On June 20, following a long and detailed review process, the IRS announced its plan to deny tens of thousands of highest-risk Employee Retention Credit (ERC) claims while resuming the processing of only the lowest-risk ERC claims. The perceived large-scale fraud involved in ERC claims created major challenges to both the government and taxpayers. We expect the IRS will continue to introduce additional measures on this front, including a possible second voluntary disclosure program, requiring taxpayers to closely explore available alternatives in general and in the context of M&A transactions, in particular. We further anticipate enhanced focus on the ERC front in M&A transactions, with regards to both the due diligence efforts and in terms of the contractual provisions addressing ERC claims and related funds.
Background
As mentioned in prior Kramer Levin client alerts (see here and here), the ERC is a refundable payroll tax credit that was created by the CARES Act in 2020 to help certain businesses that continued paying qualified wages during the COVID-19 pandemic. Amid growing concerns about a flood of fraudulent ERC claims, following multiple public announcements warning taxpayers against aggressive promoters of improper ERC claims, the IRS imposed a moratorium on processing ERC claims in September 2023. In mid-October 2023, the IRS introduced an ERC withdrawal process that has resulted in over 4,800 taxpayers withdrawing more than $500 million worth of claims to date. In late December 2023, the IRS announced a voluntary disclosure program (ERC-VDP) allowing taxpayers to keep 20% of the ERC claimed and avoid penalties and interest, provided that applications were filed by March 22, 2024. The IRS warned taxpayers that future programs, if implemented, may have terms that are not as favorable. Despite its short duration, the ERC-VDP resulted in over 2,600 applications and a total disclosed amount in excess of $1 billion.
The IRS Analysis and Next Steps
Since imposing the moratorium, the IRS has reviewed nearly 1 million ERC claims representing more than $86 billion in ERCs. As part of such review, the IRS sorted the claims based on their risk profile. The IRS concluded that between 10% and 20% of the claims are considered highest-risk, showing clear signs of being erroneous. Tens of thousands of these highest-risk claims are expected to be denied in the coming weeks. In addition to such highest-risk group, the IRS estimates that between 60% and 70% of the claims show an unacceptable level of risk. The IRS will analyze these claims further with a goal of improving the IRS' compliance review and processing time of valid claims while protecting against improper payments. Based on the IRS analysis, the remaining 10% to 20% of claims represent a low risk, and the IRS expects it will begin judiciously making payments on these claims later this summer.
There are more than 1.4 million unprocessed ERC claims, and the IRS will be processing the oldest claims first. Claims submitted during the moratorium will not be processed at this time.
The IRS' claim withdrawal program remains open, and the IRS is considering a second voluntary disclosure program on less favorable terms than those of its initial ERC-VDP.
Considerations for M&A Transactions
Acquirors in M&A transactions should proceed with caution when acquiring businesses that have claimed ERCs in light of the substantial percentage of erroneous claims and the IRS' heightened scrutiny of ERC claims. If a target's ERC claim is pending but has not yet been processed, acquirors may wish to consider whether the claim is erroneous and should be withdrawn. Where a refund payment has already been made to a target, the acquiror should consider whether that refund could be subject to clawback by the IRS if later identified as erroneous. Due to the nature of the underlying information, the ERC claims previously filed were not always fully vetted as part of the due-diligence process conducted by acquirors, thereby resulting in a potential gap in knowledge. We expect additional measures to be considered by the IRS, including a possible second voluntary disclosure program requiring taxpayers to closely explore available alternatives in general and in the context of M&A transactions, in particular. We further anticipate enhanced focus on the ERC front in M&A transactions, with regards to both the due diligence efforts and in terms of the contractual provisions addressing ERC claims and related refunds.
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