A Lesser-Known Pandemic Relief Program Inspires Widespread Fraud

As the pandemic recedes, many COVID-19-related government support programs are phasing out. But one area showing an increase, instead of a decline, is the number of fraudulent claims associated with employee retention assistance. And while the Department of Justice (DOJ) has brought both civil and criminal cases against thousands of individuals and entities for fraud involving billions of Paycheck Protection Program (PPP) funds, several recent publications from the Department of Treasury indicate that a lesser-known program, the Employee Retention Credit (ERC), may be the source of another looming massive tax scam. This issue brief reviews the background of these relief programs, the abuse of the ERC, and federal responses to fraudulent tax schemes.[1] 

The Exploitation of the PPP

The PPP was created by the Coronavirus Aid, Relief, and Economic Security (CARES) Act to provide emergency financial assistance to American workers suffering from economic losses caused by the COVID-19 pandemic.[2] The program itself was administered by the Small Business Administration (SBA) to help businesses keep their workforce employed during the COVID-19 crisis. Although designed as a loan, if a borrowing business spent a certain percentage of PPP funds on payroll expenses within a designated time, the loan could be forgiven.

There was confusion and uncertainty during the early days of the PPP,[3] and economists have been studying the effectiveness of the program ever since. These reviews generated mixed results.[4] At over $800 billion, the PPP’s enormous size dwarfs several other similarly purposed programs and has attracted attention from both honest employers and criminals alike.

The DOJ has brought cases against numerous PPP abuses since 2021,[5] and the department persists with its enforcement efforts.[6] As of September 2022, the DOJ filed criminal charges against over 1,500 individuals for alleged relief fund frauds of over $1.1 billion. The department also conducted civil investigations into more than 1,800 individuals and entities for alleged misconduct related to pandemic relief loans totaling more than $6 billion.[7] Practitioners expect still more civil investigations and prosecutions against PPP frauds to surface in the near future.

New Rules Have Increased Fraud in the ERC

To help workers stay on payroll, the Department of Treasury was tasked with administering several assistance programs through the tax system. These programs include the paid sick leave and family leave refundable tax credits, employment tax deferral, and the ERC.[8]

The paid leave credits essentially require employers with fewer than 500 employees to provide paid sick leave to employees who are unable to work due to situations related to the pandemic. These employers can then claim refundable tax credits for the required leave paid. In addition, the employment tax deferral provision allows all employers to defer their share of Social Security tax through December 31, 2020. 

In March 2020, the CARES Act created the ERC to help eligible employers keep employees on payroll despite experiencing economic hardship related to COVID-19. Congress has subsequently made several major changes to the ERC (discussed below). The initial rules stipulate that the credits are equal to 50% of up to $10,000 of wages per year, including health plan expenses, between March 12, 2020, and December 31, 2020. The ERC is refundable, which means that employers can receive payments from the government if their credits exceed employment tax liabilities.[9] Businesses and tax-exempt organizations that had a significant decline in gross receipts compared to the same quarter in 2019 (defined as a 50% reduction or more), or with operations fully or partially suspended due to government orders, were eligible to apply.[10]

Some practitioners point out that the ERC’s eligibility, even in its initial design, was flexible.[11] For instance, a partial shutdown or disruption in the business caused by the inability to access equipment or visit a client’s job site, government requirements to limit customer capacity, supply chain shutdowns, or closed vendors, all potentially qualified the taxpayer for the ERC. Some practitioners also believe that even if the business revenue increased or remained stable during the pandemic, the taxpayer may still qualify for the ERC as long as its operations experienced partial disruption due to government orders.

The subsequent Consolidated Appropriations Act of 2021 (CAA of 2021) amended the ERC and made some key changes.[12] It extended the effective date of the credits to June 30, 2021. It also increased the maximum credit to 70% of up to $10,000 of wages per quarter for 2021. Therefore, for eligible employers, the maximum benefit could equal $28,000 per year for each employee. In addition, the law lowered the gross receipts reduction threshold from 50% to 20%. This means that in any quarter of 2021, if an entity’s gross receipts were 20% less than the same quarter in 2019, the entity would be eligible for the ERC. If an entity did not exist in 2019, the taxpayer can rely on its 2020 gross receipts to determine eligibility.

Another major change is that the CAA of 2021 explicitly allowed PPP borrowers ineligible under the CARES Act to apply for the ERC. This expanded eligibility was retroactive to 2020. Thus, employers could file amended employment tax returns starting in 2021 — to claim the ERC for qualifying wages paid in 2020 — as long as the wages were not paid out of PPP funds.

The American Rescue Plan Act of 2021 (ARPA) further extended the ERC through December 2021.[13] It also expanded the eligibility to “recovery startup businesses,” which previously were not qualified, if these businesses started their operations after February 15, 2020 and their average annual gross receipts over a three-year period were below $1 million.

The final complication came when the Infrastructure and Investment in Jobs Act (IIJA, commonly known as the “Infrastructure Bill”) became law in November 2021.[14] The Infrastructure Bill retroactively eliminated the ERC for the fourth quarter of 2021 except for recovery startup businesses. In other words, recovery startups were eligible for the ERC between July 1, 2021, and December 31, 2021, whereas all other businesses had their ERC eligibility end on September 30, 2021.

Overall, there were four laws involved in the creation and modification of the ERC, with each of the latter three generally making eligibility more generous and applicable to more entities. These adjustments all happened within an 18-month period and involved two retroactive changes. The ERC rules were convoluted for legitimate businesses that relied on these benefits to survive, complicated for tax pros to follow, and a bonanza for crooks that saw chances for fraud.[15] This confusion was reflected in the portion of returns the IRS rejected associated with the claims: A Government Accountability Office (GAO) study indicated that the IRS rejected over 72% of all Form 7200s (the form used to request an advance payment of employer credits) as of September 30, 2021.[16] The agency also noted a surge of Form 7200 filings after the CAA of 2021 made PPP borrowers eligible for the ERC.[17]

Prior Use of the ERC Was Limited to Physical Disasters

The ERC has historically been used to help in disaster recovery after storms, wildfires, hurricanes, and floods.[18] The rationale behind the ERC program is that if the after-tax cost of employee compensation is lower, employers are more likely to retain workers. This mechanism is thus less disruptive to workers’ lives and also reduces costs to the unemployment insurance system. A recent example prior to the pandemic is the Taxpayer Certainty and Disaster Tax Relief Act of 2019, which granted credits to employers who continued to pay wages to their employees after a disaster that made the business inoperable.[19]

However, there are some key differences between the credits in 2019 and the ERC created by the CARES Act.[20] First, the earlier disaster recovery credits operated under the income tax system as general business credits, whereas the pandemic-related ERC is administrated through the payroll tax system. This is primarily because payroll taxes can be processed more quickly and frequently than income taxes. In addition, because nonprofit entities are income tax-exempt and the CARES Act intended to include nonprofits, payroll tax was an obvious candidate for administering the new ERC rules. Furthermore, the 2019 credits were not refundable, although carryforwards and carrybacks were allowed. In addition, earlier disaster relief credits were more targeted and had smaller benefit amounts, and so involved lower costs to the government. For instance, the Joint Committee on Taxation (JCT) estimated the 2019 disaster relief credits would cost $0.3 billion of federal revenue.

Fiscal Impacts: From $85 Billion to $2 Trillion?

The JCT originally estimated the ERC would cost $55 billion over 10 years under the CARES Act.[21] Subsequent amendments and extensions brought the price tag to approximately $85 billion.[22] Even when all tax provisions that help employers support and retain employees are considered (i.e., paid sick leave and family leave tax credits, employment tax deferral, and the ERC), the cost estimate was $237.8 billion for fiscal years 2021 to 2031.[23] Therefore, it came as a surprise when the Treasury Inspector General for Tax Administration (TIGTA) published a report stating the IRS had identified 11,096 suspicious returns claiming more than $2 trillion in credits as of March 2022. [24] Many of these returns were associated with identify thefts or applicants who were ineligible to receive the ERC. Considering the entire CARES Act costs roughly $2.1 trillion, this amount is overwhelmingly large.[25]

Some Preparers Are Actively Promoting ERC Fraud

Some practitioners are concerned that the fraudulent ERC claims could end up being one of the largest tax scams in U.S. history.[26] Many note that there are aggressive promoters soliciting taxpayers to claim ERC benefits even when they do not qualify. These providers market their services through social media, internet ads, radio stations, telephone, and text messages. In addition, because individuals do not qualify for the ERC, some of these scammers even convinced independent contractors to convert their businesses to LLCs for the sole purpose of claiming the credit. [27]

One common ERC abuse relates to recovery startup businesses. The TIGTA report indicates that it is hard for the IRS to verify whether a taxpayer’s business actually began operation after February 15, 2020. Therefore, it is difficult to deny credits for businesses that do not meet this criterion. Generally, the IRS relies on taxpayers’ attestation on the employment tax return that the businesses qualify for the ERC as a result of its recovery startup businesses status.

Some third-party preparers also failed to inform employers that they could not claim the ERC on wages reported as payroll costs to obtain PPP loan forgiveness.[28] In addition, the IRS clarifies that wage deductions claimed on a business federal income tax return must be reduced by the amount of the credit. If a business filed an income tax return deducting qualified wages before it filed an employment tax return claiming the credit, the business should file an amended income tax return to correct any overstated wage deduction.[29]

IRS Enforcement Will Take Years — But Taxpayers Remain Responsible for Any Fraudulent Claims

Although the ERC itself has expired, fraudulent claims continue to be an issue because businesses can still file amended returns (Form 941-X) to claim the credits.[30] Specifically, the deadlines for claiming 2020 and 2021 ERC are April 15, 2024, and April 15, 2025, respectively. It will also take the IRS several years after filing deadlines have closed to audit and examine claims that demonstrate questionable characteristics.

The agency has been warning taxpayers about the illegitimate ERC promoters since last year, cautioning that, in general, taxpayers are ultimately responsible for the information reported on their tax returns. Therefore, even if promoters promised unrealistically large tax benefits, taxpayers are still liable for the back taxes and penalties if the agency eventually decides the claims are unjustified.

The IRS recently published its Dirty Dozen tax scams, an annual list of the 12 most common and offensive tax schemes. Fraudulent ERC claims were highlighted at the top of the list.[31] The announcement puts all “ERC mills” on notice, and warns taxpayers against blatant attempts by promoters to con ineligible taxpayers for claiming the ERC. The notice also informs tax professionals that they should withhold pressure from taxpayers pushing for these credits when they are not eligible.

Conclusion: More Enforcement Is Coming

In response to the pandemic, Congress rolled out massive pandemic relief programs totaling more than $5 trillion.[32] The quick launch of enormous government spending led to wasted funds, confusion among taxpayers, and windfalls for criminals. It will take government agencies years and a tremendous amount of resources to claw back the misused funds.  

Taxpayers who file legitimate ERC claims have relied on these benefits as lifelines for their businesses during the pandemic and the subsequent recovery period. However, the lucrative benefits have attracted promoters who continue to lure ineligible and unwary taxpayers into claiming the credits. Although the credits have expired, fraud will continue to be an issue so long as eligible businesses owners can still claim these benefits and criminals continue to abuse them. Given the recent attention to fraud, ERC-associated returns will no doubt be under even more scrutiny and, possibly, extensive audit. Clearly, for ineligible taxpayers who are considering the ERC, it is unwise to file unqualified claims against an agency that just received $80 billion in funding to strengthen its tax compliance efforts and oversight systems.

Endnotes

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[1] This brief focuses on the ERC. It discusses several other employee retention assistance programs, including the PPP, the paid sick leave and family leave refundable tax credits, and the employment tax deferrals, to the extent they are related to the ERC.

[2] The Coronavirus Aid, Relief, and Economic Security (CARES) Act, Pub. L. No. 116-136, 116th Cong. (March 27, 2020), https://www.congress.gov/116/plaws/publ136/PLAW-116publ136.pdf. 

[3] Joyce Beebe, “The Paycheck Protection Program: Troubled Beginning, Improved Prospects?” Baker Institute Blog, March 27, 2020, https://www.bakerinstitute.org/research/paycheck-protection-program-troubled-beginning-improved-perspectives. 

[4] See (1) Stacy Cowley, “Little of the Paycheck Protection Program’s $800 Billion Protected Paychecks,” The New York Times, February 1, 2022, https://www.nytimes.com/2022/02/01/business/paycheck-protection-program-costs.html, and (2) Ben Casselman and Jim Tankersley, “$500 Billion in Aid to Small Businesses: How Much Did It Help?” The New York Times, August 17, 2021, https://www.nytimes.com/2021/02/01/business/economy/ppp-jobs-small-business.html#commentsContainer

[5] U.S. Department of Justice, “Fraud Section Enforcement Related to the CARES Act,” May 4, 2022, https://www.justice.gov/criminal-fraud/cares-act-fraud. 

[6] U.S. Department of Justice, “Man Convicted for Multimillion-Dollar COVID-19 Relief Fraud,” February 8, 2023, https://www.justice.gov/opa/pr/man-convicted-multimillion-dollar-covid-19-relief-fraud; U.S. Department of Justice, “Florida Resorts Agree to Pay $325,000 to Settle False Claims Act Allegations Relating to False Certifications on a Paycheck Protection Program Loan Forgiveness Application,” March 21, 2023, https://www.justice.gov/opa/pr/florida-resorts-agree-pay-325000-settle-false-claims-act-allegations-relating-false. 

[7] Jose Vela, Jr., “US Department of Justice Expanding Prosecution of Individuals and Companies for Payroll Protection Program Fraud,” Clark Hill, December 19, 2022, https://www.clarkhill.com/news-events/news/us-department-of-justice-expanding-prosecution-of-individuals-and-companies-for-payroll-protection-program-fraud/. 

[8] IRS, “COVID-19-Related Employee Retention Credits: Overview,” last updated January 31, 2023, https://www.irs.gov/newsroom/covid-19-related-employee-retention-credits-overview. 

[9] Employment tax here generally refers to the Federal Insurance Contribution Act taxes (payroll taxes), including Old-Age, Survivors and Disability Insurance (Social Security) and hospital insurance (Medicare) taxes.

[10] The wages paid to employees that count for the paid leave credits cannot also be counted for ERC purposes.

[11] Rick Meyer, “The 10 Biggest Myths of the Employee Retention Credit,” Illinois CPA Society, 2021, https://www.icpas.org/information/copy-desk/insight/article/digital-exclusive---2021/the-10-biggest-myths-of-the-employee-retention-credit. 

[12] Consolidated Appropriations Act of 2021, Pub. L. No. 116-260, 116th Cong. (December 27, 2020), https://www.congress.gov/bill/116th-congress/house-bill/133 (Specifically, Section 206 of the
Taxpayer Certainty and Disaster Tax Relief Act of 2020, which was enacted as Division EE of the CCA of 2021).

[13] The American Rescue Plan Act of 2021, Pub. L. No. 117-2, 117th Cong. (March 11, 2021), https://www.congress.gov/bill/117th-congress/house-bill/1319. 

[14] Infrastructure and Investment in Jobs Act, Pub. L. No. 117-58, 117th Cong. (November 15, 2021), https://www.congress.gov/117/plaws/publ58/PLAW-117publ58.pdf. 

[15] Carmen Reinicke, “Biden Encourages Businesses to Take Advantage of the Employee Retention Credit. Here’s What You Need to Know,” CNBC, May 12, 2021, https://www.cnbc.com/2021/05/12/biden-is-encouraging-eligible-businesses-to-take-advantage-of-this-big-tax-break.html. 

[16] Form 7200 primarily includes advance payments of ERC and paid leave credits. There are no separate statistics for the ERC.

[17] GAO (U.S. Government Accountability Office), “IRS Implemented Tax Relief for Employers Quickly, but Could Strengthen Its Compliance Efforts,” GAO-22-104280, May 2022, https://www.gao.gov/products/gao-22-104280.   

[18] Molly F. Sherlock and Jennifer Teefy, “Tax Policy and Disaster Recovery,” R45864, Congressional Research Service, September 3, 2021, https://crsreports.congress.gov/product/pdf/R/R45864. 

[19] Further Consolidated Appropriations Act of 2020, Pub. L. No. 116-94, 116th Cong. (December 20, 2019), https://www.congress.gov/116/plaws/publ94/PLAW-116publ94.pdf (The Consolidated Appropriations Act of 2021 continued the similar disaster recovery credits (see Division EE, Sec. 303), and also added a payroll tax credit for tax exempt organizations.) 

[20] Molly F. Sherlock, “COVID-19: The Employee Retention Credit,” CRS Insight-IN 11299, Congressional Research Service, May 12, 2020, https://crsreports.congress.gov/product/pdf/IN/IN11299. 

[21] JCT (Joint Committee on Taxation), “Estimated Revenue Effects Of The Revenue Provisions Contained in An Amendment in The Nature of A Substitute to H.R. 748, The CARES Act (JCX-11-20),” March 26, 2020, https://www.jct.gov/publications/2020/jcx-11-20/. 

[22] CBO (Congressional Budget Office), “The Budgetary Effects of the Employee Retention Tax Credit during the Coronavirus Pandemic,” July 16, 2021, https://www.cbo.gov/publication/57365. 

[23] GAO, “IRS Implemented Tax Relief for Employers Quickly, but Could Strengthen Its Compliance Efforts.”

[24] TIGTA (Treasury Inspector General for Tax Administration), “Delays Continue to Result in Businesses Not Receiving Pandemic Relief Benefits,” Report Number 2022-46-059, August 31, 2022, https://www.tigta.gov/sites/default/files/reports/2022-09/202246059fr.pdf. 

[25] Max Shenker, “An IRS ERC Refund Status Report from the Treasury Inspector General,” Experian, September 9, 2022, https://www.experian.com/blogs/employer-services/new-treasury-inspector-general-report-on-employee-retention-credit-processing-delays/.

[26] Lynnley Browning, “A $2 Trillion Fraud with Employee Retention Credits Puts Financial Advisors on Edge,” National Society of Accountants for Cooperatives, September 20, 2022, https://nsacoop.org/articles/2-trillion-fraud-employee-retention-credits-puts-financial-advisors-edge. 

[27] Pandemic Response Accountability Committee, “A Little-known Tax Credit. A Lot of Potential Fraud,” last modified January 12, 2023, https://www.pandemicoversight.gov/news/articles/a-little-known-tax-credit-a-lot-potential-fraud. 

[28] IRS (Internal Revenue Service), “Guidance on the Employee Retention Credit under Section 2301 of the CARES Act,” Notice 2021-20 (Section I: Interaction with Paycheck Protection Program Loans), March 1, 2021, https://www.irs.gov/pub/irs-drop/n-21-20.pdf. 

[29] IRS, “Employers Warned to Beware of Third Parties Promoting Improper Employee Retention Credit Claims,” IR-2022-183, last updated November 3, 2022, https://www.irs.gov/newsroom/employers-warned-to-beware-of-third-parties-promoting-improper-employee-retention-credit-claims. 

[30] IRS, “Instructions for Form 941-X (04/2022),” last updated June 23, 2022, https://www.irs.gov/instructions/i941x#en_US_202204_publink1000300104. 

[31] IRS, “IRS Opens 2023 Dirty Dozen with Warning about Employee Retention Credit Claims; Increased Scrutiny Follows Aggressive Promoters Making Offers Too Good to be True,” IR-2023-49, March 20, 2023, https://www.irs.gov/newsroom/irs-opens-2023-dirty-dozen-with-warning-about-employee-retention-credit-claims-increased-scrutiny-follows-aggressive-promoters-making-offers-too-good-to-be-true. 

[32] Pandemic Response Accountability Committee, “The Six Laws that Funded Pandemic Relief Programs,” last modified March 7, 2023, https://www.pandemicoversight.gov/about-us/pandemic-relief-program-laws. 

 

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