous refunds are subject to the underpayment penalties of sections 6662 and section 6663.
The final regulations also provide that deemed underpayment of ERC "may be assessed and collected by the Secretary in the same manner as taxes."9 This is important – now if the IRS makes a payment in respect of the ERC to a taxpayer that is not entitled to it, it can recover the erroneous refund through an assessment.
The final regulations are not new – they are identical in the respects discussed above to temporary and proposed regulations promulgated in 2020 and 2021.10 Those temporary regulations were effective on issuance and purportedly retroactive to cover all relevant ERC payments,11 but under section 7805(e)(2), those regulations could only be effective for three years. This was not nearly long enough given that claims may be submitted as late as April 15, 2025, and refunds may (and will) be paid and disputed for years after that. Treasury and the IRS only received two comments on the temporary and proposed regulations, which they "considered" in promulgating the final ones.
The End of the Beginning
There are no cases, either currently docketed or decided, that relate to the ERC in general or the IRS's attempt to impose penalties on an erroneously refunded ERC, or to assess the erroneously refunded credit and associated penalty. It seems likely to expect a taxpayer to challenge the IRS's penalty or assessment authority in litigation at some point, however. Treasury and the IRS based their authority for the final regulations primarily on section 2301(l)(5) of the CARES Act12 and section 3134(m)(3), each of which directs the Secretary to issue "such forms, instructions, regulations, and other guidance as are necessary…to prevent the avoidance of the purposes of limitations under this section, including through the leaseback of employees."
There are many "limitations" inherent to the statutory provisions of the ERC, but no specific mention of penalties. There is a mention of assessment authority: section 2301(j)(3)(B) of the CARES Act13 and section 3134(j)(3)(B) provides that if a taxpayer receives an "advance payment" of the ERC (i.e., a payment of the credit in advance of filing its Form 941 employment tax return for the quarter, authorized under section 3134(j)(1)) to which it is not entitled, the applicable employment tax for the quarter is increased. Treating the excess credit as an increase in tax by statute ipso facto gives the IRS both the authority to assess it under section 6201(a) and the authority impose underpayment penalties.
Thus, the final regulations provide in part for something that the statutes already permitted, but in a much more limited scope. A taxpayer may argue that this is evidence that Congress did not intend to allow Treasury and the IRS to address these issues, and, absent any direct grant of authority, Treasury and the IRS do not have the power to treat an erroneous refund as an underpayment of tax subject to underpayment penalties and the assessment procedures. Time will tell.
Miller & Chevalier has been working with taxpayers since the passage of the CARES Act to support their claims for the ERC. For more information, please contact:
1Treasury and IRS published the final regulations in the Federal Register on July 26, 2023. See 88 Fed. Reg. 48188. The final regulations also provide rules relating to paid sick and family leave credits under sections 3131 and 3132; these provisions are not covered in this alert.
2All "section" references are to the Internal Revenue Code of 1986, as amended and currently in effect, unless otherwise indicated.
3Pub. L. 116-136 (March 27, 2020).
4Pub. L. 116-220, § 207 (Dec. 27, 2020)
5Investment and Jobs Act, Pub. L. 117-58, § 80604(a) (Nov. 15, 2021).
6Under CARES Act § 2301(c)(1), applicable employment taxes meant the taxes imposed on employers by section 3111(a) (i.e., Social Security tax). As the credit is generally refundable (i.e., can exceed the amount of the taxes against which it is taken), this distinction is not significant.
7The Gross Receipts Test for calendar quarters ending in 2020 was slightly different, and beyond the scope of this alert. See CARES Act, § 2301(b)(2)(A)(ii)(II) and (B).
8Section 3134(c)(3)(A); CARES Act, § 2301(b)(3)(A)(ii); CAA, § 207(e)(1).
9Treas. Reg. §§ 31.3134-1(a), 31.3111-6(b), and 31.3221-5(b).
10T.D.9953, 86 Fed. Reg. 50637 (Sept. 27, 2021). T.D. 9904, 85 Fed. Reg. 455134 (Aug. 17, 2020) (applying to ERC under section 2301 of the CARES Act).
11Treas. Reg. §§ 31.3134-1T(d), 31.3111-6T(e), and 31.3221-5T(e).
12As amended by the CAA, Pub. L. 116-260, § 207(d) (Dec. 27, 2020).
13As amended by the CAA, Pub. L. 116-260, § 207(g) (Dec. 27, 2020).
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