ERC Under Fire: What to Do If the IRS Is Auditing Your Employee Retention Credit Claim

The Employee Retention Credit (ERC) was one of the most generous COVID-era tax benefits available to businesses — potentially worth up to $26,000 per employee for qualifying employers. But it was also one of the most aggressively promoted and widely abused credits in IRS history. Now the reckoning is here.

The IRS has sent over 28,000 disallowance letters, demanded repayment of more than $1 billion through 30,000 recapture letters, and launched over 400 criminal investigations related to ERC claims. The One Big Beautiful Bill Act (OBBBA) extended the IRS’s audit window for ERC claims to six years, added new promoter penalties, and blocked refunds for certain late-filed claims.

If your business claimed the ERC and you’ve received — or expect to receive — an IRS examination notice, The Law Office of Pietro Canestrelli can help. We defend businesses across Temecula, San Diego, Riverside, San Bernardino, and throughout California in ERC audit proceedings. Here’s what you need to know.

The Enforcement Landscape in 2026

The IRS has made ERC enforcement one of its top priorities. Key developments include:

• 28,000+ disallowance letters: The IRS denied approximately $5 billion in ERC claims it determined were ineligible
• 30,000+ recapture letters: Businesses that already received ERC refunds are being ordered to pay them back — with interest
• 400+ criminal cases: Promoters and some business owners face criminal fraud charges for fabricating eligibility
• 6-year audit window: The OBBBA extended the statute of limitations for ERC claims from 3 years to 6 years, giving the IRS until at least 2027-2030 to audit most claims
• Promoter penalties: The OBBBA added new penalties targeting the firms that aggressively marketed ERC claims to businesses that didn’t qualify

A February 2026 Government Accountability Office (GAO) report found that approximately 83% of $235 billion in ERC refunds were paid well after the pandemic period — raising concerns about the volume of potentially improper claims. The IRS continues to process remaining claims while simultaneously auditing already-paid refunds.

Common Reasons ERC Claims Get Denied or Audited

Government Order Test Failures

Many businesses claimed ERC based on the “government orders” test — arguing that a federal, state, or local government order fully or partially suspended their operations. The IRS has narrowly interpreted this test, requiring that the order specifically impacted the employer’s operations (not just the industry generally) and that the suspension was more than de minimis (more than 10% of operations, measured by revenue or service hours).

Common denial reasons:

• The business was classified as “essential” and remained open during government orders
• The business voluntarily reduced operations rather than being ordered to do so
• The government order didn’t actually restrict the employer’s specific operations
• The employer couldn’t identify a specific government order that applied to them

Gross Receipts Test Miscalculations

The alternative eligibility path — a significant decline in gross receipts (50%+ for 2020 quarters, 20%+ for 2021 quarters compared to the same quarter in 2019) — requires careful revenue comparison. Errors include comparing wrong quarters, using inconsistent accounting methods, or failing to account for PPP loan proceeds in gross receipts.

Large Employer Wage Issues

For “large” employers (over 500 employees in 2020, over 500 in 2021), only wages paid to employees not providing services are eligible. Many large employers incorrectly claimed credits for active employees.

PPP Double-Dipping

The same wages cannot be used for both PPP loan forgiveness and the ERC. Many claims failed to properly exclude PPP-covered wages from the ERC calculation.

What to Do If You Receive an IRS ERC Notice

Disallowance Letter (Claim Not Yet Paid)

If the IRS sends a letter disallowing your ERC claim before the refund has been issued, you have the right to:

• Respond with additional documentation supporting your eligibility
• Request a conference with the IRS examiner
• File a formal protest and request an Appeals hearing
• If Appeals is unsuccessful, file suit in the Court of Federal Claims or District Court

Recapture Letter (Refund Already Received)

If you already received an ERC refund and the IRS determines the claim was improper, you’ll receive a recapture letter demanding repayment — plus interest from the date the refund was issued. Your options include:

• Paying the full amount if the IRS is correct
• Challenging the recapture through administrative channels
• Negotiating an installment agreement if you can’t pay in full
• Filing an Offer in Compromise if the business can’t afford repayment

Criminal Investigation Contact

If you’re contacted by IRS Criminal Investigation (IRS-CI) — not just the examination division — stop talking immediately and contact a tax attorney. Criminal investigations involve potential fraud charges with penalties of up to $250,000 and 5 years imprisonment per violation. Attorney-client privilege protects your communications — communications with CPAs and enrolled agents do not have the same protection in criminal matters.

The Voluntary Disclosure Program

For businesses that received ERC refunds they now realize they weren’t eligible for, the IRS offered a Voluntary Disclosure Program (VDP) that allowed repayment of 85% of the refund (keeping 15%) without penalties. While the initial VDP windows have closed, the IRS has indicated openness to voluntary corrections on a case-by-case basis.

If your business received an ERC refund and you have concerns about eligibility — especially if a third-party promoter handled your claim — proactive correction is almost always better than waiting for an audit. The cost of voluntary compliance is consistently lower than the cost of enforcement.

What Documentation to Gather Now

Whether or not you’ve received an audit notice, every business that claimed the ERC should have the following documentation readily available:

• Copies of specific government orders that affected your operations, with dates and geographic scope
• Documentation showing how the orders partially or fully suspended your business operations
• Quarterly gross receipts calculations with supporting financial records (tax returns, P&L statements, bank records)
• Payroll records showing which employees were paid and which were not providing services
• PPP loan documents and forgiveness applications showing which wages were allocated to PPP
• The original ERC claim (Form 941-X) and any supporting worksheets
• Communications with any third-party promoter who assisted with the claim

Promoter Liability Under the OBBBA

If a third-party firm prepared your ERC claim and it turns out to be improper, the OBBBA’s new promoter penalties create an avenue for accountability — but the business is still liable for the repayment. The IRS holds the taxpayer responsible regardless of reliance on a promoter.

However, if you can demonstrate that you relied in good faith on a qualified tax professional’s advice and provided all relevant information, this may support a penalty abatement argument (though it won’t eliminate the underlying tax liability). Read our article on the OBBBA’s business updates for more on the new promoter provisions.

Get Experienced ERC Audit Defense

At The Law Office of Pietro Canestrelli, we provide comprehensive ERC audit defense for businesses across Temecula, San Diego, Riverside, San Bernardino, and throughout California. Our team analyzes your claim’s eligibility, prepares supporting documentation, handles all IRS communications, and fights for the best possible outcome — whether that means defending a legitimate claim or negotiating favorable terms for a claim that falls short.

Facing an ERC audit or received a recapture letter? Contact our office immediately. Time-sensitive deadlines apply, and early engagement produces better outcomes.