Introduction to Employee Retention Credit Audits
Did you make use of or claim for the Employee Retention Credit (ERC) previously? The IRS is cracking down on audits due to widespread misuse and billions in questionable claims.
Originally created as a COVID-19 relief program to help employers keep staff on payroll in 2020 and 2021, the ERC offered a refundable tax credit to qualifying businesses. This means that if the credit exceeded your payroll tax liability, the excess was paid out to your business as a cash refund.
Although you can no longer submit new claims, a surge of improper filings has led the IRS to aggressively audit past returns. If your business claimed the credit, you need to understand what triggers ERC audits and how to prepare for them.
In this article, we break down the IRS’s current audit priorities, the documentation they expect if you are audited, and how you can stay prepared.
Eligibility Criteria for Employee Retention
To avoid issues during an ERC audit, you need to understand the eligibility rules, which differ between 2020 and 2021. Accurate calculations are essential.
Meeting the Gross Receipts Test
Your business needed to show a decline in gross receipts compared to pre-pandemic levels:
- 2020: A reduction of 50% or more in a calendar quarter compared to the same quarter in 2019.
- 2021: A reduced threshold of 20% compared to the same 2019 quarter.
The IRS requires each quarter in 2020 and 2021 to be compared directly with its corresponding 2019 quarter. Using annual totals, mismatching periods, or applying the test incorrectly are common audit triggers and can result in penalties.
Full or Partial Business Suspension by Government Order
Businesses could also qualify for the ERC if a government order related to COVID-19 caused a full or partial suspension of operations.
To meet this test, your business needed to demonstrate:
- A specific government order that limited commerce, travel, or group gatherings.
- A direct operational impact from that order – such as capacity limits, supply-chain interruptions, restricted services, or workspace closures.
If you claimed for this, you need strong motivating documentation. The IRS continues to challenge claims based on broad statements like “COVID impacted our business” when they are not tied to an actual mandate.
A restriction is considered significant only if it caused more than a nominal impact – generally at least a 10% reduction in capacity, output, or revenue, and you must be able to prove that the government order materially restricted your operations.
This includes justifying:
- The exact government order relied upon
- The dates the order was in effect
- How it limited operations (e.g., capacity caps, distancing rules, supply chain stoppages)
- How those limits reduced your ability to operate normally
ERC Eligibility for Essential Businesses
Even if your operations weren’t fully suspended and you continued operating, you could still qualify for the ERC if a government order restricted how your business functioned.
You may have qualified under the suspension rules if you experienced:
- Capacity limits, distancing requirements, or workflow changes imposed by a government order
- Supply chain delays caused by a supplier subject to a qualifying order
- Reduced operating hours or limited access to key workspaces
- Service restrictions that materially affected output or revenue
Eligibility depends on whether your operations were meaningfully restricted significantly. Many essential businesses continued operating but still faced constraints significant enough to qualify, when properly documented.
Recovery Startup Businesses
A recovery startup business is a company that began operations after February 15, 2020, and had average annual gross receipts of $1 million or less. Because these businesses were new and didn’t have a 2019 revenue history to compare against, the IRS created a separate path for eligibility.
While most employers could only qualify for the ERC in 2020 and the first three quarters of 2021 by showing a revenue decline or a government-ordered suspension, recovery startups were treated differently:
- They could qualify automatically for Q3 and Q4 of 2021,
- Without meeting the gross receipts test or the suspension test,
- With a credit cap of $50,000 per quarter to keep claims proportional, compared to higher per-employee limits available to other eligible businesses in 2020 and 2021 (covered later in this article).
This carve-out was designed to help businesses that launched during the pandemic and therefore couldn’t demonstrate a pre-COVID decline in revenue.
Interaction with Other Relief Programs
The IRS also looks at how your ERC claim interacts with other relief programs, with wage overlap being one of the quickest ways to trigger an audit.
Coordinating ERC With Federal Relief Programs
If your business used the Paycheck Protection Program (PPP) or other COVID-19 relief programs, you must show exactly how wages were allocated.
For PPP, the rule is clear: you cannot use the same wages for both PPP forgiveness and the ERC.
Auditors often request:
- Worksheets showing which payroll costs were applied to PPP forgiveness
- Wage allocations used for ERC calculations
- Documentation proving wages weren’t counted twice
If your business participated in multiple relief programs, you must demonstrate how payroll costs were separated and how each program influenced your ERC claim. Clear allocation is critical as any ambiguity increases the likelihood of audit adjustments.
Qualified Wages and Essential Business Considerations
Did your business include the right wages in its ERC calculation? Many audit adjustments stem from misclassified wages, so understanding how wage rules differ by employer size is critical. Qualified wages depend on whether your business was considered a small or large eligible employer during the claim period.
Small employers are those with:
- 100 or fewer full-time employees in 2020
- 500 or fewer full-time employees in 2021
These employers can count wages paid to all employees during eligible quarters, whether they were working or not.
Large employers are those with:
- More than 100 full-time employees in 2020
- More than 500 full-time employees in 2021
These employers can only count wages paid to employees who were not working during eligible periods, such as paid time off during shutdowns or operational slowdowns.
Before calculating, keep in mind that ERC wage caps apply to both small and large employers. The rules determine which wages you can count, not how much you can claim in total. Only wages paid during eligible quarters qualify, and wages already used for PPP forgiveness or other relief programs cannot be counted again.
ERC wage caps:
- 2020: Up to $10,000 in qualified wages per employee for the year (maximum credit $5,000).
- 2021: Up to $10,000 in qualified wages per employee per quarter (maximum credit up to $21,000).
- Recovery startup businesses (Q3–Q4 2021): Limited to $50,000 total per quarter.
Documentation and Common Wage Calculation Errors
Because wage calculations are a major audit focus, solid documentation is essential for supporting your numbers and avoiding common mistakes, including:
- Counting wages for related individuals who do not qualify
- Misclassifying full-time employees
- Failing to include or incorrectly allocating employer health plan expenses
- Using estimates instead of actual payroll figures
To support your claim, you should maintain:
- Payroll registers and detailed wage reports
- Records of employer-paid health plan expenses
- Work schedules or service logs showing whether employees were providing services
- Internal worksheets showing how qualified wages were calculated
- Documentation separating PPP wages from ERC wages
- Any adjustments made to prevent double counting across relief programs
Understanding the Statute of Limitations and Required ERC Documentation
The statute of limitations determines how long the IRS has to audit your ERC claim – and for some ERC periods, that window is much longer than usual. Because ERC reviews can occur several years after the credit was claimed, strong documentation is essential.
How Long the IRS Can Audit Your ERC Claim
ERC audits generally follow standard IRS timelines, but certain years carry extended review periods:
- Three-year statute: Most ERC claims can be audited for up to three years from the date the original return was filed.
- Five-year statute for 2021 claims: Congress extended the audit window for 2021 ERC filings to five years, giving the IRS additional time to examine eligibility, gross receipts tests, and wage calculations.
Documents To Must Keep for ERC Audit Protection
Because the IRS can review ERC claims years after they were filed, maintaining complete documentation is essential. You should retain ERC-related records for at least five years, including:
- Quarterly gross receipts calculations
- Eligibility analyses for the gross receipts or suspension tests
- Copies of government orders used to support suspension claims
- Payroll records and detailed wage calculation worksheets
- Work schedules or service logs for large employers
- Documentation separating PPP wages from ERC wages
- Internal notes, memos, and timelines supporting eligibility decisions
- Communications or engagement letters from ERC advisors
This documentation forms the backbone of your defense in an IRS review—and ensures you’re prepared for the audit risks businesses are now facing.
Full or Partial Suspension and Audit Risks
Because the suspension test is one of the most commonly misunderstood eligibility routes, it also carries some of the highest audit scrutiny. Even if your business had a valid government order, the IRS now looks closely at whether the disruption was substantial and whether your documentation clearly demonstrates that impact.
Auditors commonly challenge claims when:
- The “government order” cited is actually guidance, recommendations, or general COVID precautions
- The operational impact was minor or never quantified
- The claim does not explain how the restriction limited operations
- Businesses fail to show measurable reductions in capacity, output, or revenue
- Documentation does not align with the dates or requirements of the cited order
To reduce audit risk, your records must show the specific order, the time period it applied, and how it limited operations in a measurable way, without relying on broad or generic COVID impact statements.
Avoiding Improper Claims and Penalties
Before looking at potential penalties, it’s important to understand why many ERC claims are being challenged today. Auditors are focusing heavily on filings that rely on vague eligibility explanations, mass-produced templates from third-party ERC companies, or incomplete documentation—especially when the narrative doesn’t clearly tie back to a qualifying government order or accurate wage calculations.
With audits increasing, now’s the time to make sure your ERC claim is solid. Improper or unsupported filings can lead to:
- Having to repay the full credit
- Accuracy penalties and interest
- Civil penalties for negligence or substantial understatement
- Criminal consequences in cases of fraud
To protect your business:
- Re-validate eligibility using updated IRS guidance, not outdated marketing materials or assumptions.
- Ensure documentation is complete, especially around government orders, wage calculations, and PPP allocations.
- Review any ERC claim prepared by a third party, particularly if the eligibility explanation feels generic or overly broad.
- Work with a qualified CPA who understands the current IRS enforcement environment.
- Consider the IRS ERC Voluntary Disclosure Program if you believe your claim may not be fully supportable; it allows businesses to correct past filings proactively and often reduce penalties.
Did you claim the ERC? If you’re unsure whether your justifications are in order in the event of an audit, our CPAs can help. We validate eligibility, strengthen documentation, and resolve past claims with confidence. Contact us for a free Discovery Call today.
Frequently Asked Questions About ERC Audits
Will the IRS audit the ERC credit?
Yes. The IRS is aggressively auditing ERC claims due to widespread misuse and billions in questionable filings. While claiming the ERC doesn’t automatically trigger an audit, any claim that lacks strong documentation or relies on vague eligibility explanations faces a higher chance of review.
What is most likely to trigger an IRS audit in 2025?
Key triggers include:
- Claims based on generic or unclear government orders
- Large refund amounts that don’t match payroll size
- Quarter comparisons calculated incorrectly
- PPP wages double-counted for both ERC and forgiveness
- Claims prepared by promoters using copy-and-paste eligibility narratives
- Missing or weak documentation for the suspension test or gross receipts test
- Any factor suggesting the claim wasn’t evaluated carefully may lead to closer scrutiny.
What does the IRS look at when you get audited?
Auditors focus on whether your business truly met eligibility criteria and whether you can prove it with documentation. They typically review:
- Gross receipts calculations for each quarter
- Government orders you relied on
- How those orders materially restricted operations
- Wage records, health plan expenses, and staffing levels
- PPP forgiveness worksheets and wage allocations
- Internal memos or analyses explaining eligibility decisions
- The IRS wants to verify that every part of your claim ties back to actual rules, not assumptions.
What throws red flags to the IRS?
Some patterns push a claim to the top of the audit list:
- Claims submitted through promoter firms promising “guaranteed refunds”
- Identical eligibility statements used across multiple businesses
- Suspension claims tied to general COVID conditions, not a specific mandate
- Inflated wage numbers or mismatched employee counts
- Businesses unable to produce government orders or wage support
- Amended returns filed late with large ERC amounts
- Any sign that a claim was rushed, exaggerated, or unsupported signals risk.
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