Pop-up companies aggressively pushing a small business tax credit may soon be in hot water with the IRS.

Last month, the agency stopped processing tax returns with the employee retention credit (ERC) until at least the end of the year due to growing concerns that these companies were persuading small business owners to fraudulently claim the credit. Now, the Internal Revenue Service is reviewing previously filed ERC returns, including auditing and investigating suspicious claims from these so-called “ERC mills.”

The moves strongly suggest the agency is building criminal cases against these fraudulent firms altogether rather than just targeting specific tax returns, two IRS experts told Yahoo Finance. Any small business owners who fell prey to these promotions should be ready to return any money they received from the credit and — if complicit — possibly face charges themselves.

“I suspect you’ll see some indictments in the next couple of months, and it will send a message to those bad actors to knock it off,” Mark Everson, a former IRS commissioner from 2003 until 2007 and vice chairman at alliantgroup, a national tax consulting services firm, said.

“I agree with that completely,” Michael Sardar, tax controversy attorney and partner at Kostelanetz LLP, said. “I am certain they are working on ERC criminal cases and I’m certain they will bring criminal cases.”

The ERC scam

The ERC is a legitimate tax credit established to help businesses with the cost of keeping staff employed during the pandemic, enacted by the Coronavirus Aid, Relief, and Economic Security Act, or CARES Act.

But it’s been a target for abuse because the credit qualification is complicated and lucrative. Small business owners often don’t have the resources to understand the IRS’s filing requirements or were not aware that the ERC was retroactively available in 2023. And the payments are attractive — qualified employers can claim up to $26,000 per worker on the payroll between March 12, 2020, and Dec. 31, 2021, a windfall for the ERC companies that get a cut.

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“I think that’s certainly a part of it,” Sardar said.

A year ago, the IRS had been warning about abuse related to ERC. In May, it specifically warned against pop-up ERC companies that were luring unqualified small businesses into claiming credits through aggressive promotions — even adding it to the agency’s annual Dirty Dozen scam list.

That came after the IRS criminal investigation division started 122 investigations involving over $1.2 billion of potentially fraudulent ERC claims.

These companies often advertise that they can determine ERC eligibility for a small business within minutes without a discussion with clients, according to the IRS. The companies file the ERC credit on behalf of a small business owner for a fee that is typically a percentage of the tax credit amounts.

“The problem is that while there are totally legitimate CPAs like us around the country who have helped taxpayers with [ERC claims],” Everson said, “there is a pop-up industry where people came in and they started saying, ‘hey! you qualify for this.'”

One of the IRS’s primary concerns was that ERC companies were improperly qualifying or over-qualifying small businesses.

The IRS website stated that to be eligible for credits, employers must have payroll employees between March 12, 2020, and Dec. 31, 2021, and experienced a significant decline in gross receipts during the pandemic.

But that’s not all.

Another essential requirement is that a business’s decreasing income is directly related to government mandates or orders, a distinction often overlooked. For instance, a small business that sells event tickets experiencing a revenue downtown after government mandates had been lifted would not qualify for the ERC, Sardar said.

“You can have all sorts of losses, but unless it’s tied to a government action that caused it, you don’t qualify for the ERC,” Sardar said, “[This is] where a lot of the mistakes happened, some of which were just innocent mistakes and some of which were fraudulent mistakes.”

Businesses with no W-2 employees, no significant decline in gross receipts, and no more substantiated nominal impact on the business were other common reasons that clients don’t qualify, according to alliantgroup, a tax advisory firm specializing in tax credits.

“We’ve processed thousands of [ERC returns] and helped taxpayers of different sizes get the money there,” Everson said. “We have also screened out thousands and told taxpayers they don’t qualify.”

One ERC-filing company said while it wants to help small business owners who otherwise don’t have the resources to apply for the credit, it understands the concerns the IRS has.

“While I can’t speak to the process of others in the space, the IRS is right to address those that have not taken a data-driven and compliant approach. I am disappointed that there are companies using the complexity of this tax incentive to prey on deserving small businesses,” Howard Makler, CEO of Innovation Refunds, told Yahoo Finance.

“As a compliant player in this space, we are mirroring the IRS moratorium.”

Makler also detailed how his company uses tax attorneys to analyze documents from small businesses when deciding eligibility. A tax lawyer or CPA signs off on all applications. The company also defends its work in case of IRS questioning. It also charges a 25% contingency fee, a practice the IRS has warned taxpayers about on its website, though the company stated that clients only pay when a refund is received.

In light of the IRS announcement, the company has stopped taking on new clients and is preparing for an anticipated flood of audits from the tax agency.

“We haven’t seen a large number of audits yet. Just too early,” Makler said. “They are coming. We all know they’re coming.”

While the IRS has directed its concerns toward the ERC mills, small business owners that relied on their services unfortunately will be caught up in the middle. For most, who innocently trusted these ERC mills, they will need to return any amounts for the credit they didn’t qualify for.

The IRS is creating a settlement program for repayment for any small business owners who got “an improper ERC payment.” The agency plans to release more details on that program soon.

“So [the IRS] is not doing anything to punish you,” Sardar said. “It is just saying you were never entitled to it, so you should give it back and that’s consistent with how the tax system always works.”

But if the small business owner agreed to the ERC fraud, the IRS could prosecute them as well.

“That’s a judgment that the IRS will make with the US Attorney in the jurisdiction they are looking at,” Everson said. “It would have to be a pretty blatant case of fraud to go after the taxpayers.”

Rebecca Chen is a reporter for Yahoo Finance and previously worked as an investment tax certified public accountant (CPA).

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