Criminal Fraud in COVID Relief Programs (Part II)
This is a second post related to federal fraud within the COVID relief programs. In the first post, we generally discussed two major COVID relief programs, Paycheck Protection Program (PPP) and Employee Retention Credit Program (ERC). We focused on criminal fraud within the PPP program laying out the common schemes that are being indicted in federal courts across the country. In this post, we will focus on ERC; providing a general overview of the program, eligibility requirements, and the common schemes associated with criminal fraud within ERC. While PPP fraud has been the focus of DOJ for a few years, ERC fraud is a fresher topic. Most applications or requests have been filed within the last 48 months and DOJ is still navigating their response to the issue.
The Employee Retention Credit Program
The ERC is a COVID relief program designed to incentivize employers to retain employees during the COVID pandemic. Unlike the PPP, which provided a loan that would later be forgiven under proper circumstances, the ERC is a tax credit given to employers. Tax credits are a dollar for dollar credit a taxpayer can claim on their returns.
There are two types of tax credits in the federal system, refundable and non-refundable. Non-refundable credits will allow a taxpayer to lower their liability. However, once the liability hits zero, the credit is exhausted. Refundable tax credits allow a taxpayer to lower their liability and potentially increase refunds. Under refundable tax credits, the credit continues to run even when the liability hits zero.
For example, let’s assume a taxpayer owes $30,000 in taxes and has a tax credit for $40,000. If the credit was non-refundable, the taxpayer would zero out their liability for that year. If the tax credit was refundable, the taxpayer would create a refund of $10,000.
Two of the most common tax credits for Americans are the earned income tax credit and the child tax credit. The earned income credit gives lower income families relief on their tax bill if they meet the requirements. The earned income credit is refundable. The child tax credit applies to families with dependents. In 2023, a portion of the child tax credit is refundable.
The ERC program utilized the principles surrounding tax credit legislation to create a new refundable tax credit for certain businesses. If they qualified, the business could amend their quarterly employment tax returns (941s) to reduce their liability and recognize the credits.
For a business to qualify, they must swear they meet one of two requirements: 1) the business was either fully or partially suspended by government order during the quarter where the credit is sought or 2) the employer’s gross receipts fell below 50% of the receipts in the corresponding quarter in 2019. If the employer qualifies under the second requirement, the credit stopped when the gross receipts reached 80% of the corresponding 2019 quarter. These requirements had to be met for each quarter where the credit was being lodged.
The ERC applies to all wages paid from March 13, 2020 to December 31, 2020. The credit limits are 50% of employee wages up to a maximum of $10,000 per employee. Further, the legislation makes a distinction between those businesses that had more or less than 100 employees in 2019. For those businesses with over 100 employees, the credit applies to wages paid to employees who could not work during the relevant quarter. If a business has less than 100 employees, the credit applied to all paid wages regardless of whether the employees actually worked. The wage amount includes cash, salary checks, and health care benefits.
The United States Treasury provided guidance for business owners regarding credit reception. The UST advised businesses seeking the credit to reduce the payroll taxes withheld from employee paychecks to immediately recoup the tax credit. This resulted in many businesses filing 941X forms to amend their withholdings for specific quarters under the program.
One key limitation on the tax credit occurs at the cross section of the ERC and PPP program. The government does not allow double dipping into the programs. If an employer received PPP funds for employee retention during COVID, and the loan was forgiven, an employer cannot claim those wage payments under the ERC. This cross section serves as one of the many sticking points in this complicated tax credit legislation.
Unqualified Firms Blitzkrieg ERC
The ERC legislation was originally promulgated in the CARES Act of 2020. However, it has been amended multiple times in subsequent bills, including the Tax Payer Certainty and Disaster Relief Act of 2020, the American Rescue Plan of 2021, and the Infrastructure Bill in 2021.
The rules underlying the ERC, and its eligibility requirements, have become less clear with time. In various bills, the government made material changes to the qualifications, including: changes to the maximum allowable per employee, adding standards for “severely distressed employers”, increasing the 100 employee threshold for certain quarters, and adding recovery startups to the list of qualified businesses.
In an attempt to fine tune the ERC, the government made the program more confusing and complicated than its original vision. The eligibility requirements and credit amounts became moving bars, and only qualified professional guidance could ensure the rules were being followed from eligibility to credit amounts.
Most businesses were uncomfortable with applying for the credit without assistance. As with more tax matters, businesses seek assistance from experts in a particular area. Out of this backdrop rose numerous preparation businesses who saw a chance to make capital by offering to facilitate the ERC for restaurant/small business owners across the country. These preparation businesses ran huge marketing campaigns to increase awareness of the ERC in hopes of securing clients interested in the program. The businesses advertised as ERC specialists.
The marketing campaigns resulted in a flood of program applications and amended 941s hitting the IRS. The IRS was responsible for sifting through thousands of claims and determining eligibility standards. As the IRS began their review, they noticed that a large percentage of the claims were from businesses that did not qualify for the program. Many of these applications came from the same preparation businesses actively marketing ERC preparation.
The IRS quickly became overwhelmed with the number of applications and the quality of the claims. In September of 2023, the IRS announced a stop on new application processing until the end of the 2023 calendar year. They were/are concerned about the presence of bad applications and the impact it will have on the tax credit system. The IRS hopes to raise awareness about the unqualified firms marketing for ERC preparation, slow down the application filing numbers, and ultimately, handle the current application load when the filing speed becomes more manageable.
Criminal Fraud in the ERC
The ERC issue presents a unique problem under criminal fraud statutes. Unlike the IRS civil process, where the IRS is merely determining whether an applicant qualifies, criminal fraud requires specific intent to file a false claim. Put differently, the government must prove a specific business or filer knew the rules surrounding the program and intentionally filed claims that ran afoul of those rules.
In white collar defense, there is an overarching rule that underlies a defense under the intent element – the more complicated the standards underlying an alleged scheme, the more difficult it is to prove. An example likely highlights this best. Let’s assume we have two defendants charged with filing a false tax return. Defendant A filed a return where he omitted two million dollars in income. Defendant B filed a return where he took the long term capital gains rate on the sale of property that he held for eleven months instead of one year (the rules require a taxpayer to hold property for at least one year before the long term gains rate can be taken).
To prove tax fraud, the government must show the taxpayer knew of the rules surrounding the filing and intentionally chose to file the falsity. For Defendant A, the government would likely have an easy time meeting that standard. It would be hard to find a jury that believed Defendant A did not know he had to report all his income on his tax return. For Defendant B, it gets a little more difficult. If Defendant B was unaware of the one-year rule for capital gains treatment, he would not have the requisite intent necessary for criminal prosecution. As the rules become more esoteric and less well known, the intent element becomes a more fertile battle ground in a criminal prosecution.
Most of the unqualified applications before the IRS are going to suffer from the issue highlighted above. The ERC program is complicated with rules moving over time. The taxpayer could be wrong about his eligibility, but proving he understood the rules sufficiently to act with intent may be tough for most applicants.
ERC Fraud Moving Forward
The IRS’ review of existing ERC applications will certainly result in numerous denials of claims. There are going to be a lot of claims that are denied under the program. There will be accepted credits the IRS is forced to claw back upon further review. This civil process is common in IRS interactions with taxpayers.
The real question is whether any of these claims will result in criminal prosecution in line with the PPP fraud we are seeing across the country. In 2023, we are starting to see some movement in this area. The movement is coming from two sources. First, the criminal division is looking at individual business owners who outright lied on paperwork to meet the qualifications of the ERC. If the government can prove a business owner lied about their reduction in income to meet the 50% threshold, specific intent becomes an element that can be proven. After all, it will be difficult for the taxpayer to argue they did not know the rules when their false statement was clearly designed to meet the rules that form the basis for the violation. Second, the criminal division has opened investigations into the preparation businesses that profited from the mass filings of ERC claims. These businesses will undoubtedly have more knowledge about the ERC rules than the average business owner. If a preparation business is routinely filing unqualified applications, they are either grossly incompetent, have a misunderstanding of the rules, or intentionally filing falsities in hopes of profiting under the program. For preparation firms, the damaging evidence is often found in the internal emails and communications at the business. Intent is often not obvious from the filings themselves; however, if the government can uncover emails where the preparers are discussing their understanding of the rules and their decision to violate said rules, these preparation businesses could find themselves under indictment.
One of the goals of the criminal division of the IRS is to curb future waste by making examples of the worst actors. There is value in issuing a press release showing a business owner or preparation firm has been criminally prosecuted for ERC fraud.
The COVID Relief Programs
Like many government programs, there is a large amount of waste the occurs. The government designed PPP and ERC to ease the financial impact of government regulations and the realities of the pandemic. For many businesses, the programs served their purpose well. For other actors, the programs were viewed as a ticket to free money. Any time the government is giving away money, it is nearly guaranteed that false filings will occur. The only question is how many and how much money is associated with the filings.
PPP fraud is common in federal courts across the country. The government has a plan of attack for these false applications. They are implementing this attack on the most egregious actors. ERC fraud is an emerging area that is not fully developed in the criminal system. In 2023, the IRS-CID opened investigations into numerous persons and preparers across the country. Only fifteen people have been formally indicted. I would expect that number to grow as the IRS gets a handle on the thousands of claims on their desks. It will be interesting to see how this unfolds, including the theories of prosecution and the targets of DOJ.