Claiming and Defending the Employee Retention Credit

The Employee Retention Credit (ERC) is a generous credit of up to $5,000 per employee for the year (March 13 to December 31, 2020) and up to $7,000 per employee per quarter (January 1 to September 30, 2021, though a recovery startup business may claim ERC through December 31, 2021). The potential ERC for any eligible employer could be quite significant. For example, a business with 200 employees could potentially be eligible for an ERC of up to $1.4 million in just one quarter in 2021. Eligible businesses with a significant decline in receipts (bright line test) or with operations that were fully or partially suspended due to a government order (facts and circumstances test) that did not claim the ERC on their original employment tax returns may take advantage of the ERC by filing an adjusted employment tax return IRS Form 941-X to claim the ERC credit for prior quarters. It can be anticipated soon the Internal Revenue Service will be scrutinizing ERC claims, whether taken on original or amended returns.

The ERC’s Four Iterations

The ERC, which is codified in section 3134 of the Internal Revenue Code of 1986, as amended, has a complicated statutory history. It has been amended three times over the course of less than two years, after initially being put in place by the Coronavirus Aid, Relief and Economic Security (CARES) Act in March 2020. The Taxpayer Certainty and Disaster Tax Relief Act of 2020 (Relief Act), enacted December 27, 2020, amended and extended the ERC to the first and second calendar quarters of 2021. The American Rescue Plan Act of 2021 (ARP Act), enacted March 11, 2021, modified and extended the ERC to the third and fourth quarters of 2021. Then, the Infrastructure Investment and Jobs Act (Infrastructure Act), enacted November 15, 2021, terminated the employee retention credit for wages paid in the fourth quarter of 2021 for employers that are not recovery startup businesses. The IRS website currently has a nice summary chart available “Employee Retention Credit – 2020 vs 2021 Comparison Chart” (available at www.irs.gov/newsroom/employee-retention-credit-2020-vs-2021-comparison-chart).

ERC Eligible Employers

For 2020, any employer operating a trade, business or a tax-exempt organization may be an eligible employer; however, governments, their agencies, and instrumentalities, may not be. For 2021, the Relief Act expanded the definition of an eligible employer to include certain government employers including federal credit unions, colleges or universities, and entities providing medical or hospital care. In addition, the business must experience either a significant decline in gross receipts or a full or partial suspension of operations due to a government order due to COVID-19. Beginning in the third calendar quarter of 2021, special rules are provided for recovery startup businesses.

When the CARES Act was originally enacted, a business that received a forgivable Paycheck Protection Plan (PPP) loan could not qualify as an eligible employer. However, this limitation was retroactively changed so that an eligible employer can take the ERC provided that ERC wages are not paid with PPP funds.

ERC Refundable Credit on Qualified Wages Against Employer’s Share of Employment Taxes

The ERC is a refundable tax credit of 50 percent per employee for the year (2020) or 70 percent per employee per quarter (2021) against up to $10,000 of qualified wages that applies to employment taxes, specifically, the employer’s share of Social Security taxes in 2020 and the first and second quarters of 2021 and against the employer’s share of Medicare taxes after that (because of ARP Act as explained in Notice 2021-49). This translates into an ERC of up to $5,000 per employee per year in 2020 or up to $7,000 per employee per quarter in 2021.

Unless otherwise excepted, qualified wages are wages and compensation (subject to Social Security and Medicare taxes) paid by an eligible employer to some or all its employees (excluding certain employees related to the employer) and include the eligible employer’s qualified health plan expenses that are properly allocable to such wages.

Whether an eligible employer’s wage payments are qualified wages depends on the average number of full-time employees in 2019. To be considered “full-time,” an employee, with respect to any calendar month, must have been employed for an average of at least 30 hours of service per week or 130 hours of service in such month. Employees of a controlled group are treated as a single employer.

For the 2020 ERC, for an eligible employer with greater than 100 average full-time employees in 2019, only wages paid to employees not providing services are qualified wages, but an eligible employer with 100 or fewer average full-time employees in 2019, wages paid to employees providing services in addition to wages paid to employees not providing services are qualified wages. For the 2021 ERC, the 100 average full-time employee cut off was increased to 500, making many more employers eligible for ERC on all of their employees whether or not providing services. Beginning in the third calendar quarter of 2021, a severely distressed employer may treat all wages as qualified wages.

The ERC can add up quickly, especially in 2021.

Significant Decline in Gross Receipts

The bright line test for whether an employer is eligible for the ERC is whether the employer experienced a significant decline in gross receipts. For 2020, a significant decline in gross receipts begins when gross receipts for a quarter in 2020 are less than 50 percent of gross receipts for the same calendar quarter in 2019 and ends in the first calendar quarter after the calendar quarter in which gross receipts are greater than 80 percent of gross receipts for the same calendar quarter in 2019. An IRS FAQ provides an example:

Employer I’s gross receipts were $100,000, $190,000, and $230,000 in the first, second, and third calendar quarters of 2020, respectively. Its gross receipts were $210,000, $230,000, and $250,000 in the first, second, and third calendar quarters of 2019, respectively. Thus, Employer I’s 2020 first, second, and third quarter gross receipts were approximately 48 percent, 83 percent, and 92 percent of its 2019 first, second, and third quarter gross receipts, respectively. Accordingly, Employer I had a significant decline in gross receipts commencing on the first day of the first calendar quarter of 2020 (the calendar quarter in which gross receipts were less than 50 percent of the same quarter in 2019) and ending on the first day of the third calendar quarter of 2020 (the quarter following the quarter for which the gross receipts were more than 80 percent of the same quarter in 2019). Thus, Employer I is entitled to a retention credit with respect to the first and second calendar quarters.

For 2021, the 50 percent decline requirement was amended to less than 80 percent of gross receipts for the same calendar quarter, making the decline requirement easier to hit. Also, for calendar quarters in 2021, an alternative quarter election rule was added that gives employers the option of looking at the prior calendar quarter and comparing it to the same calendar quarter in 2019 to determine whether there was a decline in gross receipts. A rule was also provided for employers not in existence in 2019 to allow them to compare a quarter in 2021 to the same calendar quarter in 2020.

Full or Partial Suspension of Operations Due to a COVID-19 Government Order

The significant decline in gross receipts test is mathematically complicated but fairly straightforward as compared to the facts and circumstances test of whether “the operation of the trade or business … is 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 the coronavirus disease 2019 (COVID-19).” 26 U.S.C. § 3134(c)(2)(A)(ii)(I).

There are multiple facts and circumstances that may be at play. Was there a governmental order that applied to the employer? Was the employer an essential business that was exempted from the governmental order? What was the effect of the governmental order on the employer’s business?

Unsurprisingly, the IRS has not promulgated regulations to provide substantive guidance regarding the ERC; rather, IRS guidance takes the form of IRS Notices and FAQs.

The IRS has taken the position that the following is not a circumstance that would indicate that an employer has a full or partial suspension of its operations due to a government order:

• An employer that operates an essential business that is not required to close its physical locations or otherwise suspend its operations is not considered to have a full or partial suspension of its operations for the sole reason that its customers are subject to a government order requiring them to stay at home. IRS FAQ 32.

In contrast, the following is such a circumstance, when a government order’s effect on an employer’s suppliers, as compared to its customers, result in a government order influencing the employer’s operations:

• An employer with an essential business may be considered to have a full or partial suspension of operations if the business’s suppliers are unable to make deliveries of critical goods or materials due to a governmental order that causes the supplier to suspend its operations. IRS FAQ 31.

Further, according to the IRS, following is another circumstance that would indicate that a business has a full or partial suspension of its operations due to a government order where that business operates in multiple jurisdictions:

• Employers that operate a trade or business in multiple locations and are subject to State and local governmental orders limiting operations in some, but not all, jurisdictions are considered to have a partial suspension of operations. Employers that operate a trade or business on a national or regional basis may be subject to governmental orders requiring closure of their locations in certain jurisdictions but may not be subject to such a governmental order in other jurisdictions, including because it may be an essential business in some of those jurisdictions. To operate in a consistent manner in all jurisdictions, these employers may establish a policy that complies with the local governmental orders, as well as the Center for Disease Control and Prevention (CDC) recommendations and the Department of Homeland Security (DHS) guidance; in this case, even though the employer may not be subject to a governmental order to suspend operations of its trade or business in certain jurisdictions, and may merely be following CDC or DHS guidelines in those jurisdictions, the employer would still be considered to have partially suspended operations. Therefore, the employer would be an Eligible Employer with respect to all its operations in all locations. IRS FAQ 36.

Other circumstances are more complicated, especially in the IRS’s view, where an employer was able to pivot to remote work or a government order had only a nominal effect:

• If an employer’s workplace is closed by a governmental order, but the employer can continue operations comparable to its operations prior to the closure by requiring its employees to telework, the employer’s operations are not considered to have been fully or partially suspended because of a governmental order. However, if the closure of the workplace causes the employer to suspend business operations for certain purposes, but not others, it may be considered to have a partial suspension of operations due to the governmental order. IRS FAQ 33.
• If an employer’s workplace is closed by a governmental order for certain purposes, but the employer’s workplace may remain open for other purposes or the employer is able to continue certain operations remotely, the employer’s operations would be partially suspended. However, if all an employer’s business operations may continue, even if subject to modification (for example, to satisfy distancing requirements), such a modification of operations is not considered to be a partial suspension of business operations due to a governmental order, unless the modification required by the governmental order has more than a nominal effect on the business operations under the facts and circumstances. IRS FAQ 34.

The IRS has provided examples in its FAQs as well as a disclaimer, “This FAQ is not included in the Internal Revenue Bulletin, and therefore may not be relied upon as legal authority. This means that the information cannot be used to support a legal argument in a court case.” While the IRS’s FAQs are not binding authority, they are a good indication of the IRS’s view.

IRS Enforcement

One can imagine a myriad of points of disagreement between taxpayers and the IRS. The IRS has already issued a temporary regulation allowing the IRS to recapture excess employment tax credits, including the ERC. And the IRS just received $45.6 billion in funding for enforcement.

Too much sugar for a dime? The IRS has cautioned against inflated refunds as one of its 2022 “Dirty Dozen” scams. Red flags? The IRS cautions, “Not signing a return is a red flag that the paid preparer may be looking to make a quick profit by promising a big refund or charging fees based on the size of the refund.”

Assume that the IRS will examine an ERC position. Ensure that the ERC position is a good position. Evaluate it considering the Internal Revenue Code and available IRS guidance. Always be prepared for a review, audit, or exam, especially for a big dollar issue like the ERC. Assemble and maintain documents supporting all aspects of the positions taken in arriving at the ERC, especially if adjusted (i.e., amended) returns are being filed.

This is a modified version of Mark A. Loyd’s regular column, Tax in the Bluegrass, “Claiming and defending the Employee Retention Credit” which appeared in Issue 4, 2022 of the Kentucky CPA Journal.

November 28, 2022