By Anthony Diosdi
The Internal Revenue Service or (“IRS”) has warned business owners to watch out for misleading claims involving the employee retention credit. See IR-2023-105, 5/25/2023. The general public continues to be subject to a barrage of broadcast advertisements and online promotions involving the employee retention credit or (“ERC”). The IRS has stated that while the benefits of the ERC are real, aggressive promoters are misrepresenting and exaggerating who can qualify for the ERC. See This Little-Known Pandemic-Era Tax Credit Has Become a Magnet for Fraud, Alan Rappeport, New York Times, May 26, 2023.
The IRS has stepped up audit and criminal investigations involving ERC claims. The IRS is investigating both businesses claiming an employee retention credit and the promoters of these credits. When properly claimed, the ERC is a refundable tax credit designed for businesses that continued paying employees while shut down due to the COVID-19 pandemic or that had a significant decline in gross receipts during eligible periods. Those considering applying for the ERC need to carefully review the requirements of the credit. The IRS has been issuing warnings about aggressive ERC scams since 2022, and the improper claiming of the credit has made the IRS’s list in 2023 of the Dirty Dozen tax scams.
The IRS has emphasized that the investigation of ERC claims is going to be a priority area. The IRS has trained auditors to examine ERC claims and the IRS Criminal Investigation Division is working to identify fraud and promoters of fraudulent claims. Any business considering claiming an ERC should not only carefully examine their eligibility for the credit but also the professional that advised them to claim the credit. Business owners should avoid any so-called tax professional that uses aggressive ERC marketing tactics. The IRS stated that warning signs of aggressive ERC marketing include:
1. Unsolicited calls or advertisements “easy application process” of the ERC.
2. Large upfront fees to claim the credit.
3. Aggressive claims from a professional that a business qualifies for an ERC before a review of the business’ tax and financial situation. The ERC is a complicated credit that requires a careful analysis before a determination is made to claim the credit.
The IRS has pointed out that promoters of an ERC often do not accurately explain eligibility requirements or how the credit is computed. Instead, promoters or some professionals pushing the credit tend to make broad arguments suggesting that all employers are eligible to claim an ERC without evaluating an employer’s individual circumstances. Improperly claiming an ERC can result in criminal prosecution for both business owners claiming the credit fraudulently and the promoter of the credit. A business owner that fraudulently claims an ERC and the promoter of the credit may find themselves ultimately charged with a number of criminal offenses. Below, is a partial list of the offenses that business owners and promoters involved in the claiming of a fraudulent credit could face.
False or Fraudulent Returns or Statements
Under Internal Revenue Code Section 7206(1), any person who willfully signs and files any return, statement, or other document containing a declaration that is under penalties of perjury, and that he or she does not believe to be true and correct as to every matter, is guilty of a felony.
Aiding and Abetting the Preparation or Filing of False or Fraudulent Return
Internal Revenue Code Section 7206(2) is principally designed to reach tax preparers. It can and has been used against any attorney, CPA, tax preparer, and anyone else who “aids or assists in, or procures, counsels, or advises” in taking a fraudulent position on a tax return. If an individual is prosecuted and convicted under Section 7206(2), he or she will be guilty of a felony.
Below, please see Illustration 1, Illustration 2, and Illustration 3 which discusses an example of a fraudulently claimed ERC and its potential consequences.
Illustration 1.
Tom is a tax attorney in Los Angeles, California. His firm’s business has been on the decline over the past several years. Tom is good at marketing, but he is not a very good attorney. In order to fund his law practice, Tom decides to aggressively market the ERC to local businesses through a radio and online marketing campaign. In his marketing campaign, Tom wildly misrepresents the credit and exaggerates who can qualify for the credit. As a result of Tom’s advertisements, Sue, a business owner that has employees, is lured to Tom’s office for a “consultation.” During the consultation, Tom tells Sue that her business is eligible to claim the credit. Tom knew that Sue’s business does not qualify to claim the ERC. Sue ultimately claims the ERC for her business. Tom prepares the return and signs the return to be filed with the IRS claiming the credit. The IRS audits the ERC submission and refers the matter to the IRC Criminal Investigation Division. Can Tom and Sue be criminally prosecuted for fraudulently claiming the credit?
The Government could charge Tom with violating Internal Revenue Code Section 7206(2). The elements of Section 7206(2) are as follows:
1) The defendant aided and assisted in, or procured, counseled or advised the preparation or presentation of a return or document in connection with a matter arising under the internal revenue laws.
2) The return, statement or other document was false in respect to a material matter.
3) The defendant acted willfully.
Here, Tom knew that Sue’s business did not qualify to claim an ERC. Yet, Tom prepared a false return to claim the ERC. Tom will likely be convicted of violating Section 7206(2). Tom will also likely be convicted of violating Section 7206(1). This Code section punishes individuals that file false tax returns. Because Tom signed and filed a false or fraudulent tax return with the IRS, Tom can also be convicted of filing a false tax return under Section 7206(1).
Sue on the other hand will not be convicted of any tax crime because she did not “willfully” intend to fraudulently claim the credit. In order for Sue to be convicted of a tax credit, the Government will have to prove that Sue willfully intended to claim the credit her business was not entitled to claim. Willfulness is an essential element of tax crime related to fraud. An act is done “willfully” if done purposely with the specific intent to disregard the law, or do that which the law forbids. The word “willfully” as used in connection with tax fraud means with a bad or evil purpose of defrauding the government. Sue’s acts in connection with claiming the credit are not “willful” because of her good faith reliance on Tom, her tax attorney. Although Sue will not be criminally prosecuted, she must pay back the improperly claimed credit along with penalties and interest.
Illustration 2.
The facts are the same as Illustration 1, but Tom assigns the preparation of return claiming the ERC to Kent, as associate of Tom’s law firm. Kent knows that Tom has exaggerated who can qualify for the credit in the past, but he did nothing about it. Kent is also aware that Sue’s business does not qualify for the credit. However, Kent is eager to please Tom, so he prepares and signs the return claiming the ERC for Sue’s business.
Can Tom and Kent be criminally prosecuted?
Just because Tom did not prepare and sign the return claiming the ERC does not mean he cannot be criminally prosecuted. Prosecutions under Section 7206(2) can be brought against anyone who “aids, abets, counsels, induces, or procures” the commission of an offense by another may be charged as a principal. In this example, Tom induced Sue to file a fraudulent ERC claim. Even if Tom did not sign the return claiming the ERC, Tom convinced Sue file a claim for a credit her business was not entitled to claim. Then Tom assigned the preparation of the fraudulent ERC claim to his associate. As a result, Tom can still be prosecuted under Section 7206(1). Kent violated Section 7206(1) and Section 7206(2) by filing fraudulent ERC claims with the IRS for the same reasons as discussed in Illustration 1..
Tom and Kent can also be charged under 18 U.S.C. Section 371. The statute punishes individuals for conspiring to defraud the United States.
Section 371 provides in relevant part:
If two or more persons conspire either to commit any offense against the United States, or to defraud the United States, or any agency thereof in any manner or for any purpose, and one or more of such persons do any act to effect the object of the conspiracy, each shall be fined under this title or imprisoned not more than five years, or both.
The elements of Section 371 are as follows:
1) The existence of an agreement to accomplish an illegal or unlawful objective or to defraud the United States.
2) The defendants knew of the agreement and with such knowledge voluntarily participated in the conspiracy.
3) The commission of an overt act by conspirators in furtherance of the objective of conspiracy.
Since Tom and Kent conspired together to file a return fraudulently claiming a credit that defrauded the Government, both Tom and Kent can be prosecuted under Section 371.
Illustration 3.
Let’s assume that Tom tells Kent that he wishes to form a “unified front” as a defense to the charges alleged by the IRS. As part of the unified defense, Tom and Kent will have their own defense counsel. But the attorneys will work together. Tom has also told Kent that his firm will pay for Kent’s legal defense.
Can Tom and Kent enter into such an agreement?
Once the criminal prosecution commences, Tom and Kent will likely begin to point the preverbal finger at each other. Thus, agreeing to a unified front is problematic. In addition, Tom’s payment of Kent’s legal fees may make the situation worse for Kent. The value of payment of Kent’s legal fees from Tom’s business may be taxable to Kent. The failure to report the value of the legal services on Kent’s tax return could make the situation even worse for him.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.