Many Employers May Benefit from Newly Revised Employee Retention Credit

February 25, 2021 | Kristine A. Tidgren

Update: On March 11, the American Rescue Plan Act was signed into law. The new law extends the ERC through December 31, 2021, with some modifications to quarters 3 and 4. On April 2, IRS issued guidance as to the CAA expansion for quarters 1 and 2 of 2021. This guidance, Notice 2021-23, did not address the ARPA expansion. On March 1, 2021, IRS issued guidance related to the 2020 Employee Retention Credit, including the interaction between the ERC and the PPP in 2020.

During 2020, Congress focused much COVID-19 relief on helping hard-hit businesses keep employees on the payroll. At year end, Congress made one key relief provision—the employee retention credit (the “ERC”)—much more available and generous through provisions in the Consolidated Appropriations Act of 2021 (the “CAA”), Pub. L. 116-260 (December 27, 2020).  Because of these changes, some businesses are retroactively eligible for this fully refundable payroll tax credit for qualified wages paid in 2020. Others are eligible for the newly expanded credit available through June 30, 2021.

This post provides an overview of the ERC provisions, as they are understood at the beginning of 2021. Most 2020 ERC guidance was informal, issued mainly through IRS FAQs. These FAQs have not been updated to reflect the new law, nor has IRS issued more formal guidance. Consequently, many important questions (a few detailed at the end of this post) remain. Even so, businesses and their advisers should not overlook this potentially generous credit, even in the midst of this busy filing season. We will provide additional updates as guidance issues.

Background

Section 2301 of the CARES Act allowed “eligible employers” an employee retention credit (the “ERC”), equal to 50 percent of “qualified wages” paid to each employee for each calendar quarter during the COVID-19 crisis. The ERC is a fully refundable payroll tax credit, meaning that even though it’s claimed against payroll tax, the amount of the credit may exceed the actual payroll taxes due.

Eligibility

“Eligible employers” for 2020 were those employers whose businesses were:

  1. fully or partially suspended during the calendar quarter due to orders from an appropriate governmental authority limiting commerce, travel, or group meetings due to COVID-19 or
  2. those employers that experienced a “significant decline in gross receipts” for a given calendar quarter. 

Employers of any size, including tax exempt organizations, are eligible to claim the ERC. Self-employed individuals are not eligible to claim the ERC for their own earnings, although they may claim the credit for wages paid to their employees if they are otherwise eligible. Federal, state, and local governments were ineligible for the ERC under the CARES Act.

 “Fully or Partially Suspended”

IRS FAQs provide a fairly detailed analysis of the “fully or partially suspended” requirement. Generally, the informal guidance states, “the operation of a trade or business is partially suspended if an appropriate governmental authority imposes restrictions on the employer’s operations by limiting commerce, travel, or group meetings (for commercial, social, religious, or other purposes) due to COVID-19 such that the employer can still continue some, but not all of its typical operations.” The FAQs analyzing partial or full suspensions, as applied to essential and non-essential businesses, may be found here. It is important to note, for example, that under this guidance mere recommendations to close (as opposed to orders) or decreased customer activity do not count as a full or partial suspension. Additionally, if the work can continue in a “comparable” manner through telework, there is no partial suspension.

Note: If an employer qualified for the ERC based solely upon the “fully or partially suspended” criteria, “qualified wages” include only those otherwise eligible wages paid during the full or partial shutdown period.

“Significant Decline in Gross Receipts”

In 2020, an employer became an “eligible employer” under the “significant decline in gross receipts” test 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 in 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.

Note: If an employer qualified for the ERC based upon the “significant decline in gross receipts” criteria, “qualified wages” include all otherwise eligible wages paid during the applicable quarter.

An IRS FAQ states that “gross receipts” are defined as follows for purposes of the ERC:

“Gross receipts” for purposes of the Employee Retention Credit for an employer other than a tax-exempt organization has the same meaning as when used under section 448(c) of the Internal Revenue Code (the “Code”). Under the section 448(c) regulations, “gross receipts” means gross receipts of the taxable year and generally includes total sales (net of returns and allowances) and all amounts received for services. In addition, gross receipts include any income from investments, and from incidental or outside sources. For example, gross receipts include interest (including original issue discount and tax-exempt interest within the meaning of section 103 of the Code), dividends, rents, royalties, and annuities, regardless of whether such amounts are derived in the ordinary course of the taxpayer's trade or business. Gross receipts are generally not reduced by cost of goods sold, but are generally reduced by the taxpayer’s adjusted basis in capital assets sold. Gross receipts do not include the repayment of a loan, or amounts received with respect to sales tax if the tax is legally imposed on the purchaser of the good or service, and the taxpayer merely collects and remits the sales tax to the taxing authority.

When determining eligibility for the ERC, affiliated employers are treated as a single employer. IRS FAQs detail these aggregation rules.

“Qualified Wages”

“Qualified wages” for 2020 must have been paid after March 12, 2020, and before January 1, 2021. Employers that averaged more than 100 employees in 2019 could only take the credit based upon wages of employees who were not providing service. Employers with 100 or fewer employees in 2019 could claim the credit based upon wages of all employees, regardless of whether they worked or not

“Qualified wages” include related qualified health plan expenses. Qualified wages in 2020 could not exceed $10,000 per employee for all quarters in 2020. In other words, the total 2020 ERC an employer could receive for each employee was $5,000.

An employer may not claim the ERC for wages used to claim a Families First Coronavirus Response Act or Work Opportunity Credit.

Claiming the Credit

The ERC is taken against the applicable employment taxes on the qualified wages (employer's share of Social Security tax), but any excess is fully refundable. Employers claim the credits on payroll tax returns, including the applicable quarterly Form 941 or the yearly Form 943. Before filing these returns, however, businesses could seek an advance of the credit by filing a Form 7200. If an advance payment was received, this advance amount was reconciled on the payroll tax return.

Could not Originally Claim Credit if Received PPP Loan

The ERC was available to employers in 2020; however, many employers who would otherwise have been eligible for the credit were unable to claim it because the CARES Act did not allow an employer to take the ERC and receive a Paycheck Protection Program loan. Faced with this choice, many employers opted for the PPP.

Retroactive Changes

Section 206 of the CAA’s Taxpayer Certainty and Disaster Tax Relief Act of 2020 (the “Disaster Tax Relief Act”) retroactively changed the law to allow employers who received PPP loans in 2020 or those will receive one in 2021 to qualify for the ERC. To ensure that the same wages are not used for both programs, the PPP was retroactively revised to state that “payroll costs” do not include “qualified wages” taken into account in determining the ERC. The Disaster Tax Relief Act provides that the taxpayer can elect to not take the ERC into account for wages paid. It also states that payroll costs paid during a PPP covered period will not fail to be treated as “qualified wages” to the extent that the loan is not forgiven. As discussed below, IRS has not provided necessary guidance detailing the interaction between the ERC and the PPP.  

In addition to this revision, the Disaster Tax Relief Act also clarified that the gross receipts test for tax exempt businesses applies to all gross receipts, not just the gross receipts from unrelated trade or business income. It also clarified that qualified wages can include qualified health plan expenses, even if the employee is on furlough and not receiving any other compensation. Aside from these modifications, the original law, rules, and guidance detailed above continue to apply to the 2020 ERC.

To retroactively claim the credit, employers may file a Form 941-X or a Form 943-X, as appropriate. Because an employer has three years to amend these returns, it is likely advisable to wait for more detailed guidance before seeking to claim the credit for 2020. As noted below, however, the ERC will impact income tax returns because associated deductions are disallowed. As such, it may important to also delay filing the 2020 income tax return until the eligibility and impact of the 2020 ERC has been determined.

Example of 2020 Credit

The following chart shows a simple calculation of the ERC for an employer eligible to claim the credit in 2020, based upon the fact that Q2 gross receipts in 2020 were less than 50 percent of Q2 2019 gross receipts. In this example, the employer would not be eligible to take any additional credits in 2020 for employees 1 or 2, even if the employer continued to qualify for the ERC under the gross receipts test in Quarter 2. The employer would have an additional credit of $4,000 to claim for employee 3 if the employer otherwise qualified in quarters 3 or 4.

 

Wages1

Qualified Wages2

ERC3

Employee 1

$12,000

$10,000

$5,000

Employee 2

$20,000

$10,000 

$5,000

Employee 3

$ 2,000

$2,000

$1,000

Total

$34,000 

$22,000

$11,000

1including healthcare expenses
2Capped at $10,000
350 percent of Qualified Wages
 

Prospective Changes

Section 207 of the Disaster Tax Relief Act extended and significantly expanded the ERC for 2021, through June 30, 2021. Except as mentioned below, the general rules for the ERC in 2021 remain the same as the rules for 2020 detailed above.

Credit Percentage Increased

From January 1, 2021, through June 30, 2021, the new law increases the ERC percentage from 50 percent of qualified wages to 70 percent.

Qualified Wages Expanded

Additionally, in 2021, employers can count qualified wages in an amount up to $10,000 per employee per quarter (instead of across all quarters) in calculating the credit. This means that an eligible employer can claim up to a $14,000 credit per employee in 2021. Employers of any size, including tax exempt organizations, remain eligible to claim the ERC.

In 2021, employers with more than 500 employees in 2019 (as opposed to 100 or more employees) may claim the credit based upon wages of employees who were not providing service. Employers with 500 or fewer employees in 2019 may claim the credit based upon wages of all employees, regardless of whether they worked or not.  Additionally, some governmental employees are newly eligible for the credit, including:

  • colleges and universities
  • those whose principal purpose or function is providing medical or hospital care

“Significant Decline in Gross Receipts” Test Easier to Meet

Becoming an “eligible employer” under a more lenient “significant decline in gross receipts” test is much easier in 2021. Employers may now generally qualify for the ERC if their gross receipts for a calendar quarter are less than 80 percent of the gross receipts (more than a 20 percent decline) for the same calendar quarter in calendar year 2019. The new law also allows a business to qualify for the ERC in 2021 if their gross receipts from the prior quarter were less than 80 percent of the gross receipts for the corresponding quarter in 2019. IRS has yet to issue guidance on the implementation of these provisions, but the law states that this alternative calculation is made by election.

As a result of these changes, many employers who did not qualify for the ERC in 2020 may now qualify for the newly expanded 2021 ERC. Additionally, the credit will generally be larger.

Claiming the Credit in 2021

As in 2020, employers may claim the credit on their payroll tax returns and may, before filing the payroll tax return, seek an advance payment of the credit by filing a Form 7200. A Form 7200 advance, however, is only available to “small employers” in 2021. This is defined as those employers with an average of 500 or fewer full-time employees in 2019. On January 26, 2021, IRS provided limited informal guidance on claiming this advance credit in IR-2021-21.

Example of 2021 Credit

The following chart shows the ERC for an employer eligible to claim the credit in 2021, based upon the fact that Q1 gross receipts in 2021 were less than 80 percent of Q1 2019 gross receipts. Alternatively, the taxpayer could take this same credit if gross receipts in 2020 Q4 were less than 80 percent of gross receipts for 2019 Q4 (at the election of the taxpayer). As stated above, IRS is yet to provide guidance on this election.

 

Wages1

Qualified Wages2

ERC3

Employee 1

$12,000

$10,000

$7,000

Employee 2

$20,000

$10,000 

$7,000

Employee 3

$2,000

$2,000

$1,400

Total

$34,000 

$22,000

$15,400

1including healthcare expenses
2Capped at $10,000
350 percent of Qualified Wages
 

Note that in addition to the larger quarterly credit in 2021, this employer would be eligible for another credit in quarter two, in these same amounts if wages stayed the same and the employer continued to meet the “significant decline in gross receipts” test.

Tax Treatment of Employee Retention Credit

Although the employer does not include the ERC in income, section 2301(e) of the CARES Act provided that “rules similar to” IRC § 280C(a) apply. This means that an employer that receives the ERC must reduce their aggregate deductions by the amount of the credit.

Ongoing Questions

As noted above, IRS has yet to issue formal guidance related to the newly revised and expanded ERC. As such, a number of questions remain. While we watch for further guidance, the following issues of are particular interest.

Related Party Rules

Sole proprietors and partners in partnerships are not eligible to take a credit for their own compensation because they do not receive “wages.” Owners of corporations, however, do receive a wage. An outstanding question is whether the wages paid to owners or their spouses are “qualified wages” for purposes of the ERC. IRS has not spoken directly on this issue.

Section 2301(e) of the CARES Act provided that rules “similar to the rules of IRC § 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. In its FAQ, IRS summarizes this related party rule[i] as follows:

Wages paid to related individuals, as defined by section 51(i)(1) of the Internal Revenue Code (the "Code"), are not taken into account for purposes of the Employee Retention Credit. A related individual is any employee who has of any of the following relationships to the employee's 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.

 Noticeably absent from IRC § 51(i)(1) or from the IRS informal guidance is a prohibition on including wages paid to an owner of a corporation or a spouse of that owner when calculating the ERC. The absence of this prohibition is likely due to the nature of the work opportunity credit from which this rule was borrowed (it’s available to those who hire employees from certain targeted groups who have consistently faced significant barriers to employment). Even so, neither the code nor the informal guidance currently seems to restrict employers from counting the wages of owners or their spouses when calculating the ERC.[ii]  In the above FAQ, IRS appears to interpret IRC § 267(c) to apply only to the listed relatives as well, but no clear direction is provided for owners and spouses. The CARES Act empowers IRS to create rules “similar to” the related party rules for the WOTC. Formal guidance is needed to understand how IRS will apply ERC to apply to owners and their spouses.

Interaction of the PPP with the ERC

Update: On March 1, 2021, IRS issued Notice 2021-20, providing guidance with respect to the interaction between PPP and ERC qualified wages. Specifically, the guidance provides:

An eligible employer that received a PPP loan is deemed to have made the election under section 2301(g)(1) of the CARES Act for those qualified wages included in the amount reported as payroll costs on a PPP Loan Forgiveness Application. Specifically, the amount for which the eligible employer is deemed to have made the election is the amount of qualified wages included in the payroll costs reported on the PPP Loan Forgiveness Application up to (but not exceeding) the minimum amount of payroll costs, together with any other eligible expenses reported on the PPP Loan Forgiveness Application, sufficient to support the amount of the PPP loan that is forgiven. The employee retention credit does not apply to the qualified wages for which the election or deemed election is made. [In other words, only those qualified wages necessary to support the forgiveness application are excepted from the ERC, even if additional payroll costs are listed.]

An eligible employer is not deemed to have made an election for any qualified wages paid by the eligible employer that are not included in the payroll costs reported on the PPP Loan Forgiveness Application. Notwithstanding a deemed election, if an eligible employer reports any qualified wages as payroll costs on a PPP Loan Forgiveness Application to obtain forgiveness of the PPP loan amount, but the loan amount is not forgiven by reason of a decision under section 7A(g) of the Small Business Act, those qualified wages may subsequently be treated as subject to section 2301 of the CARES Act and may be taken into accountfor purposes of the employee retention credit. If an eligible employer obtains forgiveness of only a portion of the PPP loan amount, then the employer is deemed to have made an election for the minimum amount of qualified wages included in the payroll costs reported on the PPP Loan Forgiveness Application necessary to obtain the forgiveness of that amount of the PPP loan.

[This same guidance does not allow borrowers to retroactively offset payroll costs with "other expenses" they did not include on the forgiveness application to free up more wages for ERC. The guidance does reiterate many of the FAQs on the IRS website, this transforming them into the formal guidance requested by taxpayers.]

As detailed above, the Disaster Tax Relief Act allows those who received or will receive a PPP loan to qualify for the ERC, as long as the same wages are not taken into account for the ERC and for PPP forgiveness. What this means for the 2020 credit, in particular, in not entirely clear. The law states that taxpayers may elect to not take the ERC into account for wages paid and that payroll costs paid during a PPP covered period will not fail to be treated as “qualified wages” to the extent that the loan is not forgiven. Despite this language, guidance is needed to detail the procedure for making this election and the new law’s application, in particular, to 2020 PPP loans that have already been forgiven.

On January 22, 2021, IRS posted a notice on its website stating that borrowers with 2020 PPP loans for which forgiveness was denied could claim the ERC on the fourth quarter Form 941. This limited instruction applying to a very narrow set of borrowers answered none of the real key questions facing PPP recipients who want to retroactively claim the ERC.

Many borrowers, for example, may have listed more payroll costs on their forgiveness applications than were necessary to receive full forgiveness. They also may have chosen not to include non-payroll costs otherwise eligible for forgiveness because the payroll costs on their own got them full forgiveness. In light of the changes, the same borrower may have paid enough wages to be eligible for both the ERC and PPP forgiveness for different wages. Whether this is possible is a question that must be answered and detailed by the IRS. The AICPA has written a letter asking Treasury to resolve these questions in a taxpayer-friendly manner, in keeping with the intent of the COVID-19 relief laws.

Until these and other questions are answered, impacted borrowers should likely wait to claim the ERC. In the meantime, get your spreadsheets ready! Claiming the PPP, ERC, and other credits will require some careful allocation of wages. We are hoping guidance issues quickly. We are also watching pending legislation that would extend this generous credit through December 31, 2021.

 

[i] This is the IRS summary of IRC § 51(i)(1) which states, “No wages shall be taken into account under subsection (a) with respect to an individual who—A) bears any of the relationships described in subparagraphs (A) through (G) of section 152(d)(2) to the taxpayer, or, if the taxpayer is a corporation, to an individual who owns, directly or indirectly, more than 50 percent in value of the outstanding stock of the corporation, or, if the taxpayer is an entity other than a corporation, to any individual who owns, directly or indirectly, more than 50 percent of the capital and profits interests in the entity (determined with the application of section 267(c)).”

[ii] except for those cases where one owner may bear a relationship listed above to another owner.