Filed under: Tax Compliance & Planning
The Consolidated Appropriations Act of 2021 changed some of the rules regarding the Employee Retention Credit. Read here for updated information.
Updated May 11 to include new guidance from the IRS pertaining to furloughed workers and eligibility.
Updated April 28 to reflect clarifying information from the IRS and the Joint Committee on Taxation report.
The CARES Act (the Act) includes a program that allows a credit against “applicable employment taxes” (AET). This program, The Employee Retention Credit for Employers Subject to Closure Due to COVID-19 (the ERC) applies to wages paid after March 12th, 2020 and before January 1st, 2021.
AET is defined as the employer’s share of:
- The Old-Age, Survivors and Disability Insurance Tax (known as the Social Security tax; i.e., 6.2% of wages up to $137,700 in 2020) and
- If applicable, the portion of the Tier 1 Railroad Retirement Tax Act excise tax that corresponds to the 6.2% Social Security tax.
The ERC allows a credit up to a maximum of $5,000 of credit per employee.
It is important to note that recipients of the Payroll Protection Program (PPP) loans through the SBA are not eligible for the ERC. Employers who make otherwise valid claims under this program and later receive a PPP loan during a subsequent quarter will be subject to credit recapture provisions.
Additional definitions and eligibility rules prescribed by the ERC program are summarized below. This article will be updated as information and guidance become available.
Calculating and Claiming the Credit
Employers who meet the eligibility requirements (discussed below) must first determine the amount of qualifying wages (defined below) per employee under this program. The credit is equal to 50% of qualified wages paid to an employee during an applicable quarter, up to a maximum of $10,000 for all applicable quarters, or a maximum credit of $5,000. However, care must be taken to not count the same wages under multiple programs. (See No Double Benefit under Qualified Wages below.)
Eligible employers must also calculate the amount of health insurance costs (see discussion below) that are allocable to qualifying wages. These amounts are added to qualifying wages.
Next, the employer must calculate the AET due for the quarter with respect to all employees of the employer. This amount is reduced by any credits claimed under other programs (discussed below). If the ERC exceeds the employer’s total AET for the quarter, the excess is treated as an overpayment and is refundable.
Reduction for Credits Claimed under Other Programs. For purposes of determining the employer’s total AET for the quarter, the AET is reduced by credits allowed for under the following programs:
- Employment of qualified veterans (veteran’s credit),
- Research expenditures of a qualified small business (research credit), and
- The Families First Coronavirus Response Act (paid sick leave credit).
Example 1. Assume that, for a calendar quarter, an eligible employer had AET prior to any credits of $10,000 and is claiming the following credits:
- A $4,000 research credit
- A $3,000 paid sick leave credit, and
- A $5,000 ERC.
The eligible employer’s AET (before the ERC) is reduced to $3,000 ($10,000 less $4,000 research credit less $3,000 paid sick leave credit). Next, the ERC reduces the AET to zero ($3,000 less $3,000 of the ERC) and it has a $2,000 ERC refundable overpayment. If, instead, the eligible employer had AET prior to any credits of $2,000, its applicable employment taxes are reduced to $0 and it has an $8,000 refundable overpayment (i.e., the $2,000 is reduced by a portion of the refund credit to $0. Since the paid sick leave credit and the ERC are both refundable, $8,000 is the amount of the refund claim ($3,000 paid sick leave credit plus $5,000 ERC).
Reporting of the ERC begins in the Second Quarter 2020 Form 941. To claim the credit, eligible employers should report their total qualifying wages and the related health insurance costs for each quarter on their quarterly employment tax returns (Form 941) beginning with the second quarter.
To expedite the cash benefit of the credit, the IRS has announced that employers who retain deposits equal to the credit(s) for the quarter will not be penalized for failure to deposit (see Notice 2020-22). Eligible employers are allowed to retain a corresponding amount of employment taxes for all employees (including federal income tax withholding and the employee’s and the employer’s shares of Social Security and Medicare taxes) that otherwise would have been deposited up to the amount of the credit. Keep in mind that the penalty waiver only applies to the amounts not deposited that are equal to the ERC less the amount of refundable tax credits to which the employer is entitled under the Families First Coronavirus Response Act.
Reasonable Cause Waivers are Available. Penalties for failure to make payroll deposits are to be waived if the Secretary determines that failure was due to the reasonable anticipation of the credit allowed under this program.
Example 2: Eligible Employer A paid $30,000 in qualified wages during the second quarter of 2020 to employees and, as result, is allowed an ERC of $15,000. Employer A is otherwise required to deposit $10,000 in federal employment taxes, including taxes withheld from all of its employees, on wages paid during the same calendar quarter. Assuming that Employer A is not eligible to claim paid sick or family leave credits, Employer A can retain the $10,000 of taxes that it is otherwise required to deposit without penalties. Employer A may also file Form 7200 requesting an advance credit/refund for the remaining $5,000.
As mentioned in the example above, an eligible employer may claim an advance payment of the refundable tax credit for Qualified Retention wages (under the ERC program) by filing Form 7200, Advance Payment of the Employer Credits Due to COVID-19. However, the amount of any retained employment tax subject to the waiver is reduced by the amount of the refund requested on Form 7200. Employers are permitted to file Form 7200 several times during each quarter, if needed to expedite refunds, but not after they file Form 941 for the quarter. Employers should not file Form 7200 for any portion of the credit for which they have already reduced deposits. Form 7200 is filed by faxing the completed form to 855-248-0552.
Eligible Employer
While most other stimulus programs included in the CARES Act and the Families First Coronavirus Response Act are limited to employers with “no more than 500 employees” or “fewer than 500 employees”, respectively, the ERC program is available for a much broader group of employers.
Any employer is eligible for the ERC for a 2020 quarter if either of the following occurred/occurs:
1. The employer was carrying on a trade or business during the quarter, and the operation of the employer’s trade or business is/was fully or partially suspended during the calendar quarter due to orders from an appropriate governmental authority limiting commerce, travel, or group meetings (for commercial, social, religious, or other purposes) due to COVID-19. This is referred to as the “governmental order test.”
The IRS FAQ site has clarified that a business is “partially suspended” if a governmental authority imposes restrictions, such that “operations can still continue to operate BUT not at its normal capacity” and provided the following example:
Example 3: A state governor issues an executive order closing restaurants, bars and similar establishments to reduce the spread of COVID-19, but the order allows those establishments to continue food or business sales to the public on a carry-out, drive-through, or delivery basis. This results in a partial suspension of the operations of the trade or business due to an order of an appropriate governmental authority with respect to any restaurants, bars and similar facilities that provided full sit-down service, a dining room, or other on-site eating facilities for customers prior to the executive order.
In addition, the Joint Committee on Taxation staff have included examples clarifying the governmental order test. (Many of the examples below are from their report.)
Example 4: A restaurant in a state under statewide order that restaurants offer only take-out services meets the government’s order, as does a concert venue in a state under a statewide order limiting gatherings to no more than 10 people meets the governmental order test.
Example 5: An accounting firm that is in a county where accounting firms are among businesses subject to a directive from public health authorities to cease all activities other than minimum basic operations and that closes its offices and does not require employees who cannot work from home (e.g., custodial employees, mail room employees) to work meets the government order test.
Example 6: A grocery store in a state that generally imposes limitations on food service, gathering size, and travel outside the home, but exempts grocery stores (and travel to and from grocery stores) from any COVID-19 related restrictions (e.g., because grocery stores are deemed an “essential business” that is excepted from restrictions) would not meet the governmental order test.
2. The employer was carrying on a trade or business during the quarter, and the employer’s gross receipts for the quarter are less than 50% of gross receipts for the same calendar quarter in the prior year. This is referred to as “Gross Receipts Decline” or “the GRD test.”
Note that for employers qualifying under the GRD test, qualification ends with the quarter following the first quarter that:
a. begins after a quarter described in the GRD test occurs, and
b. gross receipts for the quarter are greater than 80% of the gross receipts for the same quarter in the prior year.
Example 7: Employer A experiences a decline in gross receipts for the first quarter of 2020. Employer A’s first quarter gross receipts are less than 50% of its gross receipts for first quarter 2019. In the second quarter of 2020, A’s gross receipts increase to 65% of its gross receipts in second quarter 2019. In the third quarter, Employer A’s gross receipts exceed 80% of its gross receipts for third quarter 2019. Assuming it meets all other eligibility requirements, Employer A is eligible for the credit the first three quarters of 2020.
Note that in the example above, the credit program rules apply on a calendar quarterly basis. Employers who normally report on a fiscal basis other than calendar years will need to measure activity on a calendar year quarterly basis in order to support credit eligibility.
For employers that began/begin operations in 2020, the GRD test will not apply as explained above because they have no comparable operations during calendar year 2019. Instead, the Act instructs the Treasury Secretary to prescribe how the rules apply to employers that were not operating a business for all or part of the same quarter in 2019.
Section 501(c) Organizations. An organization described in section 501(c) may qualify as an eligible employer under either test. The requirement that an eligible employer be carrying on a trade or business during calendar year 2020 and the governmental order test are to be applied as if they referred to all operations of such organization, and not merely those which are treated as a trade or business.
Qualified Wages
Normally, the term “wages” includes all remuneration for “employment,” including the cash value of all remuneration paid in kind (non-cash items). This includes salaries, vacation allowances, bonuses, deferred compensation, commissions, and some fringe benefits. (The Act defines wages by referring to Internal Revenue Code (IRC) Sections 3121(a) and 3231(e).)
For purposes of calculating the ERC, qualified wages is two-pronged. Employers are required to determine the number of employees employed during 2019, which is referred to as the “100 employee test.”
1. If the average number of full-time employees employed during 2019 was greater than 100, then qualified wages include only wages paid to employees not providing services due to circumstances described in either the governmental order test or the GRD test. While the Act is silent with how the phrase “not providing services” is to be interpreted, other guidance published by the federal government has provided some interpretative examples as follows:
Example 8: If a restaurant that had an average of 150 full-time employees during 2019 meets the governmental order test, and the restaurant continues to pay kitchen employees” wages as if they were working 40 hours per week but only requires then to work 15 hours a week, the wages paid to the kitchen employees for the 25 hours per week with respect to which the kitchen employees are not providing services are qualified wages.
Example 9: Same as example 8 except the restaurant reduces kitchen employees’ hours from 40 hours per week to 15 hours per week and only pays wages for 15 hours per week, no wages paid to the kitchen employees are qualified wages.
Example 10: If an accounting firm continues to pay administrative assistants their full salaries but only requires them to work two days per week on a rotating schedule reflecting reduced demand for assistance resulting from the office closure, the portion of an administrative assistant’s salary attributable to days not worked are qualified wages.
30-day limitation rule. For employers who employed on average greater than 100 full-time employees during 2019, qualified wages are further limited. Wages paid do not qualify to the extent that the wages exceed the amount the employee would have been paid for working an equivalent duration during the 30 days immediately preceding the period described in the governmental order test or the first quarter described in GRD test (“the 30-day limitation rule”).
Example 11: If an eligible employer subject to the 30-day limitation rule paid an employee $15 per hour for all hours worked prior to meeting the governmental order test, but during the period when the eligible employer meets the governmental order test pays the same employee $10 per hour for hours when the employee is providing services and $20 per hour for hours when the employee is not providing services, only $15 per hour of wages paid when the employee is not providing services are qualified wages.
Example 12: If an eligible employer subject to the 30-day limitation rule paid an employee $15 per hour for all hours worked prior to meeting the governmental order test, but during the period when the eligible employer meets the governmental order test pays the same employee $20 per hour (both for hours when the employee is providing services and for hours when the employee is not providing services), only $15 per hour of wages paid when the employee is not providing services are qualified wages.
2. If the average number of full-time employees employed during 2019 was not greater than 100, qualified wages includes any wages paid to the employee during any period described by either the governmental order test or the GRD test, even if employees were providing services during the applicable period. The 30-day limitation rule does not apply to employers who employed on average, 100 full-time employees or less during 2019.
Example 13: If a restaurant that had an average of 45 full-time employees during 2019 meets the governmental order test, and the restaurant continues to pay kitchen employees’ wages as if they were working 40 hours per week but only requires them to work 15 hours per week, all of such employees’ wages paid during the period to which the governmental order applies are qualified wages. (In contrast, only the wages for the 25 hours of pay for hours not required would be eligible if the employer had an average of over 100 full-time employees – see Example 8 above.) If the same restaurant responds to the governmental order by reducing the hours of kitchen employees who had previously worked 40 hours per week to 15 hours per week and only pays wages for 15 hours per week, such wages paid during the period to which the governmental order applies are qualified wages.
Example 14: If a grocery store that had an average of 75 full-time employees during 2019 meets the GRD test for the second and third calendar quarters of 2020, all wages paid by the grocery store during those quarters are qualified wages.
Qualified wages also include the portion of the eligible employer’s qualified health plan expenses “as are allocable to such wages.” Qualified health plan expenses are defined as amounts paid or incurred by the employer to provide and maintain a group health plan, but only to the extent such expenses are excluded from gross income of the employees.
Health plan costs that are paid on an after-tax basis by employees as a payroll reduction are not included. The Act instructs the Treasury Secretary to draft regulations that prescribe how health plan expenses are to be allocated, but it also provides that allocations made on the basis of being pro rata among employees and pro rata on the basis of periods of coverage “relative to the periods to which such wages relate” are acceptable.
Employers who Continue to Provide HealthCare Benefits for Laid Off or Furloughed Employees. Early guidance indicated that if a qualified employer laid off or furloughed employees, but they continued to pay healthcare costs for those employees, no credit could be claimed with respect to those healthcare costs. In that case, the healthcare costs were not qualified wages. This drew quick rebukes from businesses and lawmakers. In response, the Internal Revenue Service updated its ERC FAQ website to clarify that payments for healthcare costs on behalf of laid off or furloughed employees are treated as qualified wages. FAQ #64 now contains the following example.
Example 15: Employer Z averaged 100 or fewer employees in 2019. Employer Z is subject to a governmental order that suspends the operation of its trade or business. In response to the governmental order, Employer Z lays off or furloughs all of its employees. It does not pay wages to its employees for the time they are laid off or furloughed and not working, but it continues the employees’ health care coverage. Employer Z’s health plan expenses allocable to the period its operations were partially suspended may be treated as qualified wages for purposes of the Employee Retention Credit.
No Double Benefit. Any wages taken into account in determining the ERC shall not be taken into account for purposes of determining a credit under IRC Section 45S (Family and Medical Leave Act). Also, qualified wages do not include wages taken into account under Sections 7001 and 7003 of the Families First Coronavirus Response Act credit program.
Employees Included Only Once. The ERC does not apply to any employee for which a credit has been allowed under IRC Section 51 (Work Opportunity Credit Program).
Counting Employees for the 100 Employee Test
To define “full-time” for purposes of the 100-employee test, ERC provisions refer to IRC Section 4980H, which states that “full-time employee” means, with respect to any month, an employee who is employed on average at least 30 hours of service per week.
To determine if the employee meets the 30-hour rule, Section 4980H regulations provide that, with respect to hourly employees, employers are required to calculate actual hours of service from records of hours worked. For non-hourly employees, employers should use one of the following methods:
- Actual hours worked from service records,
- A days-worked equivalency, where the employee is credited with eight hours for each day for which the employee would be credited with at least one hour of service,
- A weeks-worked equivalency, where the employee is credited with 40 hours of service for each week for which the employee would be credited with at least one hour of service.
Full-time equivalents treated as full-time employees. IRC 4980H also addresses “full-time equivalents.” It indicates that for purposes of determining the number of full-time employees, in addition to the number of full-time employees for any month, an employer also includes for such month a number of full-time employees determined by dividing the aggregate number of hours of service of employees who are not full-time employees for the month by 120.
Aggregation Rules
For employers who are related through ownership to other employers, measuring the number of full-time employees for the application of the 100-employee test can be complex. Aggregations rules apply that treat multiple employers as a single employer for purposes of the test. The determination depends on the degree of relationship between the employer and other related businesses. These rules include situations involving parent-subsidiary corporation relationships, brother-sister corporation relationships, businesses with a common owner(s), and unincorporated businesses under common control. We suggest that you consult with tax advisors who are familiar with the aggregation rules before claiming the credit.
Other Limitations/Rules
Wages paid to employees who are “related” to the business (i.e., owner-employees) are not eligible for the credit program. Again, complex relationship rules apply. Disqualifying relationships include the following:
- If the employer is a corporation, an individual who owns, directly or indirectly, more than 50% in the value of the outstanding stock of the corporation.
- If the employer is an entity other than a corporation, any individual who owns, directly or indirectly, more than 50% of the capital and profits interests in the entity.
Note that “indirect” ownership means that for purposes of this test, ownership held by an individual can include ownership of other related parties (i.e., entities the individual owns an ownership interest, and other related individuals).
Rules similar to those listed above apply in the case where the business is held in a trust or estate (i.e., beneficiaries, grantors, or fiduciaries or related to any of those), or a sole proprietor (i.e., children, dependents, siblings, parents, in-laws and spouses of the owner of the business). A full discussion of the related party rules is beyond the scope of this article. As mentioned above, the related party rules are often complex and difficult to apply. Consultation with tax advisors familiar with these rules is advised before claiming the credit.
Third Party Employers
Credits allowed under the credit program apply to certified profession employer organizations (CPEO).
Credits Reduce Deductible Wages
No federal income tax deduction is allowed for the amount of wages that equals any credit claimed under the ERC. For this reason (and others, i.e., complexity, etc.), employers are allowed to elect out of the ERC.
Please contact us if you need assistance in assessing the ERC’s impact on your particular situation.
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