Employee Retention Credits in M&A Transactions
June 19, 2023
At a glance
- The main takeaway: Engaging the right tax professional is the best way to mitigate risks and identify potential solutions surrounding Employee Retention Credits (ERCs) arising from M&A transactions.
- Impact on taxpayers: Ensuring that target companies are entitled to ERC refunds is critical for buyers who wish to protect themselves from future tax adjustments and potential litigation that may arise as a result of a disallowance of ERC credits by the IRS in an audit.
- Next steps: Aprio’s Transaction Advisory team can assist buyers in identifying ERC risks in target companies and recommend potential mitigation solutions.
Are you ready to learn more? Schedule a conversation with our team.
The full story:
ERCs may have started as a helpful tool for businesses suffering from the COVID-19 pandemic, but they didn’t stay that way for long. Now, just three years later, ERCs have earned a place on the IRS’s “Dirty Dozen” list of prominent tax scams. Businesses in the market for M&A opportunities need to evaluate any and all ERCs claimed by target companies as part of the due diligence process. Failing to identify possible deficiencies in a target company’s prior ERC filing may result in the acquiring company having to return ERC amounts paid to the prior ownership back to the government, if those credits are denied on audit, as well as future tax adjustments and potential litigation with the IRS and/or the seller(s).
The ERC was originally created as a way of encouraging businesses to retain employees during the COVID-19 pandemic. Qualified businesses could receive a maximum credit amount of $5,000 per employee for the 2020 calendar year and $7,000 per employee per quarter for 2021. The ERC was available for all quarters in 2020 and Q1 through Q3 in 2021. However, for firms that qualified as “recovery startup businesses” the ERC was only available in Q3 and Q4 of 2021.
Though the credits themselves only apply for the dates listed, businesses can still apply for the ERC by filing an amended Form 941X (Quarterly Federal Payroll Tax Return) for the quarters during which the company was an eligible employer. The application period expires in 2024 for most businesses, though it extends to 2025 in some specific cases.
ERCs apply to “qualified wages” paid by “eligible employers,” of all sizes including private-sector businesses as well as certain tax-exempt organizations that continued doing trade or business during the pandemic. More specifically, an “eligible employer” is defined as a business or organization that:
- Was fully or partially suspended due to orders from the federal, state, or local government limiting commerce, travel, or group meetings due to COVID-19, or
- Experienced a significant decline in gross receipts—defined as 50% or more—during any quarter in 2020 compared to that same quarter in 2019, or
- For Q1 through Q3 of 2021, experienced a significant decline (20% or more) in gross receipts, during any quarter compared to that same quarter in 2019, or
- For Q3 and Q4 of 2021, was classified as a “recovery startup business,” AND
- Retained their employees.
The ERC is not available for employees who are exempt from Social Security and Medicare taxes, employees who are related to the employer, or who belong to certain ineligible groups. These include self-employed individual earnings, federal, state, and local government entities, or any agency or instrumentality thereof.
For 2020, the ERC was limited to 50% of the qualified wages that an employer pays in a calendar quarter, though this limit was increased to 70% of qualified wages in 2021 due to the lasting impacts of the COVID-19 pandemic.
Qualified wages include salaries and hourly wages, other forms of compensation and certain qualified health plan expenses paid by eligible employers. The ERC was available to eligible employers of any size, though the average number of full-time employees in 2019 factored heavily into determining what did and did not count as eligible wages.
If a company employed more than 100 full-time employees in 2019, the qualified wages for 2020 are considered to be wages or other compensation paid to an employee for the time that they did not work in 2020 due to:
- A full or partial suspension of business operations due to a governmental order, or
- The business experienced a significant decline in gross receipts.
If a company employed an average of 100 or fewer full-time employees in 2019, the qualified wages for 2020 are considered to be wages paid to any employee of an eligible employer. For 2021, the threshold changes from an average of 100 full-time employees to 500 full-time employees in 2019.
Thus, if there are more than 500 full-time employees on average in 2019, the qualified wages for 2021 are considered to be wages or other compensation paid to an employee for the time that the employee is not providing services due to the limitations previously noted. In other words, businesses that employed fewer than 100 full-time employees on average in 2019 had a lower threshold for determining qualified earnings than larger companies, though that preferential treatment expired in 2021.
Eligible employers and their tax advisors should be aware of certain limitations on ERC refunds. For example, ERC-eligible employers who received funds through a Payroll Protection Program (PPP) loan may not claim both the PPP funds and the ERC on wages that were reported as payroll costs when obtaining PPP loan forgiveness.
Also, it’s important to note that qualified wages do not include any wages for which the employer received a credit for qualified sick and/or family leave wages. And finally, employers may not claim both an ERC and a Work Opportunity Tax Credit (WOTC) for the same quarter(s).
Given all these caveats and complexities, it is imperative that all companies that claimed ERC refunds keep detailed documentation on any and all ERCs. Detailed documentation of all ERC receipts will help ensure the situation is cleared up promptly if the IRS decides to audit the ERC refund claim. ERC recipients bear the burden of proof in defending the refund claims in case of an audit. That responsibility becomes even more burdensome when you consider that the American Rescue Plan Act (ARPA) extends the statute of limitations for the assessment of tax from the normal three years to five years.
The Dirty Dozen
The IRS added the ERC to its list of “Dirty Dozen” tax scams beginning in 2023. The Service noted that many of the ERC claims it received were based on inaccurate information relating to eligibility and computation of the credit. The IRS also warned taxpayers to beware of third-party ERC schemes—a warning that is still prominently displayed on its website.
According to the IRS, many gullible business owners had fallen victim to unscrupulous promoters who had pressured employers into improperly claiming the credit or to claim additional credits. The IRS warned specifically about these promoters failing to heed the nuanced requirements to qualify for an ERC, not verifying whether employers had already claimed PPP loan forgiveness or other benefits and potentially collecting sensitive personal information for purposes of identity theft.
The IRS requested that taxpayers report instances of fraud, phishing attempts and abusive promoters, though not before many ERC claims were improperly filed. Additionally, the IRS also warned that taxpayers should be prepared to respond to audit questionnaires as they continue to audit ERC refund claims.
If you are negotiating the purchase of a business that has filed at least one ERC claim, it is very important that you verify that the target qualified for the ERC claim, retained supporting documentation and properly accounted for credit claims in its income tax filings, in preparation of a possible future audit as part of your due diligence.
This ERC issue may not seem like much until you consider the fact that many acquisition or merger transaction structures entitle the seller of the business to any pre-closing tax refunds. If the seller filed amended returns to claim an ERC and has not received the refund by closing, you, the buyer, may be required to pay the amount of the refund to the seller once it is received. And given the issue of fraudulent or improper ERC claims, the IRS could audit and deny the claim well after you have paid the seller the amount of the expected audit.
Buyers would be wise to obtain a second opinion on the validity of any ERC claims before they finalize any deals. If the claims are not valid, then buyers may be forced to place the funds in escrow at closing until the applicable statute of limitations has expired.
The bottom line
Aprio is here to help buyers of all sizes identify and avoid issues in transactions with sellers that have claimed ERCs. Navigating such transactions is tricky, and purchasing a company that has claimed ERCs can greatly increases the risk of hidden tax consequences that often accompanies M&A transactions on the buy side.
Aprio’s Transaction Advisory services has dedicated teams focused on transaction analysis to help identify and mitigate risk as part of the due diligence process, as well as skilled ERC specialists who are able to offer additional guidance at every step of the way.
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About the Author
Daniela is a Manager with Aprio's Tax Advisory Services team, specializing in tax diligence and buy-and-sell-side transaction tax services. With over 10 years of experience, she excels in section 382 studies and is driven to expand her knowledge to help clients achieve their goals. Previously, Daniela served as a Tax Manager at a Fortune 100 Company, handling proof of deferred tax assets and liabilities for balances exceeding $4 billion. She holds an MBA from Georgia State University.
Gary is a director on Aprio’s Transaction Advisory Services team, serving clients in a wide range of industries, including private equity, healthcare and technology. With more than 22 years of experience, he specializes in buy- and sale-side transaction tax services, transaction cost analysis, Section 382 studies, tax basis of stock calculations, Section 1202 analysis and other tax consulting services.