ERTC Due Diligence: Key Issues and Considerations for Buyers and Lenders

By Ryan Murphy, Managing Director, Quality of Earnings. Specialist in acquisition due diligence for lower middle market transactions.

Introduction

As 2024 comes to a close, we reflect on trends seen in the due diligence arena over the past year. One of the common findings LCG’s Quality of Earnings team has seen when performing tax diligence has been inadequate documentation for the Employee Retention Tax Credit (ERTC). Payroll-related liabilities, such as those from fraudulent ERTC claims, pose significant risks for companies acquiring another business. Even with careful deal structuring, buyers may still face exposure to these liabilities, making it essential to implement safeguards during the acquisition process. Failing to address these risks could result in unexpected financial and legal consequences down the road.

For Buyers

In an asset sale, the buyer might still inherit ERTC liabilities under certain conditions:

• If the sale agreement explicitly includes such liabilities.
• If the IRS considers the liabilities tied to specific assets transferred during the transaction.
• If the transaction involves transferring key business operations or employee relationships tied to fraudulent ERTC claims.

In contrast, in a stock or share sale, the buyer acquires the entire business entity, including all its assets, liabilities, and obligations. This means ERTC liabilities—whether related to fraudulent claims, penalties, or interest—are automatically inherited along with other pre-existing business liabilities.

However, there are cases where ERTC liabilities may not pass to the buyer, particularly if the buyer can show that they were not involved in the fraudulent claim and the transaction is structured to exclude such liabilities. For instance:

• A buyer may negotiate an indemnification clause in the sale agreement, requiring the seller to assume responsibility for any future liabilities arising from fraudulent ERTC claims.

• Sellers may agree to place a portion of the purchase price in escrow or holdback to cover potential liabilities, including ERTC-related issues. This provides the buyer with a financial safeguard post-sale.

For Lenders

The SFC team organized and refined financial records and management reports as well If a borrower has inadequate documentation to support their ERTC claim, a senior or asset-based lender could face several issues, including:

• Regulatory or compliance risk: If the borrower is audited by the IRS and found to have improperly claimed the ERTC, penalties, interest, or disallowed credits could result in financial strain for the borrower. Lenders may face indirect scrutiny or reputational risk if the borrower’s financial difficulties become public or severe.
• Increased credit risk: Lack of documentation might indicate broader issues with the borrower’s financial controls or management practices, suggesting potential risk in other areas of the business. Such weaknesses could impact the borrower’s overall creditworthiness and ability to repay the loan.
• Legal or fraud concerns: Inadequate documentation could raise suspicions of intentional misrepresentation or fraud. If this is the case, the borrower might face legal consequences that impact their operations and financial stability. Lenders may also need to investigate whether other representations made by the borrower are accurate, adding legal and administrative costs.

Lenders can mitigate this risk by requiring third-party due diligence that will serve to acquire robust documentation from borrowers supporting ERTC claims, including payroll records, proof of eligibility, and detailed calculations.

Conclusion

With the anticipated formation of the Department of Government Efficiency, cases of COVID-19-related fraud may be scrutinized more closely. This new department’s mission to cut waste and recover fraudulent benefits could place the ERTC under renewed examination. Buyers should remain vigilant and incorporate detailed due diligence processes into their acquisition strategies to mitigate the risk of inheriting these liabilities.

LCG Advisors is a leading financial consulting and transaction advisory firm specializing in mergers & acquisitions and other select advisory services. We offer a wide breadth of services, providing clients with one comprehensive source for high-level advisory expertise. 

If you have questions or concerns about ERTC in your transaction, or to schedule a Quality of Earnings analysis, contact Ryan Murphy Managing Director, at [email protected].