Among the many and varied COVID relief measures instituted by the federal government, the Employee Retention Credit (the “ERC”) stands out as one of the most significant to US employers as well as one of the most complex. While the ERC has not garnered as much media attention as the Payroll Protection Program (the “PPP”), the ERC has provided, and will continue to provide, significant economic relief to eligible employers. In addition to fully understanding the background of this tax credit, employers should also understand how to best prepare for a possible IRS ERC audit if they file a claim.
The ERC is a refundable payroll tax credit originally introduced in section 2301 of H.R. 748, the Coronavirus Aid, Relief, and Economic Security Act (the CARES Act), on March 27, 2020. The original legislation set the ERC to expire on December 31, 2020, but on December 27, 2020, the ERC was enhanced and extended to June 30, 2021, by the Consolidated Appropriations Act of 2021 (the “CAA”). The changes and enhancements passed by the CAA effectively created two different sets of rules, one for wages paid in 2020, and another for wages paid in 2021. The ERC was further extended to December 31, 2021, by the American Rescue Plan Act (the “ARPA”). Most notably, the ERC was retroactively repealed as it applies to Q4 of calendar year 2021 by the Infrastructure Investment and Jobs Act (the “Infrastructure Bill”).
In addition to the complex statutory text, the IRS has since released 94 FAQs on its website, four official Notices totaling 165 pages, and one revenue procedure. The Joint Committee on Taxation (the “JTC”) also released its own commentary on the ERC in April 2020. An employer considering this credit has a lot of material to digest to understand its application, risks, and benefits.
This overview includes five key considerations encountered by employers already claiming or considering claiming the ERC.
- An overview of the requirements and IRS ERC guidance with examples of how different industries and employers have applied the requirements to their own facts and circumstances.
- Deeper dive into the eligible employer requirement confronting questions such as, “how does the IRS define gross receipts?” And “what does a partial suspension due to government orders mean and how do you prove it?”
- Deeper dive into the qualified wages requirement confronting questions such as, “what does it mean for an employee to be compensated while not providing services?” And “how do you, the employer, document qualified wages for an IRS ERC audit?” This section will also cover the difference between a large and small employer and how to decide where your business fits.
- Calculating and monetizing the credit. Now that all ERC claims are retrospective, working with your payroll team, payroll provider, and/or PEO can raise unique issues independent of the ERC itself.
- What to expect from and how to prepare for an IRS ERC audit of your ERC claim.
1. Overview of ERC Requirements
The CARES Act provides that an eligible employer may claim a refundable payroll tax credit equal to a percentage (50% in 2020 and 70% in 2021) of qualified wages. The statute further defines an eligible employer as any employer:
- Carrying on a trade or business in 2020 (later modified to include 2021); AND
- Whose trade or business was fully or partially suspended during any calendar quarter “due to orders from an appropriate governmental authority limiting commerce, travel, or group meetings due to the coronavirus disease”, OR
- During any calendar quarter, experienced a decline in gross receipts of at least 50% in 2020 or 20% in 2021 when compared to the corresponding quarter in 2019.
Few employers struggle with the first criteria requiring that they carry on a trade or business, although even this issue is not always simple. The same cannot be said for the next two criteria.
The value of the ERC is determined by calculating “qualified wages.” For large employers, the CARES Act defines qualified wages as Medicare wages paid by an eligible employer, “with respect to which an employee is not providing services due to circumstances described” in the eligible employer definition sections. For all eligible employers, the value of the credit in 2020 is 50% of the first $10,000 in qualified wages paid to employees capped at a max credit per employee of $5,000 for the entire 2020 calendar year. In 2021, the CAA increased the max value of the credit to 70% of the first $10,000 in qualified wages paid per quarter, per employee with qualified wages. So, $7,000 per quarter per employee with qualified wages. Simply put, an eligible employer can potentially claim as much as $5,000 per employee in 2020 and $21,000 per employee in 2021. The value of the tax credit can be summarized as follows:
|2020 Q2 – Q4||50% of $10,000 in qualified wages for a max credit of $5,000 per employee|
|2021 Q1||70% of $10,000 in qualified wages for a max credit of $7,000 per employee|
|2021 Q2||70% of $10,000 in qualified wages for a max credit of $7,000 per employee|
|2021 Q3||70% of $10,000 in qualified wages for a max credit of $7,000 per employee|
|2021 Q4||Retroactively repealed by the Infrastructure Bill|
|Maximum available credit: $26,000 per employee|
2. Eligible Employer
The statute defines an eligible employer as any employer with a trade or business in 2020 or 2021. However, the CARES Act excluded government employers from the ERC. The CAA carved out an exception for certain government employers such as hospitals and universities for 2021. This CAA enhancement was not made retroactive to 2020.
The CARES Act further defines an employer as “all persons treated as a single employer” under IRC sections 52(a) or (b) and 414. Taxpayers need to pay attention to these aggregation rules as the rules are complex and are articulated in the code, case law, IRS ERC publications, etc. Small employers with family ownership structures may find it difficult to determine which entities, and therefore which employees, must be included in an aggregated group for purposes of the ERC.
Concepts such as Identical Ownership Requirement, Controlling Interest Requirement, and Effective Control Requirement may determine the level of participation in the ERC. For some perspective, the following is an example from the IRS on determining a brother-sister controlled group based on multiple individual ownership interests:
The only outstanding class of stock of each corporations P, W, X, Y, and Z is owned by the following unrelated individuals:
|Individuals||Corporations|| || |
|B||45||49||0||0||0||0 (if considering all corporations)|
|C||0||0||45||0||0||45 (if considering only Corporations P and W)|
Corporations P, W, X, Y, and Z are not members of a brother-sister controlled group. However, Corporations P and W are members of a brother-sister controlled group.
The good news is that the ERC did not introduce a new standard of aggregation, but defers to existing definitions and regulatory guidance. For some C corps with a clear org chart, the analysis may be less complex. For private equity, small businesses, family businesses, etc., applying the aggregation rules will likely require professional assistance.
Determining whether an employer is fully or partially suspended has turned out to be one of the more difficult pieces to place on the ERC board. Even in Q2 2020, when state and local governments ordered businesses to shut down temporarily, many businesses struggled with the question of whether and to what extent those orders applied. For example, questions regarding whether a business was essential and could remain open caused some businesses to shut down until the business owners could reasonably answer this question. A direct order shutting down an industry or geography can simplify the eligible employer determination for some, e.g., elective procedures in hospitals, in-room dining at restaurants, day care centers. For most, however, the answer is much less clear.
The statutory language requires that an employer be fully or partially suspended “due to” COVID government orders. This seemingly simple language raises many questions. Which government organizations are considered authorities for purposes of the ERC? The IRS noted federal, state, and local governments would satisfy this ERC requirement, but what about a business being suspended due to an order from a foreign government? The auto industry, for example, relies heavily on foreign factories to produce and ship parts to US distributors and dealerships. What about orders from OSHA, state universities, local school districts, etc.? What about “recommendations” from federal, state, and local governments? Not adhering to a recommendation from a state governor may lead to significant liability if non-compliance can be shown to lead to employees being placed at risk and resulting in harm. The recommendation may be as authoritative as an order to employers doing their best to keep employees safe.
Determining whether a government order has a direct enough impact to justify participation in the ERC is also problematic. What does “due to” mean? How direct or indirect the “due to” causation needs to be is not clearly defined by the statue or any subsequent commentary or guidance by the IRS. The IRS does provide a notable example of when they consider the causation to be too far removed to be considered appropriate to justify eligible employer status. Originally articulated in IRS ERC FAQ 32, and later formalized in IRS Notice 2021-20 Q&A 13, in the IRS’s view, if a government order requires the customers of a business stay at home, but the business is otherwise permitted to remain open, the business is not considered suspended due to the order. This may be a difficult pill to swallow for businesses who were severely impaired due to shelter-in-place and other stay-at-home orders which reduced or eliminated customer traffic. On the other hand, the IRS acknowledges that an indirect impact of government orders to a business’s supply chain may be sufficient to prove eligibility. If a supplier is suspended from providing critical goods or materials to a business due to a government order, the IRS appears to be comfortable that such an indirect impact from a government order on a business could result in that business being considered eligible. However, if the same business can procure the critical material, but the consumers are prohibited from purchasing the goods from the business, the IRS is less comfortable that this indirect impact results in the business being eligible for the credit. Apparently, which part of the consumer/provider ecosystem is disrupted is important to the IRS in determining ERC eligibility.
Further, the term “partial” was not defined in the CARES Act and the IRS has proposed their own standard for taxpayers to consider. In Notice 2021-20, Q&A 11, the IRS proposes that in order to be considered partially suspended, an employer should demonstrate that a government order suspended “more than a nominal portion” of the business operations. The IRS further provides a metric to determine this nominal threshold. It proposes that if the suspended portion of the business represents more than 10 percent of the total 2019 gross receipts, the suspension will be “deemed” to be more than nominal. Alternatively, if the hours of service performed by employees in the suspended portion of the business represent more than 10 percent of the total hours of service of all employees in 2019, the suspension will also be deemed more than nominal. Experian Employer Services has confirmed with the IRS that their use of the term “deemed” indicates the establishment of a “safe harbor” standard rather than a baseline requirement. This implies that the IRS may still consider a suspension to be more than nominal under the facts and circumstances even if it doesn’t meet one of the two standards above to be deemed more than nominal. The IRS isn’t clear in this Notice as to whether the denominator of the equation includes all receipts from all members of the aggregated group, just from the EIN or business location affected, or some other metric. The same questions exist for the total hours ratio.
The reality is that when the legislation was drafted, the expectation was that the country would shelter in place for a few weeks and then go back to normal. These questions likely weren’t addressed in 2020 because the pandemic and its economic impact weren’t expected to reach the levels it has reached in the past 18 months.
The legislation is clear that the suspension of operations must be due to a government order. A business voluntarily suspending its operations is not sufficient.
The other option for establishing eligibility is the gross receipts test. Where applicable, this test simplifies the process tremendously although it has its own complications. The gross receipts test is objective and mathematical and does not necessarily need to be due to any COVID orders or restrictions.
Gross receipts, for purposes of the ERC, are defined by IRC 448(c) and accompanying treasury regulations. While not always simple, the ERC does not introduce a new, unique definition of gross receipts. The analysis may become complex in the case of a business that didn’t exist for all or part of 2019, when a business acquired another business in 2019, 2020, and/or 2021, etc. IRS ERC helpful guidance and instructions are provided for most of these situations. A word of caution: gross receipts recorded for book accounting may not be the same as gross receipts considered under IRC 448(c). If unclear, consult with your CPA.
The statute provides, and the IRS clarified, that the gross receipts determination is made by comparing the calendar quarter gross receipts for the period in question to the same quarter in 2019. For example, an employer looking to claim the credit in the second calendar quarter of 2021 would compare the gross receipts from that quarter to the gross receipts in Q2 2019.
3. Qualified Wages
Wages are defined as IRC section 3121(a) wages and IRC section 3131(e) compensation.
The CARES Act defined qualified wages, for a large employer, as wages paid by an eligible employer for which an employee is not providing services due to circumstances described in the eligible employer definition analysis. “[N]ot providing services” is the extent of the guidance provided in the statute. Existing labor laws and employment tax rules generally assume that any remuneration paid to an employee is in exchange for services. This concept of paying an employee for not providing services is mostly unique to the ERC and therefore can be difficult to apply.
The difficulty of defining qualified wages was highlighted by initial tension between the IRS and Congress on this topic. The original IRS ERC FAQs specifically excluded certain healthcare benefits provided to furloughed employees from the definition of qualified wages. In response, Senator Chuck Grassley, then Chair of the Senate Finance Committee, Congressperson Richard Neal, then Chair of the Ways and Means Committee, and Senator Ron Wyden, then Ranking Member of the Senate Finance Committee, sent a letter to then Treasury Secretary Steven Mnuchin challenging the IRS’s position on this topic. Within a week, the IRS updated their website to reflect new ERC FAQs clearly stating that certain healthcare costs paid to furloughed employees may be considered qualified wages.
The IRS has expressed its position that wages paid to severed employees or to employees taking “pre-existing vacation,” sick leave, or personal leave should be excluded from qualified wages. This may be frustrating to some employers whose employees took paid time off due to COVID quarantine requirements or who permitted employees to dip into personal/sick time to avoid furloughs or reduced pay scenarios. In some cases, wages paid to an employee under an existing paid leave policy may appear to be squarely within the definition of qualified wages found in the statute. For example, a business location may have been closed down for 3 days by a state COVID order and non-exempt employees who were unable to work for those three days used vacation pay to avoid lost wages. In this scenario, it’s hard to imagine how this isn’t squarely within the statutory definition as well as legislative intent of the CARES Act.
The IRS seems to draw a distinction in its guidance between paid time off based on an existing leave policy and paid time off due to a new leave policy. Employers who developed COVID leave policies permitting employees to take paid leave above and beyond any existing paid leave policy should be more comfortable with claiming these wages as qualified wages.
Identifying and Tracking Qualified Wages
How does an employer identify and track wages paid to an employee when the employee is not providing services? If the employees are sent home for an entire day, week, or month and continue to receive pay, the tracking is simple. Most real-life scenarios aren’t this simple. In many real-life situations, some employees had much less work to do due to COVID restrictions. Doctors and nurses in a hospital may have experienced a significant decline in work needed to be performed due to restrictions on elective procedures. When possible, these medical professionals were redeployed so that some of their time may have been replaced with other work, but not entirely. Employees in an office who were now working from home due to government ordered office closures may have been able to provide some of their normal responsibilities, but not all of them due to restricted access to supplies, tools, facilities, etc. in the office. Delivery drivers who were unable to make deliveries to non-essential businesses may have experienced significant downtime during their day as they waited for delivery orders for essential businesses.
In these and other scenarios, the employer likely did not have an HR or timekeeping system to track fluid inactivity in a pay period. Where objective metrics are available, such as call volume in a call center, the analysis may be less complex. In many situations, objective metrics were not available. In those cases, surveys, interviews, statistical sampling, etc. may be useful in quantifying and documenting inactivity during the pay period.
To further complicate this analysis, some employees may be tracked and quantified differently than others in a large workforce. Delivery drivers may be analyzed differently than software developers at the same company.
Large vs. Small Employer
The size of an employer’s workforce plays a crucial role in the ERC analysis. An eligible employer with less than a specific number of full-time employees (100 for 2020 and 500 for 2021) using 2019 headcount may include all wages paid to employees for the relevant eligibility period as qualified wages in the credit calculation. The CARES Act incorporates the Affordable Care Act (the “ACA”) definitions of full-time employee found in IRC 4980H. For those familiar with IRC 4980H, you will appreciate that this isn’t always simple. Seasonal employees, measurement periods and measurement methods must be considered. IRS form 1094-C is generally a good (but not perfect) point of reference to demonstrate full-time headcount in 2019.
In addition to reviewing the ACA rules, an eligible employer must also consider the aggregate employer rules mentioned previously as the employer size is determined on an aggregate basis, not individual EIN basis. Some exceptions may apply such as passive investments by private equity in portfolio companies, for example. Whether an ownership interest is passive is a facts and circumstances analysis and should be reviewed by a professional.
An employer who had 323 full-time employees in 2019 would be considered large in 2020 and small in 2021. In 2020, this employer would need to analyze when wages were paid to employees not providing services, but in 2021 could include all wages paid to employees regardless of whether services were provided. An employer with 75 full-time employees in 2019 could apply the simplified calculation in both 2020 and 2021.
The expansion of the large employer threshold by the CAA in December 2020 had a significant impact on the effectiveness and application of the ERC. Expanding the headcount to 500 opened the door for many more employers to participate who would otherwise not have found any significant value in the ERC. This expansion was also consistent with the SBA definition of a small employer for many of its stimulus measures including the PPP. Please note that the CAA’s expansion of the large employer threshold only applies to calendar quarters in 2021 and was not applied retroactively to 2020.
4. Calculating and Monetizing the Credit
After all of this, the good news is that the calculation is relatively straight forward. Relatively. Many employers struggle with identifying IRC 3121(a) Medicare wages, but simple workarounds are available. Employers may also struggle to identify certain healthcare costs by pay period. The complexity of this stage of the ERC is in developing and running a calculation that accurately captures Medicare wages by pay period and by employee and can apply the qualified wage metric unique to each pay period and employee throughout the credit period. Small employers are significantly simplified, but an accurate calculation is necessary in any scenario. The calculation must also be able to consider wages claimed on other credits/incentives such as the PPP, the Work Opportunity Tax Credit (the “WOTC”), the Family First Coronavirus Relief Act (the “FFCRA”) Paid Leave Credit, etc. Reconciling wages claimed in each of these benefits is necessary for an accurate credit claim.
Previously, the ERC may have been claimed by one of three methods: Filing form 7200 to claim an advance payment, claiming the credit on form 941 to claim the credit on an original return, and claiming the credit on form 941-X to claim the credit on an amended return retroactively. Currently, only one method remains which is to claim the credit on form 941-X for the relevant quarter as a retroactive amendment to the original form 941. Per the form instructions, a taxpayer may amend form 941 within 3 years of the date the form was filed. Forms 941 are considered filed on April 15 of the succeeding year following the calendar quarter in which the form was filed. This means that employers who are eligible but who have not yet claimed the ERC in 2020 and 2021 still have time. This continues to be a relevant and available stimulus measure for eligible employers.
5. Documentation and IRS ERC Audit
The analysis is complete. The credit has been claimed. Now what? Now is the time to make sure your file is documented, and you are comfortable you won’t have to rely on your memory to answer an IRS ERC auditor’s questions in 3–5 years about how exactly you determined your credit claim. Ideally, this documentation should be done contemporaneously with the credit analysis and calculation, but there is still time to go back and make sure you can support your credit under an audit, IRS or otherwise. Interviews, surveys, payroll data, analysis, calculations and applicable government orders all should be saved in a single file that can be retrieved by multiple members of the employer organization if needed. In Notice 2021-20, Q&A 70, the IRS provided a list of ERC documentation to substantiate eligibility for the credit. This list included:
- Documentation to show how the employer determined it was an eligible employer that paid qualified wages, including:
- Any governmental order to suspend the employer’s business operations;
- Any records the employer relied upon to determine whether more than a nominal portion of its operations were suspended due to a governmental order or whether a governmental order had more than a nominal effect on its business operations;
- Any records the employer used to determine it had experienced a significant decline in gross receipts;
- Any records of which employees received qualified wages and in what amounts; and 101
- In the case of a large eligible employer, work records and documentation showing that wages were paid for time an employee was not providing services.
- Documentation to show how the employer determined the amount of allocable qualified health plan expenses.
- Documentation related to the determination of whether the employer is a member of an aggregated group treated as a single employer for purposes of the employee retention credit and, if so, how the aggregation affects the determination and allocation of the credit.
- Copies of any completed Forms 7200 that the employer submitted to the IRS.
- Copies of the completed federal employment tax returns that the employer submitted to the IRS (or, for employers that use third-party payers to meet their employment tax obligations, records of information provided to the third-party payer regarding the employer’s entitlement to the credit claimed on the federal employment tax return).
The ERC is remarkable for its value and its scope of application. But that comes with a price and the price is a high degree of complexity and uncertainty. Employers should not be afraid of claiming the credit as it was intended to help support the economy through a historic, global pandemic. But employers should be careful in applying the standards and definitions of the credit to their workforce. A reasonable interpretation of the rules as demonstrated by a well-documented file should be sufficient to protect the credit under an IRS ERC audit. Learn more by speaking with an Experian Employer Services tax expert on this subject.