PEO clients may not see their ERC refunds

Part 1

The IRS recently released guidance invalidating more than 2,700 returns claiming ERC filed by PEOs. These returns claimed the ERC on behalf of their clients but failed to attach the required Schedule R detailing the allocation by client. This comes on the heels of a court case in which a PEO is being accused of using its client's ERC refund to pay its own outstanding tax liability (more on this in a future issue). While the statute of limitations has expired to claim the ERC, the guidance released by the IRS and ongoing litigation continues to create uncertainty for taxpayers that thought they had refunds coming.

Photo by Anna Tarazevich

IRS's Technical Advice Memo

The IRS placed a moratorium on processing Employee Retention Credit refund claims. During this pause, the IRS scanned the 941s, 941-Xs, 943s, and 943-Xs to make them more reviewable. That review determined that approximately 2,700 amended claims submitted by Third-Party Payers had failed to attach a Schedule R with the claim. The Technical Advice Memo (TAM) reviewed the validity of such returns, and found them to be invalid as a formal or informal return or claim for refund.

Let's back up and look at the context of the problem. Third-party payers (TPP), such as Professional Employer Organizations (PEOs), will file an aggregate 941 for all of its clients under its own EIN, and pay the necessary FICA withholdings with the aggregate return. The Schedule R is an allocation schedule that lists the name, identification number, and the allocation of wages, taxes, and payment of the total. Certified PEOs and Section 3504 agents are required to file this schedule, but non-certified PEOs and other TPPs normally do not have - unless they are claiming certain credits like the ERC. This creates a problem for the IRS, since it has no way of knowing who is actually claiming the credit and for how much.

Invalidation of Returns

The IRS looked at original 941s that claimed the ERC but failed to attach a Schedule R, and amended 941-Xs that did the same. For both of these, the IRS determined that the return was invalid, as either a formal return or informal refund claim. A formal return is much what you might expect. It is a complete and proper return as defined by the IRS. In the case of filing for the ERC, the 941 instructions require the additional schedule R, and failure to attach it invalidates the return, at least as a formal return.

An informal return is any timely filed refund request that provides all the essential informational requirements for a refund claim to focus the IRS on the merits of the claim, but still fails to meet the requirements of a formal return. The informal return must put the IRS on notice that a refund is sought on behalf of the filing party (note, this is the language used by the IRS) with the amount requested. Here the IRS claims that without the additional schedule, it cannot determine the merit of the claim.

The Service's argument starts to fall short here. The informal return - here the 941-X that failed to include the Schedule R - provides the IRS with information that the filing party, the PEO, is requesting a refund, for the ERC, in a specific amount. The informal return does not require the filing party to provide information about the ultimate taxpayer, and the IRS has the ability to request more information from the filing party through its normal procedures.

Consequences

This is important, because an informal return can be perfected after the statute of limitations runs. But by saying that it is neither a vailed formal or informal return, unless the PEO refiled before the statute of limitations, then it will be barred from correcting this mistake.

But, this approach is inline with how the IRS is treating many ERC claims, denying first, and validating afterwards, if at all. But the timing of this advice makes it problematic, since now there is no administrative remedy for the PEOs, and more importantly their clients, the taxpayers.

However, the TAM is not precedential. It is meant to be internal guidance for the IRS service team. While the IRS's argument for the formal returns being invalidated is strong, the informal invalidation seems ripe to be challenged. But until it is, expect many PEO clients to receive bad news in the coming days.

Wrap-up

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The content of this article is for informational purposes only and should not be taken as tax, legal, benefits, financial, or HR advice. I am a lawyer, but receiving this newsletter does not mean I am your lawyer. Since rules and regulations change over time and can vary by location, consult a lawyer or HR expert for specific guidance.