Heightened ERC Claim Scrutiny Poses M&A Challenges, Other Risks

Companies involved in mergers and acquisitions must navigate complexities that can affect their valuation and operational integrity. The rise of questionable employee retention credit claims recently has emerged as one such concern.

The Coronavirus Aid, Relief, and Economic Security Act established the credit to support small businesses affected by the Covid-19 pandemic—up to $26,000 per employee. Many companies submitted claims that, given recent IRS guidance and announcements, may not survive IRS scrutiny. Accordingly, companies should perform thorough due diligence of a claim—whether pending or already received—to mitigate risks that cause significant issues post-transaction.

Increased ERC Scrutiny

The IRS continues to raise concerns about questionable claims and has ramped up its evaluation and enforcement of ERC submissions, such as by implementing a yearlong moratorium on processing claims.

The agency’s focus stems from what it asserts are alarming trends indicating that businesses may have engaged in questionable practices. These include misrepresenting employee counts, claiming credits for wages not actually paid, failing to deduct Paycheck Protection Program funds, claiming the credit for too many quarters, citing governmental orders that don’t meet the program’s eligibility requirements, and alleging false or misleading operational impacts resulting from the pandemic.

Even well-supported claims may face scrutiny due to the IRS’s narrow interpretation of its guidance, leading to “good” claims being denied, audited, or clawed back if payments have already been made.

The IRS has warned of civil and criminal penalties for individuals and businesses submitting claims it deems ineligible. This scrutiny can affect mergers and acquisitions, as buyers may become wary of potential liabilities stemming from the target company’s ERC claims.

Potential Risks

When companies engage in M&A, potential buyers conduct thorough due diligence, scrutinizing tax filings, revenue projections, and financial metrics. Questionable ERC claims can create significant discrepancies and mislead prospective buyers.

If these claims are deemed erroneous or fraudulent, the company could face penalties, including repayment of the credits, interest, fines, and legal action. Such liabilities can hurt a company’s valuation, leading to renegotiations, deal cancellations, litigation, or bankruptcy—and create a chilling effect on the M&A market, as potential buyers may shy away from deals perceived as high-risk.

Questionable ERC claims also can raise risks during or after a transaction has closed. If a company’s claim is challenged there are several other risks to consider.

Enforcement risk. An improper ERC claim could result in IRS denial, audit, claim clawback, or civil enforcement that may include repayment, penalties, interest, and other fees. Criminal enforcement by the IRS or Department of Justice is possible in egregious cases.

Litigation risk. If claims are found to be erroneous, companies could face lawsuits from stakeholders.

Transaction risk. A questionable ERC claim can erode confidence with prospective buyers, impact transaction terms, or jeopardize the transaction.

Reputational risk. In an era where corporate integrity is paramount, avoiding publicized disputes or penalties related to ERC claims can help preserve a company’s image and make it more attractive to buyers, reducing the risk of reputational damage.

To reduce risks, companies engaged in M&A should consider hiring independent experts who are experienced with reviewing claims.

These professionals provide unbiased assessments, identify weaknesses, ensure supporting documentation aligns with IRS guidance, and address potential red flags. They also can recommend withdrawing claims or returning funds and can represent taxpayers in IRS audits or litigation.

Resolving Unsupportable Claims

If a company discovers a questionable ERC claim during a merger or acquisition, it may consider several resolution options.

Withdraw the claim. If the option is available, proactively withdrawing an ERC claim may eliminate or reduce potential penalties and interest and demonstrate good faith.

Disclose to the buyer. Full disclosure of any ERC claim to the buyer is crucial. This transparency aids in negotiating the terms of the deal, including purchase price adjustments or indemnification clauses for potential liabilities.

Renegotiate deal terms. If an ERC claim substantially affects the financials of the deal, a company may need to renegotiate the terms of the transaction.

Purchase ERC insurance. ERC insurance may be available, but it is often costly and may involve lengthy and extensive underwriting.

Escrow ERC funds. Companies often opt to put an amount equal to the ERC claim in escrow until the statute of limitations lapses or, in cases where there is already an appeal, a final decision is made.

Prepare for potential repayment or appeal. If the IRS disallows the claim, the company should prepare either to repay the credit and any applicable penalties and interest or appeal the IRS’s decision through litigation.

Seek professional advice. Independent experts can help navigate the complexities of the ERC, strengthen claims, or work with the IRS to minimize risks.

The rise of questionable ERC claims presents a complex challenge for companies navigating M&A. As the IRS intensifies scrutiny of these claims, the risks associated with ERCs continue to increase.

By prioritizing transparency and engaging independent experts to review ERC claims, companies can mitigate financial, enforcement, litigation, transaction, and reputational risks. This proactive approach allows companies to proceed with M&A with greater confidence.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Jesse R. Morton is a managing director, and Joe Kody is a senior managing consultant, in the forensic accounting and compliance, investigations, and disputes group at Berkeley Research Group.

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