Thao Le, Jeremy Levy, and Tom Gray discuss the intricacies and implications of employee retention tax credits (ERCs) for private equity and M&A transactions.
In this episode of PE Pathways, Thao Le, Jeremy Levy, and Tom Gray discuss the intricacies and implications of employee retention tax credits (ERCs) for private equity and M&A transactions. While ERCs were created in response to COVID-19 to offer relief to employers in the early days of the pandemic, the conversation highlights the ongoing relevance of ERCs due to the statute of limitations for claiming and auditing these credits, which extends into 2025 and beyond. The speakers address the challenges posed by fraudulent claims and the IRS' scrutiny of ERCs, emphasizing the need for careful due diligence in transactions involving companies that have claimed these credits. They also discuss the strategies employed by buyers to mitigate risks during the deal-making process.
PE Pathways — The Demystification of Employee Retention Credits for Private Equity Deals
Speakers: Thao Le, Thomas Gray, Jeremy Levy
Recorded: November 19, 2024
Date Aired: January 28, 2025
Thao Le:
Welcome to PE Pathways, our podcast series where experienced dealmakers share their thoughts on current private equity and M&A trends and developments. Today, we are going to discuss Employee Retention Tax Credits. I'm your host, Thao Le. I am a partner in the private equity group at my firm, and I'm joined by two of my fellow colleagues in the private equity group, Jeremy Levy and Thomas Gray. Thomas is also a member of our firm's tax practice, and he's here to demystify everything about ERCs. Thomas and Jeremy, it's great to see you guys. Anything you want to say for the crowd?
Thomas Gray:
Hi, Thao. Thanks for having us here. This is Tom Gray. I'm a tax partner in our New York office.
Jeremy Levy:
Hi, Thao. Thanks for having us as well. This is Jeremy Levy. I'm a corporate M&A partner in our Berwyn office. What could be more fun than talking about employee retention tax credits? Excited to be here.
Thao Le:
Also known as the letters ERTC, which is very popular among deal lawyers, and it's thrown around so often. Thomas, you being the tax guru that we have here, can you tell us what ERC or Employee Retention Tax Credits really are when they were created?
Thomas Gray:
Sure. The ERC stands for Employee Retention Credit. It's a credit with respect to an employer's portion of the Social Security tax and Medicare tax the employer pays with respect to wages. The ERC was first created back in March of 2020 under the Coronavirus Aid, Relief, and Economic Security Act. Back in those dark days when the economy was shutting down, folks were not able to get to their jobs. Governments were issuing orders, mandates to shut businesses down. It looked like there was a possibility of going into not only a recession but even a deeper, darker, potentially depression. Congress decided, along with a variety of other provisions, to supply employers with the means, the cash, to fund their employee payrolls.
Thao Le:
Thomas, just to expand on that, was this something that can only be claimed by employers? Or could I have claimed something like this as well?
Thomas Gray:
Sure. Generally, it's just employers that are engaged in a trader business or tax-agent organizations. Individuals, folks who are running their own consulting business or may have had an individual with certain employees, they couldn't claim it. It had to be employers with this trader business or tax agent organizations. In order to claim that ERC, there needed to be a specific government order shutdown, or they had to reduce their gross receipts by a large percentage. That was an objective standard. You would compare your gross income versus a previous period's gross income. If you reduce that gross income by enough, you could get this credit. You qualify for this credit.
Thao Le:
Now, we're in 2025. It's been five years since the beginning of the pandemic, thankfully. But why are we really talking about this now? I mean, it seems to be one of those topics that's been done and over with.
Thomas Gray:
The reason we're talking about it now so long after the passage is those claims are still potentially being processed because of the statute of limitations. For at least 2021, those persons who still want to claim an ERTC still have the capabilities of amending prior returns. The statute of limitations for the most part for 2020 have passed. With those statute of limitations, the IRS could not go back and say that there was any type of issues. They couldn't open an audit.
For 2021, those statute of limitations generally ends next year. It should be April of 2025 for the first two quarters of 2021 tax returns. These are payroll tax returns. They're not income tax returns. They're payroll tax returns. For the third quarter of 2021, the statute of limitations was extended to five years. You have the potential for the IRS to come back up to 2027 and open an audit with respect to ERCs.
Now, that's your typical statute of limitations. These limitations, they can come out under a different procedure where, let's just say, for the 2020 tax period, you didn't get the refund till this year. Let's say – so it's the beginning of 2025. From that period, the IRS has two years to make a claim that you received an erroneous refund. Even though the technical statute of limitations for that 2020 tax period have ended, because you didn't receive that refund, the IRS has two years from the date you receive the refund, which so it can extend it. There's a lot of refunds that have not been processed yet.
Thao Le:
Just to clarify something because we use the term statute of limitations quite often. There's this one statute of limitation where the IRS can come back and said you took an improper refund. But is there another statute of limitation as to when I as the employer could have claimed that refund from this legislation?
Thomas Gray:
Yes. Generally, you have three years from the due date of the tax return. For a payroll tax return, let's say it's June 30th of 2020, for that payroll tax period, the statute of limitations starts running April 15th of 2021. That's three years. If you went to tax period of June 30th, 2021, the same thing would happen. That tax period starts running. The statute of limitations is the next year, 2022, April 15th. You have three years from that day to amend your tax return. You have three years for the IRS to come in and start looking at it.
Thao Le:
This is why five years later from 2020, we're still talking about it.
Thomas Gray:
Exactly.
Thao Le:
That makes an interesting dilemma for a deal lawyer. Jeremy, I'm going to turn this to you and say what are you thinking about – in this situation, whether you're a buyer or a seller, and you're thinking about a target company, that, one, should they have amended their tax returns to get the credit. Or if they did amend the tax return and got a credit and now you're thinking, "Did they do it properly?" Where does that put us in the deal world?
Jeremy Levy:
Part of the reason why we care, those of you listening to the podcast have noticed we've spent a lot of time talking about statutes and limitations. The reason we're talking about that is because many, many of these claims were fraudulent, poorly supported, and either contested or subject to contest from the IRS. On the buy side of deals, we've been looking for years at target companies that previously claimed these credits. We found during the course of diligence, to the extent we can diligence these topics, we'll come back to that in a minute, that in many cases, the claims were not substantiated.
In fact, Thomas will remember the IRS as a particular hatred for ERCs, there were a number of shops that were springing up out of nowhere. Our companies were getting mailers suggesting that, "Did you know you might be entitled to receive this credit?" There were these shops that were providing documentation and helping companies file for these credits and taking as a fee a portion of the amount claimed. In many cases, there were these fraudulent actors who were filing for these claims on behalf of companies, even though the company didn't necessarily realize that they were eligible for or think that they were eligible for any of these claims.
Almost from the outset, the IRS identified these as problematic. Thomas will tell us a little bit about the sort of moratoriums that were put into place. Actually, why don't you do that now? Tell us a little bit more about the history of the problems that have given rise to all this conversation about statutes limitations.
Thomas Gray:
In the beginning, when this act was passed, there were no four specifically designed to claim this refund. Folks just filed stuff willy-nilly. There's a 941 employer quarterly return that is supposed to be filed. Some people amended those returns before the actual returns were put in place to be able to claim the credit. The IRS was shut down for a number of months in 2020, just like every other organization. Then they didn't even begin processing the claims until 2021 when their computer software was updated to handle it.
Then, as you noted, there was a lot of promoters out there just pushing these claims. We had clients who received claim refunds and claim they never supported anything and then got a bill from the promoter. We had a client that was looking at providing loans based on anticipated ERC claims and asked us to review the ERC claims that the proponent borrowers had made. We went through those, and probably 19 out of 20 were things we could not substantiate that they could survive an audit by the IRS.
There was a lot of questionable practices. Folks were claiming the credits because they put hand sanitizer. They were affected. You were supposed to either have that income reduction or a government shutdown. If your supplier was shut down and you just were inconvenienced, you're not able to claim that, unless you met the gross income test. A lot of folks, because they were inconvenienced, business was difficult. They made the claim.
Because of this, the promoters, the false claims, the IRS listed the promotion of these as one of their dirty dozen tax scams that was going on. By September of 2023, the IRS stopped processing any new claims. They have a moratorium on it. They were still processing older claims, but they stopped processing new claims because they were just so inundated. If they began to have a lot of pressure to get these payments out because a lot of employers were relying on them, they definitely needed them.
But because there were so many difficulties with processing the claims, a lot of things slipped through the cracks. The Treasury Inspector General of the Tax Administration looked into 1.9 million claims that were filed and found that was about 185,000 that should have been tagged for audits that were not tagged and went back to the IRS and said, "These are funds that have been paid out with respect to claims that we should have looked closer at." The IRS has that on their list of things to do.
Just think about those numbers. That's 185,000 audits that are potentially there. If you have a target company that has a big ERTC claim, you should expect that there's a good possibility it's going to be audited. That audit may not come for a number of years.
Jeremy Levy:
Against that backdrop, we go back to Thao's original question, which is what are we doing about this in deals? During the course of call it 2021 to 2023 or so, on the buy side, we're aware of this fraud. We're aware of the relative distaste for ERCs on the part of the IRS. As a buyer, our clients would ask, as a diligence matter, did you target company claiming ERC? If the answer is yes, the buyer would simply say, "We don't believe you're entitled to it. We just are going to assume that either you claimed it incorrectly, or at least the IRS is going to come audit you about it." That is just something that the buyer does not want to be involved in.
What we were doing during that period of time was establishing escrows for any claims that had already been processed where the target company had received the funds. Those funds would be taken out of the target company's bank account or what have you and placed into escrow. It would sit until the expiration of the statute of limitations that applied to the particular credit.
Thomas went into the credits for the 2020 tax year had statute of limitations that ran for a certain period of time. Then the Q1, Q2, Q3, and Q4 of 2021 had a different statute of limitations, which is part of the problem with the law in the first place. We were just putting in purchase agreements that any amounts that had been received in respect to VRCs would go into escrow, and it would sit there until the statute of limitations passed. That was nice and clean and easy.
Unfortunately, it's now 2025, and some of the statute of limitations have passed, and other statutes of limitations for other quarters are about to pass or close to passing. But we heard Thomas say earlier that depending on when the refund might be processed, the statute of limitations for making the claim may have passed, but the statute of limitations for refunding any amounts that were improperly received may not have passed.
Now, we are in a world where we have buyers who still don't want this to be their risk. But we have sellers saying, "How are you putting this ERC amount that I received in escrow when the statute of limitations has already passed?" That is the challenge that we're facing these days when we're trying to address these and purchase agreements.
Thao Le:
Jeremy, you mentioned something interesting because I think a lot of the commentary you were just making now was a very simple transaction where seller sells company 100% to the buyer. I can tell you that in secondary transactions, which it seems to be the buzzword, the flavor of the month in the private equity world right now, which at the end of the day is just a mini M&A transaction where you give partial liquidity to existing holders in a selling company.
This is a concern that is happening as well, that you are having savvy institutional buyers who are putting money in with a private equity firm to give partial liquidity to their LPs, and they're diligencing these portfolio companies that have obtained ERCs, and they're approaching it in a very similar way through a full M&A transaction. It's basically a very simple rule or keep it simple stupid. Follow the money, right? You seller or whoever got to get out with cash, you benefited from this ERC. If it is wrong for whatever reason, then the buyer should be able to, that is, go back and reclaim some of this cash.
The other distinction I also want to make is that we'd also been talking a lot about bad actors and the dirty dozen. I think buyers are also taking this approach, even if there is nothing nefarious where you could have a bona fide, legit payroll provider who is trying to be helpful to a portfolio company and saying, "Hey, here's these EZRCs. We're your payroll provider. We know what's going on, and we can file for you, and this is cash that will help your business."
I think in that scenario, even though it's not nefarious, I think a buyer's approach is like it's strict liability. If you got the credit, no matter how, you should stand behind it as a seller. Would you agree with that, Jeremy?
Jeremy Levy:
Absolutely. I think from a buyer's perspective, this is just a risk that buyers are not willing to take. They're not willing to take it regardless of whether or not the statute of limitations for the applicable quarter has passed. I don't see any buyers who are actually paying sellers for the value of ERCs that they have previously received, or for any ERCs that have not yet been processed and are expected to be received. That's point one. No one is paying value for this. No one's paying a multiple on that cash, and no one is paying for that cash.
As far as the risk is concerned, if credits are still to come, there's still an outstanding claim, but it has not been processed by the IRS. What we're most frequently seeing is some sort of a springing escrow, where if the money does come in at some point in the future, it will be diverted directly into an escrow. Once whatever applicable statute of limitations that then exists expires, then and only then will the buyer pay those amounts over to the seller so that the seller can get the value of those. That's basically the level of risk that buyers are willing to take on it.
With respect to ERC claim, the ERCs that have already been received, even if the statute of limitations has run, most buyers are asking for no longer a release time from escrow tied to statute of limitations because that has run already, but instead they're asking for just a fixed period of time. Call it two more years. Call it three more years. Part of the reason for that is that there is and there has been outstanding legislation that has intended or at least been intended to extend the statute of limitations. Right, Thomas?
Thao Le:
Yes. There have been proposals. One made through the House but stalled in the Senate that would have extended the statute of limitations by a couple of years. Who knows if it's going to pass in the future? You can expect that in 2025, there's going to be some tax legislation that will pass, at least to try and extend the 2017 tax act that's expiring, and maybe this will come up in that tax legislation.
Jeremy Levy:
If there's a moral to this story, ERCs generally are bad, and the IRS hates them. If they're involved in your deal and you are a buyer, you want to run far away from them and put as much protection as you can in the agreement. You can't rely on the then applicable statute of limitations, which Congress still may extend. Or there is already the extended two-year period once the refund comes in, even if the statute of limitations for the claim has passed. This is something that, I think, we're going to continue to be hearing about and dealing with for the next several years.
Thao Le:
Well, this was a very interesting topic and I think also a very timely topic, given where a number of our deals are with our private equity clients and our portfolio companies to the center for representing targets. I really appreciate the time, Jeremy and Thomas. It’s always great catching up with you guys to cover some hot topics like this. Thank you for listening to our podcast. Please keep an eye out for additional episodes of PE Pathways where we bring experienced deal makers together to share their thoughts on current private equity and M&A trends.
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