How the IRS created ERC fraud

The Employee Retention Credit should go down in history as one of the IRS’s greatest failures.

The IRS has managed to fail in almost every aspect of the program. It failed to promote it the way the Treasury Department directed it to. It failed to issue guidance, either timely or properly. It failed to set up the proper procedures to review the claims. And now it is failing to process claims or issue refunds.

I am generally not one to kick the IRS because they have been down for years due to Congress not properly funding it. However, many of the failures around ERC are caused by poor decisions of the IRS leadership and not funding issues. Yes, funding has made the problems worse, but the double-speak coming out of the IRS right now regarding the credit goes to show that the Service is not serious about solving the issues with this credit. Let’s take a look at each of the failures and how the IRS has made the problem worse.

The Department of Treasury initially favored the credit and was concerned by the slow uptake. As a “broad based refundable tax credit designed to encourage employers to keep employees on their payroll,” the Treasury Department directed its Office of Tax Analysis to study how many businesses were taking advantage of it. The study expressed concerns about the slow uptake and acknowledged that businesses were not being educated on the credit. This study was published in November of 2021. Despite the concern and study by the Treasury Department, the IRS never promoted the Employee Retention Credit like it should have. As a part of the CARES Act, the ERC was designed to help businesses retain their employees throughout the pandemic and its related impact. But, such a mechanism is only useful if businesses know about and apply for it. The IRS had a chance to not only process the claims as they came in, but also to get the word out so the money from the refundable tax credit would get into the hands of the businesses that needed it. The IRS could have controlled the narrative, and could have educated not only the public but also tax preparers, who were often unaware of the credit or changes to it. Yet, the IRS failed to do this. Enter the promoters, who grabbed ahold of the credit and were often the first voices that businesses heard regarding the credit. Even as the program is reaching its natural sunset, I still regularly talk to businesses just now hearing about the tax credit. This slow ramp-up led to businesses scrambling to get the credit using the resources before them, often the same promoters that told them about the credit.

Even if a company knew about the program, the IRS failed to release meaningful guidance for the first year. After that, the guidance would trickle out, with new notices coming months before the programs end. Most of this guidance is the information that should have been issued in the first months of the program, not several years into a limited-time program. However, as the IRS continues to release guidance, it expects taxpayers to have already filed their legitimate claims. The Commissioner now claims that anyone filing a claim, even before the latest notice was released, is likely to be fraudulent. If that truly is the case, then why did the IRS feel a need to release the guidance?

But there is also the issue that the IRS failed to properly release what little guidance there was. The two main pieces of guidance that the IRS did release were released as notices. They were not released pursuant to a notice-and-comment period and did not appear to evoke an emergency exception. I won’t dwell on this point, as others have already addressed it and did a much better job of walking through the issue than I could in this space, but it results in a credit that has been almost completely implemented without any true guidance from the IRS.

That brings us to the current moratorium, which is supposed to give the IRS time to put in “protections and safeguards to stop bad claims.” But this should have been done at the program's start, not at the end. As early as June 2020, there were reports that the IRS was not properly reviewing claims. While the aggressiveness of bad actors and promoters may have been a source of surprise, it was not exactly unforeseeable. Claims started to tick up following the expansion of the credit to include 2021. The IRS spent years watching its backlog grow. It was only in 2023 that Commissioner Werfel made the dubious announcement that the backlog was almost cleared. At any point during all of this, the IRS could have started to take its enforcement role seriously. Instead, it continued to ignore the problem until the very end.

Which leads to the final failure. The moratorium is a complete failure by the IRS to perform its duty. Just as the backlog of claims was started to be cleared, although it is doubtful that it was ever as small as Commissioner Werfel claimed, the IRS declared that no new claims would be processed, and existing claims would be delayed. Yet, on a webinar held by the IRS in October, the IRS seemed outraged that taxpayers are getting tired of waiting on refunds and seeking out the same promoters it is supposed to combat to get refund loans. It is the IRS’s inaction that lets promoters flourish, but the IRS continues to think that inaction is the best way to deal with the problem.

Much of the fraud and problems with the ERC program lie at the feet of the IRS. If the IRS had promoted the program and issued guidance in a timely manner, companies would have sought out the help of their trusted tax professionals, and those professionals would have felt empowered to take action. Instead, the vacuum created by the IRS led to the emergence of promoters who have no experience with tax and no incentive to do the actual work required to properly claim the credit. Similarly, if the IRS had created the safeguards and protections initially, then promoters would not have gained a foothold, and the backlog would have been manageable.

Recently, the IRS announced that 20,000 denial letters were being sent out. But this is 20,000 out of an estimated 1,000,000 claims waiting to be processed. Assuming that the IRS is correct to deny all of these claims, which is already proving to be inaccurate, it is not even a drop in the bucket of unprocessed claims and should not be heralded as the herculean effort that the IRS would like you to believe. One can hope that the Voluntary Disclosure Program will provide the IRS with a tidy list of the worst actors in the space, but I suspect many taxpayers will still be left with an unsubstantiated credit and blamed by the IRS for it.

I am not denying that the fraud around the Employee Retention Credit exists or is rampant. But, the IRS was never powerless to stop it. On the contrary, much of the fraud is due to the IRS’s actions and lack thereof related to this credit.

Will the IRS learn a lesson from this? Yes, but it won’t be the right lesson.

Instead of being proactive, spreading the word about available programs, and setting up the right processes from the beginning, the IRS will see fraud at every turn. This will start with the credit, as Werfel has already shown, but will go well beyond it to other tax credits and likely even the everyday return.