Employee Retention Credit Guidance

On Thursday, August 4th, the IRS released Notice 2021-49 which addressed many outstanding questions about the rules for the Employee Retention Credit (ERC) and provided guidance for claiming the credit for the 3rd & 4th quarters of 2021.

Some of the guidance provided by the IRS is favorable to taxpayers, however the IRS’ interpretation of the rules for eligibility of wages for majority owners and related persons will result in unfair differences in eligibility for similarly structured businesses. Below is a discussion of selected provisions of Notice 2021-49:

Eligibility of Owner’s Wages

Since the Employee Retention Credit was first enacted in the CARES Act, there was a rule disallowing the wages of employees who are related to a more than 50% owner of the business. The list of persons considered to be related included brothers and sisters, children, parents, lineal ancestors or descendants, nieces & nephews, and aunts and uncles.[1] Spouses are not included in this list. This led to the question of whether the wages of a more than 50% owner, who had no other relatives working for the business other than a spouse, would qualify for the ERC.

To See Related Party Examples from Notice 2021-49, please click here.

The guidance from the IRS in the notice is that due to the stock attribution rules in Section 267(c), if a majority owner of the business, has any living relatives as listed above, the stock of the owner is attributed to that relative thus making the owner a relative of a more than 50% owner and disqualifying the owner from claiming the credit.

This results in a surprising exception where the wages of a sole shareholder, or shareholder who has a spouse, will qualify only if they have no other living relatives described above, regardless of whether those relatives are employees or owners of the business.

Calculation of Full-Time Employees for “Large Employer” Status

The ERC has more stringent requirements for employers deemed to be “large employers”, restricting qualifying wages to only those paid to employees during a period when the employee was furloughed (not working). For 2020, the threshold to be considered a large employer was more than 100 full-time employees. The threshold was increased to 500 for 2021.

The Notice clarifies that in calculating the number of full-time employees, only the number of individual full-time employees are included; the employer is not required to include full-time equivalent amounts from part-time employees. Furthermore, the wages of part-time employees are still included in calculating the credit. This change could greatly increase the credit available to employers who have large numbers of part-time employees.

The threshold to be considered full-time is an average of 30 hours per week or 130 hours per month.

Alternate Quarter Election

Businesses, other than Recovery Startup Businesses, who are not considered fully or partially shutdown during a quarter, may qualify for the ERC if their gross receipts are reduced in the quarter by a specified amount as compared to the equivalent quarter in 2019. In 2020 this threshold was a greater than 50% decline and in 2021 a greater than 20% decline was required. The ERC rules allow an alternative quarter election whereby the business bases the eligibility for the current quarter on the gross receipts decline in the prior quarter. For example, a business whose receipts for the second quarter of 2021 declined by 18% as compared to the second quarter of 2019 could be eligible if they make the alternative quarter election and their gross receipts for the first quarter of 2021 had declined by more than 20% as compared to the first quarter of 2019.

Many taxpayers and tax professionals were unsure, once the alternative quarter election was made, whether the taxpayer had to continue calculating eligibility based on the prior quarter or if they could choose each quarter whether to base eligibility on the current quarter vs. 2019 or the prior quarter vs. 2019. The notice clarified that this choice is available each quarter, independent of the choices that were made previously. This effectively means that if a business has a sufficient decline in gross receipts in a given quarter to qualify for the credit, it will automatically be eligible in the subsequent quarter.

Timing of Wage Deduction Disallowance

An employer receiving a credit under the ERC must reduce their wage deduction by the amount of the credit. The Notice confirms that this reduction must be made in the income tax return for the taxable year in which the wages were paid or accrued, rather than the year in which the credit was refunded or credited against the employer’s payroll tax liability. Accordingly, taxpayers who amended prior quarter Forms 941 to claim the credit may also have to amend their income tax returns to adjust their wage deductions.

Applicability of Wages for Tipped Employees and Interaction with the Tip Credit

The Notice states that an employee’s cash tips of $20 or more per month that are reported as wages may be treated as wages for the Employee Retention Credit. Additionally, the Section 45B “Tip Credit” on excess tips received by employees may be claimed on the same wages as the ERC.

Changes impacting only the 3rd & 4th Quarters of 2021

The American Recovery Plan (ARPA) extended the Employee Retention Credit to the 3rd and 4th quarters of 2021, added new exceptions to the qualification rules for “recovery startup businesses” and “severely financially distressed” businesses, and made other modifications. The Notice included clarifications regarding the implementation of these new rules:

  • Recovery Startup Businesses – This category includes employers who started their business after February 15, 2020, who have annual gross receipts of less than $1 million, and who do not otherwise qualify for the credit due to being fully or partially shutdown or having a decline in gross receipts. Such businesses will automatically qualify for the ERC in the 3rd & 4th quarter of 2021. Businesses qualifying as recovery startup businesses will be limited to a maximum credit per quarter in the 3rd & 4th quarters of 2021 of $50,000. The notice states that the average gross receipts will be determined based on the 3 taxable year period ending before the applicable quarter. The determination of whether a business is a recovery startup business will be made each quarter. Aggregation rules may apply in making the determination of whether a business qualifies as a recovery startup business and in applying the $50,000 limit per quarter.
  • Severely Financially Distressed Employers – The ARPA also added an exception to the large employer rules for “severely financially distressed employers,” those whose gross receipts declined more than 90 percent compared to the same calendar quarter in 2019. Such employers will be treated as if they were small employers for purposes of the ERC. The notice discusses the rules for determining whether an employer is considered severely financially distressed, provides examples on making this determination, and notes that the alternative quarter election may be used for this determination as it is used for the regular gross receipts test.

Please contact us with questions regarding how this credit can benefit your business.

 

[1] Step parents and parents-in-law are included as are step siblings and siblings-in-law.