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IRS rejects claims from 20,000 taxpayers for lucrative small business tax credit

The IRS is taking action against small businesses that improperly filed returns claiming a lucrative pandemic-era tax credit.

The agency sent 20,000 correspondence letters disqualifying these taxpayers from claiming the Employee Retention Credit, or ERC. Officially known as Letter 105 C Claims Disallowed, the letters targeted two types of filers that were ineligible: entities that did not exist or businesses with no paid employees during the claim period between March 13, 2020, and Dec. 31, 2021.

This was the agency's first batch of rejection letters to taxpayers in an extended effort to combat incorrect or even fraudulent claims of the ERC credit.

"With the aggressive marketing we saw with this credit, it's not surprising that we're seeing claims that clearly fall outside of the legal requirements," IRS Commissioner Danny Werfel said in the press release. "The action we are taking today is part of an initial set of steps in our compliance work in this area, and more letters will be going out in the near future, including both disallowance letters and letters seeking the return of funds erroneously claimed and received."

The prevalence of incorrect ERC returns — especially around the basic eligibility requirement — stoked the agency’s concerns over ERC pop-up firms that were aggressively marketing the credit to unaware small businesses, many of which were ineligible for the credit.

"Anytime that you have a credit that has been issued, you're going to have some unscrupulous individuals who's going to try to take advantage of it," Eric Hylton, national director of compliance at alliantgroup and former IRS deputy chief of the criminal investigation division, told Yahoo Finance.

The IRS sent out its first batch of ERC rejection letters to taxpayers in an extended effort to combat incorrect or even fraudulent claims.
The IRS sent out its first batch of ERC rejection letters to taxpayers in an extended effort to combat incorrect or even fraudulent claims. (designer491 via Getty Images)

Expanded effort to uncover suspicious ERC claims

The IRS has been increasing its ERC compliance endeavors over its concerns.

The earliest effort was in September when the tax agency put a moratorium on filing for the credit. It then asked small business owners to review pending claims and voluntarily withdraw any suspicions ones in October. Now, the agency is beginning its wave of rejection letters to unqualified businesses.

"This is a part of their overall compliance strategy to address this enormous situation," Hylton said. "[The IRS] came up with the moratorium to filter through the employee retention credit issue so that they could actually get to the legitimate claim."

It’s no surprise that the IRS is committed to combating ERC fraud, as the payments to businesses can be hefty.

Since 2020, the IRS has received nearly 3.6 million ERC returns, with more than 600,000 ERC applications in the pipeline totaling $230 billion in refunds paid, according to the Journal of Accountancy. The outstanding applications are estimated worth another $90 billion to $100 billion.

The 20,000 rejection letters sent out have an estimated total value of $2 billion to $10 billion applied credits, Hylton said as he estimated that some letters were for taxpayers making claims for $100,000 to $500,000.

Daniel Werfel said the 20,000 ERC rejection letters sent is an initial set of steps in the IRS' ERC compliance work and more letters will be going out in the near future.(AP Photo/Mariam Zuhaib)
Daniel Werfel said the 20,000 ERC rejection letters sent is an initial set of steps in the IRS's ERC compliance work and more letters will be going out in the near future. (AP Photo/Mariam Zuhaib) (ASSOCIATED PRESS)

The agency has also found ERC-related fraud totaling around $3.4 billion and initiated 252 investigations involving another $2.8 billion in potential scams as of the end of July.

The IRS has also created a withdrawal program for taxpayers to request and withdraw any claims. This option is for filers who have applications in the works but have not received a refund or for filers who received a refund they haven’t deposited yet. The option comes without any penalties or charges from the tax agency.

"They are treated as if they were never filed," the IRS website says.

The IRS has explicitly warned taxpayers of ERC mills and their practices this year. They are often internet pop-up shops without prior CPA or accounting experience and aggressively push small business owners to claim the ERC credit. They get significant cuts of the tax refund their clients receive, so they are incentivized to convince ineligible and unaware business owners to file for the credit.

Experts in the matter have previously told Yahoo Finance that the IRS is likely building criminal cases against some of these ERC internet companies that are filing numerous ineligible claims. But whether the IRS can claw back ineligible refunds that have been paid out remains difficult.

"The IRS probably will start looking at getting that paid back," Hylton said. "But this may be a challenge because a lot of businesses have actually spent those funds."

Rebecca Chen is a reporter for Yahoo Finance and previously worked as an investment tax certified public accountant (CPA).

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