IRS Fight Against Pandemic Tax-Credit Scams Won’t Be Simple or Fast

WASHINGTON—The Internal Revenue Service has labeled promoters of a popular pandemic-era tax credit as unscrupulous scammers. The agency’s task ahead: Turning that tough talk into victories in court.

Tax lawyers say they expect several busy years defending tax-credit consulting firms and employers as the IRS tries to claw back some of the $230 billion it paid in employee-retention credits, or ERC refunds. The enforcement push, including criminal prosecutions, won’t be quick or easy for the IRS.

“One acquittal is worse for the government than 1,000 guilty verdicts, because the acquittal spreads the word,” said Frank Agostino, a tax lawyer at Agostino & Associates in Hackensack, N.J. “The government needs to create the perception of invincibility.”

The tax agency has some advantages, including a flush enforcement budget and thousands of new staffers it is hiring. Attorneys say the IRS should be able to impose stiff penalties on some ERC firms that urged employers to seek refunds, despite the firms’ attempts to avoid signing returns and push crucial eligibility decisions onto clients.

There are legal gray areas complicating the IRS’s efforts. The law allowed tax credits up to $26,000 per worker for employers whose operations were partially suspended by a government order. Those terms aren’t well-defined, and judges may ultimately agree with the ERC firms’ expansive views of eligibility or at least spare them from the most severe penalties.

“If you just start looking at the statute, I think a lot of it is open to various interpretations, and I would expect that taxpayers are going to win some cases,” said Tom Cullinan, a former senior IRS official now at law firm Chamberlain Hrdlicka in Atlanta.

Congress created the ERC to help employers keep workers attached to jobs during the pandemic’s disruptions. It expired Sept. 30, 2021—then boomed as a cottage industry emerged to encourage small businesses and nonprofits to amend payroll-tax returns and claim the money. ERC firms, including Bottom Line Concepts and Innovation Refunds, often charged as much as 25% of refunds and flooded employers with advertising, calls and texts.

While paying billions of dollars, the IRS issued increasingly loud warnings, urging taxpayers to avoid ERC firms taking large upfront fees or a portion of refunds. ERC firms say that they follow IRS guidance and that any fraud is committed by other ERC firms.

The government disrupted the industry in September with a moratorium on refunds for new claims. It plans to let employers withdraw or repay already-filed claims.

In a letter Tuesday, top Republicans on the House Ways and Means Committee asked the IRS to provide more detail about how it will prevent fraud and speed refunds when processing resumes. The IRS has floated the idea of legislation accelerating the April 2025 deadline for amended returns but hasn’t engaged with Congress on that, wrote Reps. Jason Smith (R., Mo.) and David Schweikert (R., Ariz.).

Meanwhile, the abrupt restriction on the flow of ERC refunds shifted the program into the enforcement phase. The IRS has started thousands of audits and hundreds of criminal inquiries.

The IRS criminal investigation division “continues to focus its investigative efforts on promoters and professional enablers of Employee Retention Credit fraud schemes,” said spokeswoman Carissa Cutrell. “The IRS continues to educate U.S. taxpayers about how to recognize and report ERC fraud.”

Still, the IRS can’t audit and prosecute its way out of the problem. That would just consume too much staff time and court resources and drag on for many years.

Here’s a comparison: Starting in 2016, the IRS focused sustained enforcement on thousands of land-donation deals known as syndicated conservation easements. It had enough resources to audit 100% of the deals and take dozens of cases to trial. The first major case seeking an injunction against promoters concluded this year. The first significant criminal trial ended with two convictions and one acquittal in September.

The ERC landscape is comparatively vast. Employers have filed 3.6 million ERC claims, and it is impractical for the IRS to audit them all and sift out illegitimate ones. Letting taxpayers withdraw or repay ERC refunds should shrink that pile. Some taxpayers will still be tempted to play the audit lottery, hanging onto refunds and hoping they go unnoticed.

In that narrower pool, the IRS will have to be careful about the cases it pursues, and the first high-profile prosecutions will be closely watched. Tax controversy lawyers say they expect the IRS to concentrate on promoters who enabled widespread cheating and relied on cookie-cutter arguments rather than more sympathetic small-business owners who might have already spent their refunds.

That dynamic may push IRS criminal investigators toward cases of obvious fraud, where ERC firms and employers forged documents or falsified business records.

Agostino said he expects the IRS to use artificial intelligence to analyze information from settlements and audits so it can decide which promoters to target. “The voluntary disclosure gives you information from investigation at low cost,” Agostino said.

That works the other way, too.

“If they know they’ve got a bad promoter, they’re going to get all of the clients of the bad promoter,” said Bryan Skarlatos, a criminal-tax attorney at law firm Kostelanetz in New York. “You have a pretty good map, and then it is a matter of picking who you go after.”

The IRS could have more difficulty in challenging better-funded ERC firms that relied on legal opinions. They might be less-suited to prosecution and more likely to land in civil courts.

The tax code’s civil penalty system may not fit perfectly with ERC promoters’ operations. ERC firms often attempted to push key responsibilities onto clients. Many ERC firms perform the calculations of the credit amount, but use contracts saying they aren’t providing tax or legal advice. They generally don’t prepare or sign the returns.

“Innovation Refunds follows IRS guidance and the likelihood of misinterpretations of the tax code lies with the taxpayer or tax preparer,” the company said.

The IRS will attempt to pierce firms’ protections, drawing on definitions of promoters and preparers that aren’t necessarily tied to who signs a return.

“The Service has a lot of tools,” said Cullinan, the former IRS official. “Whether they’re all going to work given some of the structures out there, we’re going to be setting some precedent.”

The IRS lacks the power to regulate all tax preparers, and the Biden administration wants more authority. The IRS has previously used broad definitions to go after “ghost preparers.”

“This idea, first of all, that they’re not giving advice and they’re not preparing returns, is not really accurate,” said attorney Skarlatos. “You’re getting paid for something. So the IRS would ask, ‘What are you getting paid for?’”

Some of the tax code’s stiffest penalties can be levied on promoters who cause others to make false or fraudulent statements about their eligibility for credits. That can amount to 50% of gross income, and preparers can face similar penalties for taking unreasonable positions.

“The Justice Department was quite effective in using promoter penalties back when we had other kinds of junk stuff being sold,” said Karen Hawkins, a former senior IRS official. “That’s pretty much been the pattern. It’s like locusts. Every 10 years these guys come back and try a new trick.”

—Ruth Simon contributed to this article.

Write to Richard Rubin at richard.rubin@wsj.com