Probing the Strength of IRS Penalty Threats

ERC Strategies for PEOs: Preparing for Tax Disputes

“The IRS is trying various methods to halt what it considers improper Employee Retention Credit (“ERC”) claims, including penalty threats. Browbeating taxpayers with potential penalties is standard stuff, but it becomes particularly interesting in the ERC context, where the IRS’s ability to carry out its warnings is questionable. This article, the latest in a series, describes the evolving ERC guidance, highlights the recurrent themes of “complexity” and taxpayer “victimization,” reviews relevant penalty-mitigation standards, and suggests that taxpayers considering their next move need to determine how much weight IRS penalty threats really deserve.

Penalty Threats

A cornerstone of most tax compliance efforts is the threat of penalties. The IRS has not forgotten this when it comes to ERC claims. Case in point, the IRS has repeatedly warned that any taxpayer that “improperly claims the ERC must pay it back, possibly with penalties and interest,” and a taxpayer “could find itself in a much worse cash position if it has to pay back the credit than if the credit were never claimed in the first place.” The IRS has also cautioned taxpayers that they will be held accountable if they fall prey to “advertised schemes and direct solicitations promising savings that are too good to be true” because taxpayers “are always responsible for the information reported on their tax returns.” More recently, the IRS referenced a long list of potential penalties, and its willingness to abate them, when announcing the withdrawal option in October 2023 and the VDP in December 2023.

Penalty Mitigation

The IRS has threatened to assert several penalties against taxpayers making improper ERC claims, with the specifics depending on the circumstances in each case. Among them are federal tax deposit penalties under section 6656, late-payment penalties under section 6651, and accuracy-related penalties under section 6662. Applicable law provides that the IRS should not impose those sanctions, and courts should not uphold them if a taxpayer can demonstrate that the violation was because of “reasonable cause.” This article is not a treatise on civil penalties; that would far exceed its scope. Set forth below is a mere summary of some key points about penalty mitigation that might be relevant in ERC cases.

• First, the most important factor in determining whether a taxpayer acted with reasonable cause is the extent of its efforts to ascertain the proper tax liability.
• Second, a taxpayer may establish reasonable cause by presenting facts and circumstances showing that it exercised ordinary business care and prudence.
• Third, a taxpayer’s confusion might save the day. The regulations provide that “an honest misunderstanding of fact or law that is reasonable in light of all of the facts and circumstances, including the experience, knowledge, and education of the taxpayer,” might reach the level of reasonable cause.
• Fourth, ignorance of the law might suffice. The IRS acknowledges that reasonable cause may exist “if the taxpayer shows ignorance of the law in conjunction with other facts and circumstances,” such as the level of complexity of a tax or compliance issue.
• Fifth, the IRS generally must abate penalties in situations in which a taxpayer relies on erroneous advice (written or oral) by an IRS employee, the reliance was reasonable, the advice was given in response to the taxpayer’s request, and the error was not the result of the taxpayer providing inadequate or inaccurate information to the IRS.
• The final point warrants a paragraph of its own. A taxpayer’s reasonable reliance on an independent, informed, and qualified tax or legal professional often reaches the level of reasonable cause. The regulations broadly define the concept of “advice” to cover “any communication” from a qualified adviser, and clarify that “advice does not have to be in any particular form.” The Tax Court has held that reasonable reliance exists when three elements are present: (1) the adviser was a competent professional who had sufficient expertise to justify reliance; (2) the taxpayer provided necessary and accurate information to the adviser in a timely manner; and (3) the taxpayer actually relied in good faith on the adviser’s advice. It cautioned, however, that reliance might be unreasonable when “placed upon insiders, promoters, or their offering materials, or when the person relied upon has an inherent conflict of interest that the taxpayer knew or should have known about.” For its part, the Supreme Court has emphasized that the IRS must liberally construe the reasonable reliance defense:

When an accountant or attorney advises a taxpayer on a matter of tax law, such as whether a liability exists, it is reasonable for the taxpayer to rely on that advice. Most taxpayers are not competent to discern error in the substantive advice of an accountant or attorney. To require the taxpayer to challenge the attorney, to seek a “second opinion,” or to try to monitor counsel on the provisions of the Code himself would nullify the very purpose of seeking the advice of a presumed expert in the first place.

Conclusion

So, where are we? Congress issued four ERC laws in less than two years, and the IRS tried to keep pace, issuing guidance in the form of notices, revenue procedures, alerts, GLAMs, chief counsel advice, FAQs, and more. This administrative guidance was sometimes prospective, other times retroactive, and always dense. The complexities and timing issues created by the IRS obligated many employers to file Forms 941-X to make or adjust ERC claims, often more than once. The IRS has acknowledged that much of its guidance is not precedential; neither taxpayers nor the IRS can rely on it during ERC disputes. The validity of other IRS guidance is being challenged in court, too. Add to the mix repeated recognitions by the IRS that the ERC rules are far from straightforward. The IRS and governmental watchdogs have characterized the ERC as “complex” and “confusing,” with “very specific eligibility requirements,” creating many “opportunities for error,” and involving “technical areas that require review” by professionals. The IRS has also underscored that many employers making ERC claims are not willing perpetrators of bad behavior, but rather victims of the situation. In this regard, the IRS has publicly stated on many occasions that employers were “conned,” “lured,” “misled,” “taken advantage of,” “preyed upon,” or “victimized” by others. Finally, the regulations and cases establish a long list of justifications for penalty abatement.

The IRS has threatened taxpayers with various penalties to halt the filing of further ERC claims, encourage large concessions during audits, dissuade the filing of refund suits, and induce participation in the withdrawal option and VDP. One big question for taxpayers contemplating their next move is how much weight they should give those IRS threats in light of the unique circumstances addressed in this article.

Read the full article here.