The recently passed Consolidated Appropriations Act (“CAA”) contains retroactive changes and expansions to the Employee Retention Credits (“ERC”) that make these previously underutilized tax credits now potentially very lucrative for many small businesses.

As explained in more detail below, three main retroactive changes in the CAA making the ERC applicable to more small business are as follows:

  1. Companies can take advantage of ERC as well as the Paycheck Protection Program.
  2. Employee limit to receive the most favorable treatment of employee wages was increased to 500.
  3. The total drop in quarterly revenues to apply was decreased to a 20% decline.

BACKGROUND

The ERC was created by the CARES Act as a refundable tax credit to encourage businesses to keep employees on payroll.  Unfortunately, businesses that were able to obtain a Paycheck Protection Program (“PPP”) loan were not eligible to also claim ERC credits. The CAA changed that by allowing businesses that obtain a first or second-draw PPP loan to qualify for the ERC. However, businesses are not able to use the same wages included as qualified wages for the purpose of PPP loan forgiveness as qualifying wages for the ERC credit, so careful analysis is required to avoid any potential “double-dipping”.

GENERAL PROVISIONS

The ERC as established by the CARES Act is a fully refundable credit for employers equal to 50% of up to $10,000 in qualified wages (including qualified health plan expenses) paid to employees during the period after March 12, 2020 and before January 1, 2021. The CAA extends those benefits for the period January 1, 2021 to June 30, 2021 and expands the credit to up to 70% of qualified wages. The CAA also expands the total credit available for each employee. For 2020, the credit was capped at $5,000 per employee. For 2021, qualifying businesses will be able to obtain up to $7,000 per employee, per quarter (or $14,000 total per employee).

Example 1 – 2020 Credit Calculation

A company has two employees and qualifies to receive the ERC credit for Q2 and Q3 of 2020. As both employees were paid in excess of the annual wage limit of $10,000, the company’s total qualified wages were reduced by $7,000 ($5,000 for Employee A and $2,000 for Employee B) resulting in net qualified wages of $20,000. Multiplying the $20,000 in qualified wages by the credit percentage of 50% results in a total ERC credit of $10,000. The company would not be eligible to receive any additional ERC credits for Q3 as the $5,000 per employee cap was reached during Q2.

Example 1 – 2020 Credit Calculation

Example 2 – 2021 Credit Calculation

Same facts as in the previous example, however due to the new rules established by the CAA for claiming the credit for 2021, the total allowable credit has increased dramatically. Not only has the credit percentage increased from 50% of qualified wages to 70%, but the $10,000 per employee wage limit is now measured per quarter instead of annually resulting in total ERC credits of $28,000.

Example 2 – 2021 Credit Calculation

As we’ll discuss in the next section, not only are the new ERC credits for 2021 much more generous, the requirements to qualify have been significantly reduced compared to the 2020 credits.

QUALIFICATIONS

The ERC is available to private companies and tax-exempt organizations.  It is not available to publicly owned companies.

To qualify for ERC credits, the business must experience one of the following:

  1. A significant drop in gross receipts of 50% or more during any quarter of 2020 (reduced to 20% for Q1 and Q2 of 2021), or
  2. Had operations fully or partially suspended by government order due to COVID-19.

Businesses that qualify for the credit due to the drop in revenue are eligible to claim the credit for that quarter through the end of the quarter in which its gross receipts are greater than 80% of its gross receipts for that same quarter in 2019. For example, a business that experienced at least a 50% drop in revenue during Q2 of 2020 compared to Q2 of 2019 will be eligible to claim the credit through at least Q3 of 2020.

The CAA reduced the gross receipts reduction requirement to only 20% for Q1 or Q2 of 2021. It also provided a change in methodology allowing a reduction in the prior quarter to qualify a business for the credit in the current quarter. For example, a 20% reduction during Q4 of 2020 (compared to Q4 of 2019) will qualify a business to claim the credit during Q1 of 2021. Presumably, a 20% reduction during Q1 of 2021 (as compared to Q1 of 2019) would be required to qualify for the credit for Q2 of 2021.

For businesses that qualify for the credit due to a government shutdown order, they are only eligible to claim the credit for wages paid during the shutdown period. They will not qualify to claim the credit for the full quarter and following quarter per the above example.

The definition for qualified wages is different depending on the number of full-time equivalent (“FTE”) employees the business had for calendar year 2019. If the FTE’s are 100 or less, all wages paid (and qualified health insurance costs) qualify. If the FTE’s are more than 100, only wages paid to employees who are not working due to the shutdown or drop in gross receipts (i.e. employees who have been furloughed but are still being paid or provided health insurance). This is an important distinction as qualifying employers with 100 or less FTE’s can claim the credit for all wages paid, regardless of if that employee was working or not. The CAA increases the FTE limit before this change in treatment occurs to 500 employees for Q1 and Q2 of 2021. This will allow far more businesses to claim the credit.

LIMITATIONS AND POTENTIAL PITFALLS

Family businesses are subjected to significant limits as wages paid to any family member (child, sister, nephew, uncle, daughter-in-law, etc.) of an individual with more than 50% ownership interest are not considered “qualified wages”.

Business must also comply with the IRS “aggregation rules” which requires that all related entities are considered a single employer. This necessitates that all employees are aggregated when determining the total number of FTE’s as well as gross receipts when calculating reductions in gross receipts.

Self-employed individuals are not eligible to receive the credit in respect to their own self-employment earnings. Wages paid to an individual employed by a self-employed individual can qualify.

As noted above, qualified wages used for the purpose of PPP forgiveness must also be excluded as well as any COVID sick pay or leave for which credits were obtained through the Families First Act or any other such tax credit.

CLAIMING THE CREDIT

The credit can generally be claimed on IRS Form 941 for the quarter in which they apply. Employers who have not yet filed the 941 for Q4 of 2020 may retroactively claim any credits relating to Q2 or Q3 of 2020. Businesses that qualify for the 2021 credit will also have the option to file for an advance payment of the credit. The IRS is still in the process of finalizing these processes.

OTHER CONSIDERATIONS

Second-draw (and new first-draw) PPP borrowers who also qualify for the 2021 ERC credit should carefully consider how they apply qualified wages between the ERC credits and PPP funds to maximize benefits from both. The new expense categories qualifying for loan forgiveness added by the CAA will provide additional opportunities for borrowers to spend PPP funds on non-payroll costs, allowing more wages to be used to qualify for ERC credits. This will require careful planning and analysis on behalf of the business.

Louis Plung and Company is here to help you understand the ERC and other relief opportunities available to you and your business.  Please reach out to us for next steps to pursue these significant opportunities or to see if your business would qualify.