CPAs may face a malpractice claim when preparing tax returns that reflect ERC, even if they didn’t calculate it. Learn how to mitigate this risk.
Background
The Employee Retention Credit (“ERC”), originally enacted under the 2020 Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) and as subsequently amended, was designed to encourage businesses to keep employees on their payroll through a refundable tax credit based on qualified wages. Like many other credits, businesses claiming an ERC must reduce the deduction for salary and wages by the amount of the credit received. Accordingly, business claiming an ERC will incur a higher income tax burden in the year in which the ERC is claimed.
As with any new or novel tax savings strategy, opportunities are created for CPAs and third parties to market their skills related to the tax savings strategy. This is no different with the ERC. What is different, however, are the questions being raised related to the ERC calculations performed by certain third parties. These third parties may be taking improper positions related to taxpayer eligibility and computation of the ERC amount and may not fully appreciate the intricate, subjective and complex rules governing the ERC. Consequently, increased IRS scrutiny surrounding this issue exists and may result in a taxpayer’s future loss of valid income tax deductions. Moreover, significant penalties and interest on employment-related tax underpayments may also be assessed. One need only look at the IRS news release IR 2022-183, Employers warned to beware of third parties promoting improper Employee Retention Credit claims, issued October 19, 2022, for an indication of what may lie ahead.
Impact to CPAs
CPAs may be asked to prepare original or amended payroll and/or business tax returns reflecting ERC. As such, CPAs may face a future professional liability claim if a client’s ERC is disallowed by the IRS, even if they did not calculate the ERC.
In some cases, the IRS has up to five years to audit payroll tax returns claiming ERC, longer than the typical three-year statute of limitations for income tax returns. This two-year difference can create a “whipsaw effect” for taxpayers whereby otherwise available income tax wage deductions in years closed under the statute of limitations may be lost, along with the disallowed ERC and related penalties and interest being assessed on underpaid employment taxes.
Arguably, the third party that calculated the erroneous credit should be responsible for any errors, rather than the CPA that prepared the related tax returns. However, because positions taken on tax returns prepared now may not be overturned until several years down the road, the third party that performed the calculation may no longer be in business. Furthermore, even if the third party remains an ongoing enterprise, it may lack assets or insurance coverage, leaving the CPA to respond to client assertions of improper advice. Defending these assertions may be challenging if the CPA failed to abide by professional standards or did not maintain documentation to demonstrate such.
Applicable professional standards and CPA’s response
While U.S. Treasury Circular No. 230 §10.34(d), Standards with respect to tax return and documents, affidavits and other papers, and the AICPA Statements on Standards for Tax Services (“SSTS”) No. 3, Certain Procedural Aspects of Preparing Returns, permit tax practitioners to rely on information furnished by the client in good faith and without verification, the practitioner may not ignore the implications of information furnished to, or actually known by, the practitioner. Moreover, if the information as furnished appears to be incorrect, inconsistent with an important fact or another factual assumption, or incomplete, it is incumbent upon the practitioner to make reasonable inquiries of the client.
As a result, if a client asks a CPA to prepare or amend tax returns using information prepared by a third party, including ERC calculations, the CPA should first obtain a signed engagement letter defining which federal and state tax returns require preparation or amendment and then evaluate the information in accordance with professional standards.
SSTS No. 1, Tax Return Positions, states that a CPA should not recommend a tax return position or prepare or sign a tax return taking a position unless the CPA has a good-faith belief that the position has at least a realistic possibility of being sustained administratively or judicially on its merits if challenged.
SSTS No. 1 also states that a CPA may recommend a tax return position if the member (i) concludes that there is a reasonable basis for the position and (ii) advises the taxpayer to appropriately disclose that position.
According to the AICPA Levels of Confidence for Tax Return Positions, which is based upon Treasury regulations, “realistic possibility” is defined as a 33% possibility of prevailing in an administrative or judicial proceeding if challenged by the IRS, and “reasonable basis” is defined as significantly higher than not frivolous and lower than realistic possibility. In practice, a position has a reasonable basis if it is considered to have a 20-25% chance of prevailing in an administrative or judicial proceeding if challenged by the IRS.
Following the CPA’s analysis of the tax position, including follow-up questions asked of the client and documentation of such, the CPA should determine if professional standards permit the preparation of a tax return that reflects the ERC calculated by the third party.
Based upon that analysis, it is recommended that the CPA consider the following protocols:
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Merits of tax position
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ERC has a realistic possibility (33% chance) of being upheld
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ERC has a reasonable basis (20 – 25% chance) of being upheld
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Client does not have a reasonable basis for claiming ERC
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Should tax returns be prepared by the CPA?
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Income and payroll tax returns may be prepared or amended by the CPA without disclosure.
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Income tax returns may be prepared or amended by the CPA with disclosure. Obtain the client’s written consent to disclose the tax position.
However, payroll tax returns should not be prepared or amended as there is no disclosure option for payroll tax returns.
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Neither income nor payroll tax returns should be prepared by the CPA even if wages are added back and, therefore, taxable income is higher (see CPA communications related to client responsibilities section below).
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Communication of risks to client
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Any client claiming the ERC calculated by a third party should be informed, in writing, of the risks of doing so and the CPA should obtain the client’s acknowledgement of these risks. A copy of such communication should be maintained in the client’s file. [1]
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[1] Items to incorporate in this communication include:
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The IRS may disagree with the ERC calculation reflected on the client’s payroll tax return(s);
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If the client’s ERC claim is disallowed after the statute of limitations to amend the business tax return has passed, the client will be unable to deduct wages upon which ERC was calculated, resulting in a lost deduction and overpayment of federal income tax;
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If the client’s ERC claim is disallowed, the client may owe additional payroll taxes, interest and penalties for which the client will be responsible; and
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The client may be unable to obtain refunds for fees paid to a third party or recoup other losses from them for incorrect ERC calculations.
If a client has improperly claimed ERC on its payroll tax returns, regardless of who prepared them, the CPA should comply with Circular 230 §10.21, Knowledge of a Client’s Omission, and SSTS No. 6, Knowledge of Error: Return Preparation and Administrative Proceeding or Court Decision, by informing the client, in writing, of:
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the nature of the error on the client’s previously filed return(s);
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how the client may correct the error; and
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the potential consequences to the client of not correcting the error.
The CPA should also inform the client, in writing, that, as of the date of this writing, statutory provisions require the client's income tax returns to reflect a wage deduction in line with the ERC claim.
However, two wrongs don’t make a right. It is not recommended that the CPA prepare or amend the client’s income tax returns to comply with this statutory provision and, thus, perpetuate an ERC claim that has less than a reasonable basis of being upheld. In addition, if the CPA does so and the client’s ERC claim is later denied, the client may allege the CPA, through its preparation of the tax return reflecting the ERC claimed, tacitly agreed with it, thus negating all prior written warnings provided to the client.
Financial statement impact
CPAs providing services related to the client’s financial statements, particularly audit and review services, should also evaluate possible accounting misstatements and noncompliance with laws and regulations in accordance with applicable professional standards.
A final thought
Although positions taken on a tax return are ultimately the client’s responsibility, ERC represents a significant risk to CPAs and may lead to future claims. If a client fails to take the CPA’s advice or pressures the CPA to take an improper position, client termination may be the best option.
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February 1, 2023