Filed under: Tax Compliance & Planning

The rules and guidance for the employee retention credit (ERC) continue to change as we go. The American Rescue Plan Act of 2021, signed on March 11, 2021, now allows an extension of the ERC through the end of 2021. As organizations continue on the path of recovery from the pandemic, this credit can yield sizeable cash flow to those who qualify.

In addition to the extension of the credit, the IRS released official guidance on the ERC for 2020 and 2021 (Notice 2021-20 and Notice 2021-23). While much of the additional guidance simply repeats the Frequently Asked Questions posted to the IRS website last year, some new insights are included.

Notice 2021-20, issued March 1, 2021, provides guidance specifically for the 2020 employee retention credit. Notice 2021-23, issued April 3, 2021, guides the 2021 credit. Below are key highlights of the additional guidance provided.

IRS Guidance on PPP Loan Interplay

One area employers needed guidance on was the interplay of Paycheck Protection Program (PPP) loans and the ERC. Notice 2021-20 provides some answers to the key questions.

PPP Borrowers Who Have Submitted the Forgiveness Application

Unfortunately, if the PPP borrower received a decision on forgiveness from the SBA, no opportunities are available for changing the allocation of PPP expenses. Many early borrowers submitted their forgiveness applications only using wages as qualified expenses for PPP forgiveness, even if they had non-payroll costs during their covered period. This simplified paperwork for both the borrower and lender. Unfortunately, if the borrower chose this method, it is considered an “election” for the ERC. Those wages reported on the PPP loan forgiveness application, up to the amount of the loan, are not eligible for the ERC.

If a PPP borrower reported both payroll and non-payroll costs on the forgiveness application, the Notice indicates non-payroll costs are deducted first from the PPP loan amount, up to the cap of 40%. Wages are applied next. If a borrower’s excess wages are not needed for forgiveness, those excess wages can then qualify for the ERC.

Example

Employer A receives a PPP loan of $100,000. Employer A has $120,000 of payroll costs and $30,000 of qualifying non-payroll costs. If Employer A submitted its PPP forgiveness application reporting both amounts, $50,000 of the wages reported on the PPP forgiveness application may be used for the ERC. This is because Employer A only needed $70,000 of wages to meet full forgiveness ($100,000 proceeds less $30,000 non-payroll costs). Wages reported on the application over the amount needed are then eligible for the ERC.

If Employer A only reported $120,000 of payroll costs on their forgiveness application and didn’t mention the $30,000 of qualifying non-payroll costs, only $20,000 of payroll costs would be eligible for the ERC. 

For borrowers that submitted their forgiveness application but have not received a forgiveness decision, check with the lender to see if there are any options available. If the lender has not reviewed the application, there may be an opportunity to pull it back and revise the expense allocation. However, if the lender has submitted the application to the SBA for review, options are likely limited.

PPP Borrowers Who Have NOT Submitted the Forgiveness Application

The additional guidance from the IRS creates key planning opportunities for borrowers who have not submitted their PPP forgiveness application yet. Borrowers are highly encouraged to utilize the maximum non-payroll costs on their PPP loan forgiveness application to maximize the employee retention credit. This planning is even more critical for borrowers in 2021 as the ERC is now available on a quarterly basis.

Additionally, PPP borrowers should be thoughtful regarding which wages are utilized for the PPP loan forgiveness. While salaries are subject to a cap for highly paid individuals, employee benefits are not. Therefore, it may be beneficial to first allocate employee benefits to PPP loan forgiveness and utilize wages (up to the appropriate cap) afterwards. This will free up more wages for the ERC.

Safe Harbor for a “More Than Nominal” Business Suspension

For employers conducting both essential and non-essential activities, many were left wondering if the suspension of non-essential activities was enough to qualify for the ERC. The original IRS FAQs indicated the suspension of operations needs to be “more than nominal.” However, no definition was provided for that term. Notice 2021-20 provides a 10% safe harbor threshold for determining whether a more than nominal suspension occurred. The safe harbor can be met two ways:

  1. Gross receipts from that portion of the business are at least 10% of total gross receipts during that same quarter in 2019; or
  2. Hours of service performed by employees in that portion of the business are at least 10% of the total hours of service by all employees during that same quarter in 2019.

Example

Under a government order, a hospital was required to pause all elective surgeries for patients from April 1, 2020 to June 30, 2020.

During 2019 Q2, about 15% of the hospital’s gross receipts were attributable to elective surgeries. Since elective surgeries were at least 10% of the 2019 Q2 gross receipts, this line of business is considered a “more than nominal” activity. Because elective surgeries were suspended during 2020 Q2, the hospital is eligible for the ERC during that quarter.       

Documentation Requirements for Claiming the Credit

An additional component of Notice 2021-20 includes guidance surrounding the records an employer must keep to substantiate the credit. The Notice includes six key areas that must be documented:

  1. How the organization met the eligibility requirements for a full or partial shutdown or significant decline in gross receipts;
  2. How the employer determined qualified wages per employee;
  3. How the employer determined qualified health plan expenses per employee;
  4. Whether the employer is a member of an aggregated group and how the credit has been allocated as a result;
  5. Copies of all Forms 7200 filed with the IRS for an advance refund claim; and
  6. Copies of all Forms 941 filed with the IRS that claim the credit.

These documents should be maintained for at least four years after the date which the tax is due or is paid, whichever is later.

Prior Quarter Gross Receipts Lookback for 2021

The Consolidated Appropriations Act, signed on December 27, 2020, extended the employee retention credit into 2021. With this law, an alternative election exists for employers seeking eligibility under the gross receipts test.

Employers with a decline in gross receipts of over 20% in a quarter are eligible for the ERC. Under the alternative election, employers can also claim eligibility for the current quarter by demonstrating gross receipts in the prior quarter, compared to the corresponding quarter in 2019, declined over 20%.  Confusion existed on whether the 2019 lookback quarter was the current quarter in 2021 or the prior quarter. Notice 2021-23 clarifies this. Employers should use the 2019 quarter that corresponds with the 2021 prior quarter.

Example

Employer A’s gross receipts in 2021 Q1 are $75,000. Its gross receipts in 2019 Q1 are $100,000. The percentage decline is 25%. Therefore, Employer A is eligible for the ERC in 2021 Q1.

If gross receipts increase to $95,000 in 2021 Q2 ($100,000 in 2019 Q2), Employer A is no longer eligible when looking at the current quarter. Its decline is only 5%. However, Employer A can look at its prior quarter (2021 Q1) and compare that to 2019 Q1 to demonstrate a decline of over 20%.  Therefore, Employer A remains eligible for the ERC in 2021 Q2.

To remain eligible for the ERC in 2021 Q3, Employer A must demonstrate a decline of over 20% in Q3 when compared to 2019 Q3. It cannot use the alternative quarter test for eligibility as the prior quarter had no significant gross receipts decline.

Extension of the Credit Through December 31, 2021

The latest relief bill signed on March 11, 2021 allows for an extension of the employee retention credit through December 31, 2021. This is great news as many industries continue to be hit hard by the pandemic. The eligibility and calculation of the credit in 2021 Q3 and Q4 will remain the same for most organizations.

One slight change for Q3 and Q4 only is that the credit will offset the employer’s share of Medicare taxes rather than Social Security taxes. This doesn’t mean that the credit will be smaller. In fact, the opposite may be true. This minor change means that organizations utilizing R&D credits, veteran employment credits, and certain qualified disaster credits no longer need to reduce the employee retention credit for these other credits.

The IRS intends to issue another notice to provide specific guidance for the 2021 Q3 and Q4 ERC calculation.

In Conclusion

As organizations get back on their feet this year, careful planning should be done to take advantage of opportunities available to qualify for the employee retention credit. The credit has the potential to yield sizeable refund to organizations. If you have questions on eligibility or the calculation itself, please contact your advisor at Clark Nuber for further assistance.

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