Employee retention credits: Complexities in equity acquisitions
SEPTEMBER 13, 2023
In the post-COVID world, a purchaser contemplating an equity acquisition of a company should be aware of certain Employee Retention Credit (ERC) issues, especially if the acquired company has a large number of employees. ERC problems are on the rise because more and more business owners are applying for ERCs and receiving large tax refunds long after ERCs were made available.
This delay in timing is causing all sorts of problems, especially when an ownership change has occurred. For example, a conflict may arise between the purchaser and seller of a company as to who is entitled to the tax refund generated by the ERCs. Because ERCs are usually tied to the company’s 2020 and 2021 tax quarters, but the credits may be claimed after the close of the acquisition, both the purchaser and seller of the company may have legitimate claims to the credits.
In addition to worrying about the tax benefits of ERC, purchasers of a company need to think ahead and consider potential IRS audits relating to ERCs. Since ERCs are entity-level credits, it is the acquired company and not its former owners, who would be responsible for responding to an IRS audit and paying any resulting tax liabilities.
A purchaser needs to be aware of these issues because many of them may be resolved prior to the acquisition through due diligence or addressed in the equity purchase agreement.
What are ERCs?
ERCs are refundable tax credits for businesses that had employees and either had to suspend its business or had a significant decline in the business’ gross receipts due to the COVID-19 pandemic. The credits are generally available to eligible businesses that paid qualified wages to some or all employees in Q2 of 2020 through Q3 of 2021. The credits reduce the employer’s share of employment taxes for those quarters. An eligible business can claim up to $26,000 of credits per employee, so ERCs can result in a sizable tax refund to the business.
To claim the credit, eligible businesses must amend its Form 941 by filing Form 941-X for each quarter to reflect the application of ERCs. The deadline for claiming the ERCs is December 31, 2024, for 2020, and December 31, 2025, for 2021.
Acquisition due diligence
A purchaser of a company should include ERCs as part of its tax due diligence process. During due diligence, the purchaser should determine whether the acquired company has already filed for ERCs and received a tax refund. If a tax refund has not been received, a purchaser should understand where the company is in that process. Where a tax refund has already been received, the purchaser should carefully review the documents filed and analysis performed for claiming ERCs.
Since this is such a hot-button tax topic and an area rife with promoter scams, a purchaser should be extra diligent in confirming that the acquired company satisfied the requirements to claim ERCs. The IRS has up to five years to audit the acquired company, so it will be the purchaser’s (and acquired company’s) responsibility to respond to that IRS audit and pay the resulting tax liability, if any.
Equity purchase agreements
If the seller of the company has not filed and received an ERC refund, the equity purchase agreement should include provisions that address ERC. Specifically, these provisions should clearly state whether the purchaser or seller is entitled to claim ERCs.
If it is agreed that the seller is entitled to claim ERCs, then the purchaser should at minimum reserve the right to review the documents and ERC analysis before any Form 941-Xs are filed. The purchaser may want to go as far as to reserve a veto right to prevent the seller from filing any Form 941-Xs if the purchaser does not agree with the ERC analysis.
In addition, if the acquired company is a pass-through entity such as a limited liability company taxed as a partnership or an S corporation, the purchaser may want to require the seller to amend his/her personal tax return to include any additional income resulting from the ERC. Since the seller would financially benefit from the ERC, it may be prudent to include provisions in the equity purchase agreement that shift the financial responsibility of the costs of the ERC review and the IRS audit to the seller if they happen.
Post-acquisition issues
If due diligence is not performed properly, or if the equity purchase agreement fails to address ERCs, many ERC issues may arise after the close of the acquisition. For example, the seller could prepare and file an ERC claim with the IRS without the consent or knowledge of the purchaser or the acquired company. Although, the purchaser (or acquired company) likely will discover the ERC filing when the tax refund checks are received by the acquired company. The obvious issue in this example is whether the purchaser or the seller is entitled to the tax refund. Assuming it is agreed that the seller is entitled to the tax refund, the next issue is whether the acquired company met the requirements for claiming ERCs and therefore, was entitled to the tax refund. The purchaser in this case would be concerned about protecting the acquired company from an IRS audit and avoiding any subsequent tax liability. To address these concerns, the purchaser could require the seller to enter into an indemnification agreement and escrow money for any future ERC related tax liability.
The newness of the ERC and the lack of legal guidance around it has created a plethora of potential issues for the acquisition of companies that benefited from the COVID-era tax benefit. Purchasers need to be alert and aware of these ERC issues so that they can be addressed before closing, to avoid post-closing surprises.
If you have any questions about the potential acquisition or sale of a company that benefited or plan to benefit from the ERC, please contact me to discuss the possible ramifications.
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Thank you – PAULINE W. MARKEY and Saxton & Stump for allowing us to share this article.
