Introduced through the CARES Act of 2020, the Employee Retention Credit (“ERC”) is a fully refundable payroll tax credit meant to encourage businesses and nonprofits impacted by the pandemic, especially “small” organizations, to keep employees on their payroll.
The ERC is generated based on a combination of qualified wages and health plan costs paid to employees. The fully refundable credit means that the business receives the full amount of the ERC regardless of the amount of the organization’s payroll tax liability.
CARES Act of 2020
While the CARES Act introduced the ERC, initially a business could not claim the ERC if it also obtained a forgivable PPP loan. As a result, many businesses did not focus on the ERC or eligibility requirements. For tax year 2020, ERC produced a maximum credit of $5,000 per employee based on wages and health care costs paid during eligible periods from March 13 through December 31, 2020.
Consolidated Appropriations Act, American Rescue Plan Act, and Infrastructure Investment and Jobs Act of 2021
Subsequent legislation to the CARES Act resulted in changes to the ERC program. Under the Consolidated Appropriations Act, obtaining a PPP loan was no longer prohibitive and the ERC benefits per employee were increased. In 2021, the ERC’s maximum benefit was $7,000 per employee per quarter versus a maximum benefit of $5,000 per employee for the entirety of 2020.
Under the American Rescue Plan Act, the ERC was available for Q1, Q2, and Q3 of 2021. For most businesses operating before the pandemic, the Infrastructure Investment and Jobs Act ended the program early by excluding Q4 as an eligible period. However, under the American Rescue Plan Act, “Recovery Startup Businesses,” those opening after February 15, 2020 and with revenue of $1,000,000 or less, could continue to claim the ERC through Q4 of 2021.
There are two paths to eligibility for small businesses. In 2020, a small business was defined as having 100 or fewer full-time employees, and in 2021 having fewer than 500 full-time employees.
- The Decline in Revenue Test:
- For 2020: A business that experienced a 50% decline in gross receipts compared to the corresponding 2019 quarter.
- For 2021: A business that experienced a 20% decline in gross receipts compared to the corresponding 2019 quarter.
- The Partial Shut Down Test:
- For 2020 and 2021: A business where a more than “nominal portion” of operations were partially shut down due to a government order related to COVID-19.
- “Nominal Portion” Defined: The revenue from that portion of the business that was “shut down” is not less than 10% of the total gross receipts from 2019, or (ii) the hours of services performed by employees in that portion of the business was not less than 10% of the total number of hours of service performed by all employees in the business during 2019.
IMPORTANT ITEMS TO CONSIDER
How to Make a Claim: The ERC is claimed by filing amended payroll tax returns (Form 941X).
Documentation and IRS Audit Risk: It is extremely important to keep detailed records to support refund claims. The IRS has signaled that it is gearing up their teams to audit ERC submissions. Businesses must retain records in “sufficiently usable form and detail” to substantiate ERC claims.
Statute of Limitations: The statute of limitations for the 2020 and 2021 ERC do not expire until April 15, 2024 and April 15, 2025, respectively.
PPP Loan Interaction: You must not calculate an ERC with wages paid using PPP funds.
IRS Notice IR-2022-183: On October 19th, 2022, the IRS warned taxpayers to be cautious of third parties advising them to claim the ERC when they may not be qualified. These third parties often charge large upfront fees or a fee that is contingent on the amount of refund. The IRS encouraged businesses to be cautious with direct solicitations promising tax savings that seem too good to be true.
Related Owner Wages: Wages paid to a close relative of a more-than-50% owner are not allowed to be included in the ERC calculation.
Income Tax Return Impact: Businesses must adjust their wage deductions in the amount of the ERC being claimed. The IRS’s guidance states that an adjustment to taxable income in the amount of the ERC must be made in the year the wages were paid and not in the year the refund was filed or received. For example, when a business makes an ERC refund claim for a qualified period in 2020, the business must reduce wage expenses by the amount equal to the credit being claimed, thereby increasing taxable income on the 2020 federal income tax return, even when the ERC was filed in a later year.
Partial Shut Down Eligibility: Extra attention must be paid by businesses seeking to claim the ERC using the Partial Shut Down eligibility test. Essential businesses were not considered to be “partially shut down” unless they had a critical supply chain disruption that affected their ability to continue to operate. Partial Shut Down eligibility criteria should be evaluated carefully and supported by documentation in the event of a future IRS audit.
Refund Timing: Currently, the IRS has a backlog of unprocessed refund claims that is five to six times larger than normal, and a likely length of time to receive the actual refund from the date a claim was made is six months to a year.
BPM has resources to help assess ERC eligibility, determine the estimated size of the ERC benefit, provide detailed calculations and supporting memorandum, prepare amended payroll tax returns, and make claiming the ERC as thorough and efficient as possible.