IRS Clarifies Outstanding ERC Questions
The employee retention credit (ERC) has been an important tax credit for many employers in 2020 and 2021. Although a fairly complicated credit, the ERC can be very beneficial to many employers. Recent guidance has clarified several longstanding questions. Here, we provide a brief overview of the credit, as well as a summary of the new guidance. For those readers seeking more detailed information on the ERC, IRS FAQs and the referenced guidance will be helpful.
To encourage employers to keep employees on the payroll during the COVID-19 crisis, Congress created the ERC as part of the CARES Act, passed March 27, 2020. The ERC is a fully refundable payroll tax credit, meaning that, although it’s claimed against payroll taxes, the amount of the ERC may exceed the actual payroll taxes due.
When originally implemented, employers were not eligible for the ERC if they received a Paycheck Protection Program (PPP) loan. Because the PPP was generally more beneficial in 2020, most eligible businesses elected to participate in the PPP instead of the ERC. On December 27, 2020, Congress significantly modified the ERC in the Consolidated Appropriations Act, 2021 (CAA). The CAA retroactively changed the law to allow employers who received PPP loans to qualify for the ERC, as long as the payroll expenses paid with forgiven PPP proceeds did not duplicate qualified wages used to claim the ERC. The CAA also extended and significantly expanded the ERC for 2021, through June 30, 2021.
Because of the CAA, many employers who were previously ineligible for the ERC in 2020 are now eligible to claim it.
Note: Some employers may benefit from filing amended payroll tax returns to retroactively claim the ERC. They must, however, also amend 2020 income tax returns to reduce the corresponding wage deduction.
On March 11, 2021, the American Rescue Plan Act extended the ERC to apply from July 1, 2021, until December 31, 2021. Because the eligibility rules for 2021 are less stringent than those for 2020, many more employers may be eligible for a larger ERC in 2021. Although generous, the ERC is also complicated, which has, in some cases, prevented eligible employers from claiming it.
Note: The Infrastructure bill that passed the Senate on August 10, 2021, would end the ERC early, on September 30, 2021, for all but recovery startup businesses. The House is scheduled to vote on this bill by September 27, 2021
For 2020, the ERC is equal to 50 percent of qualified wages paid to employees, up to a limit of $10,000 of qualified wages per employee per year. In other words, the ERC is limited to $5,000 per employee for 2020. In 2020, employers could calculate the credit for qualified wages paid during periods during which the business was shut-down, fully or partially, by a government order.
Note: Qualified wages also includes healthcare benefits, although those benefits also count toward the $10,000 cap.
Alternatively, employers could calculate the credit for quarters during which they had a “significant decline in gross receipts,” as compared to 2019. An employer had a significant decline in gross receipts in 2020 during the first calendar quarter for which gross receipts for that quarter were less than 50 percent of gross receipts for the same calendar quarter in 2019. The eligibility period ended with the earlier of January 1, 2021, or the calendar quarter following the first calendar quarter in which gross receipts were greater than 80 percent of gross receipts for the same calendar quarter in 2019.
Employers with 100 or more employees could only include wages paid during periods when the employees were not working. Small employers could count wages paid for employees who continued to work.
For 2021, the credit is equal to 70 percent of qualified wages paid to employees, up to a limit of $10,000 of qualified wages per employee per quarter. In other words, the ERC is limited to $28,000 per employee for 2021 (but, as noted above, the Reconciliation bill seeks to change this by ending the ERC September 30, 2021). In 2021, employers may calculate the credit for qualified wages paid during periods during which the business was shut-down, fully or partially, by a government order.
Alternatively, employers may calculate the credit for quarters during which they had a “significant decline in gross receipts.” Becoming an “eligible employer” under the latter test is much easier in 2021. Employers may generally qualify for the ERC if their gross receipts for a calendar quarter in 2021 are less than 80 percent of the gross receipts (>20 percent decline) for the same calendar quarter in calendar year 2019.
Employers may also elect to use an alternative quarter to calculate gross receipts. Under this election, an employer may generally determine if the decline in gross receipts test is met for a calendar quarter in 2021 by comparing its gross receipts for the immediately preceding calendar quarter with that for the corresponding calendar quarter in 2019 (substituting 2020 for 2019 if the employer did not exist as of the beginning of that quarter in 2019). This means that for the first quarter of 2021, an employer may elect to use its gross receipts for the fourth calendar quarter of 2020 compared to those for the fourth calendar quarter of 2019 to determine if the gross receipts test is met.
In 2021, employers with more than 500 employees in 2019 (as opposed to > 100 employees) may claim the credit based upon wages of employees who were not providing service. Employers with 500 or fewer employees may claim the credit based upon wages of all employees, regardless of whether they worked or not. Large employers that are “severely financially distressed employers” may also claim the credit for the wages of workers who continued to provide services in quarters three and four of 2021.
On August 4. 2021, IRS issued Notice 2021-49, answering several important outstanding ERC questions.
Wages for Related Individuals
The August 4 guidance confirmed that the related party rules for ERC are unusual. In the end, the credit can be claimed for the wages of majority owners and spouses (in a corporation), but only if they do not have any living relatives.
Section 2301(e) of the CARES Act provides that rules “similar to the rules of I.R.C. § 51(i)(1)” apply in calculating the ERC. This provision prevents employers from counting wages paid to certain relatives as “qualified wages” for purposes of calculating the Work Opportunity Credit. As such, wages paid to related individuals may not be taken into account for determining qualified wages for the ERC. I.R.C. § 152(d)(2)(A)-(H) defines “related individual” as any employee who has of any of the following relationships to the employer, who is an individual:
- A child or a descendant of a child;
- A brother, sister, stepbrother, or stepsister;
- The father or mother, or an ancestor of either;
- A stepfather or stepmother;
- A niece or nephew;
- An aunt or uncle;
- A son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law.
In addition, if the eligible employer is a corporation, then a related individual is any person that bears a relationship described above with an individual owning, directly or indirectly, more than 50 percent in value of the outstanding stock of the corporation.
If the eligible employer is an entity other than a corporation, then a related individual is any person that bears a relationship described above with an individual owning, directly or indirectly, more than 50 percent of the capital and profits interests in the entity.
If the eligible employer is an estate or trust, then a related individual includes a grantor, beneficiary, or fiduciary of the estate or trust, or any person that bears a relationship described above with an individual who is a grantor, beneficiary, or fiduciary of the estate or trust.
For purposes of I.R.C. § 51(i)(1), indirect ownership is determined through the application of I.R.C. § 267(c), which provides the following (among other) rules:
- An individual shall be considered as owning the stock owned, directly or indirectly, by or for his family.
- The family of an individual shall include only:
- brothers and sisters (whether by the whole or half-blood),
- ancestors, and
- lineal descendants.
Wages of Owners and Spouses
Noticeably absent from IRC § 51(i)(1) or from early IRS ERC guidance was a direct prohibition on claiming the ERC for wages paid to a majority owner of a corporation or the spouse of the owner. The August 4 guidance directs the following process for determining which wages should be excluded by the related party exclusion.
Step One: For corporations, partnerships, or LLCs, apply the I.R.C. § 267(c) rules to determine any owners with a direct or indirect majority interest.
Step Two: Were wages paid to someone who has one of the relationships listed in I.R.C. § 152(d)(2)(A)-(H) to that majority owner? If so, the wages are not qualified wages for the ERC.
IRS summarized the following rules in its guidance:
- A majority owner of a corporation is a related individual for purposes of the employee retention credit, whose wages are not qualified wages, if the majority owner has a brother or sister (whether by whole or half-blood), ancestor, or lineal descendant.
- The spouse of a majority owner is a related individual, whose wages are not qualified wages, if the majority owner has a family member who is a brother or sister (whether by whole or half-blood), ancestor, or lineal descendant (and thus is deemed to own the majority owner’s shares under section 267(c) of the Code) and the spouse bears a relationship described in section 152(d)(2)(A)-(H) of the Code to the family member.
- In the event that the majority owner of a corporation has no brother or sister (whether by whole or half-blood), ancestor, or lineal descendant as defined in section 267(c)(4) of the Code, then neither the majority owner nor the spouse is a related individual within the meaning of section 51(i)(1) of the Code and the wages paid to the majority owner and/or the spouse are qualified wages for purposes of the employee retention credit, assuming the other requirements for qualified wages are satisfied.
The guidance also provided several examples, adapted here.
Sue Sherman is a 60% owner of Sherman Steers, Inc. Her co-owner is Bob Bradley, who is not related to her or her husband. Sue employs her husband, Jim Sherman and pays him a wage.
Sue cannot count Jim’s wages as qualified wages for the ERC because Sue has a living brother, Sam, who is not part of the business, but is a constructive majority owner in the business. Jim is a brother-in-law to Sam, a majority owner, a barred relationship under I.R.C. § 152.
Don Rolfes owns 80% of a farming S corporation with his daughter Dina Rolfes, who owns the other 20%. Don and Dina are both deemed 100% owners in the business under family attribution rules. They each have a barred relationship to a majority owner under the rules of I.R.C. § 152.
Don and Dina cannot count their wages as qualifying wages when calculating the ERC.
Ronald King is the 100% owner of King Farms, Corp. and his wife is a non-owner employee. His wife, Jean, is deemed to be a 100% owner of the business through I.R.C. § 267. Ron and Jean have no other relatives listed under I.R.C. § 267. As such, no other person has an indirect majority ownership interest in King Farms, and neither Ron nor Jean bear a relationship listed in I.R.C. § 152 to a majority owner.
In this rare circumstance, the wages of Ron and his wife are qualified wages for the ERC.
Tips as Wages
Notice 2021-49 also clarified that cash tips of $20 or more in a month are qualified wages when calculating the ERC and that eligible employers are not prevented from receiving both the ERC and the section 45B credit for the same wages. The section 45B credit is available with respect to unreported tips in an amount equal to the “excess employer social security tax” paid or incurred by the employer. This is a generous interpretation of the credit for restaurants.
Recovery Startup Businesses
Notice 2021-49 also confirmed that recovery startup businesses may qualify for the ERC as a RSB in the third quarter, but as a regular employer in the fourth quarter, or vice versa. “Recovery startup businesses" are eligible for the ERC during quarters three and four in an amount up to $50,000 per quarter. A recovery startup business, a term created by the ARPA, is an employer that:
- Began carrying on a trade or business after February 15, 2020;
- Had average annual gross receipts of $1 million or less for the three tax years ending with the tax year before the calendar quarter in which the employee retention credit is claimed; and
- Isn't otherwise eligible for the third or the fourth quarter, as applicable, for the ERC because business operations weren’t fully or partially suspended due to a governmental order or because gross receipts aren't less than 80 percent of the gross receipts for the same calendar quarter in calendar year 2019.
If an employer meets the gross receipts test or the shutdown test in either quarter, they are eligible for the ERC without a $50,000 limit. They are not a recovery startup business under the definition. The guidance confirmed that this determination is made each quarter.
Alternative Quarter Calculation
Employers may generally qualify for the ERC in 2021 if their gross receipts for a calendar quarter in 2021are less than 80 percent of the gross receipts (> 20 percent decline) for the same calendar quarter in calendar year 2019. The employer may elect to use an alternative quarter to calculate gross receipts. Under this election, an employer may generally determine if the decline in gross receipts test is met for a calendar quarter in 2021 by comparing its gross receipts for the immediately preceding calendar quarter with those for the corresponding calendar quarter in 2019 (substituting 2020 for 2019 if the employer did not exist as of the beginning of that quarter in 2019). The August 4 guidance confirms that this election is not permanent. In other words, the employer may use either method for any month, allowing greater eligibility for some employers throughout 2021.
Amendment Required for 2020 Return
The August 4 guidance also confirmed that an employer retroactively amending payroll tax returns to claim the 2020 ERC must also amend the income tax return for 2020 to make a corresponding adjustment to the wages deduction. The employer must reduce this deduction by the amount of the credit.
The guidance stated, “The taxpayer should file an amended federal income tax return or administrative adjustment request (AAR), if applicable, for the taxable year in which the qualified wages were paid or incurred to correct any overstated deduction taken with respect to those same wages on the original federal tax return.”
Finally, Notice 2021-49 confirmed that when an employer is counting employees for purposes of determining whether they are a large employer (allowed only to count wages paid for employees who were not working), they must only count full time employees, not full-time equivalents.
PPP Safe Harbor
On August 10. 2021, IRS issued Rev. Proc. 2021-33, a safe harbor allowing employers to exclude the following from “gross receipts” for purposes of the ERC only:
- The amount of the forgiveness of a PPP loan;
- A grant for Shuttered Venues (Economic Aid to Hard-Hit Small Businesses, Nonprofits, and Venues Act); and,
- A restaurant revitalization grant under the American Rescue Plan Act.
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