This is part 1 of a 3-part series that reviews the latest developments of the Employee Retention Credit (ERC), which was first introduced as part of the CARES Act in the Spring of 2020.
Employee Retention Credit – 2020 tax year
In 2020, Congress introduced the Employee Retention Credit (ERC) in response to the pandemic. Employers that qualified for Paycheck Protection Program (PPP) loans were not eligible for the ERC initially. Due to the passing of the Consolidated Appropriations Act, 2021 (CAA), businesses may now be eligible to claim both incentives in 2020 and 2021.
Eligibility for the 2020 ERC can be obtained using one of two methods:
First option – Gross Receipts Test
- The first method looks at quarterly gross receipts as reported on the 2020 tax return in comparison to the same quarter in 2019. An employer qualifies when there is a 50% or greater reduction in gross receipts during a particular quarter when compared to the same quarter in 2019.
- The employer qualifies for subsequent quarters of 2020 until they reach 80% or more of gross receipts when compared to the same quarter in 2019. If they reach that standard in the subsequent quarter, then the employer would not qualify for ERC in the next quarter – unless their gross receipts again drop below 50% of the same quarter in 2019.
- Ultimately, any employer who qualifies for the ERC in one quarter will automatically qualify in the subsequent quarter.
Second option – Shutdown Test (Full or Partial)
- In the event that a government order caused a business’ operations to be fully or partially shut down, an employer may qualify for the ERC. Since the ERC came into existence, the IRS has published guidance in the form of Notices 2021-20, 2021-23 and 2021-49 to aid in determining eligibility. There are many scenarios, despite the guidance, not specifically covered by the IRS. Employers and their advisors are left wondering whether they qualify for the ERC in their situation and whether any additional IRS guidance will be issued. Employers should carefully document their facts, circumstances and interpretations of the rules that qualify them for the credit.
Next, for small employers, defined for 2020 as those with 100 or less full-time employees in 2019, the ERC is generated on payroll expenses of employees regardless of their work status. For large employers (generally defined as having more than 100 employees in 2019), the ERC can only be claimed if the employee is paid not to work. While this may seem unlikely to occur, careful review of the facts, circumstances and the definition of “not working” can present some opportunities.
Examples: a large employer that laid off employees but continued to pay their health insurance would have qualifying payroll expenses eligible for the ERC. Or, the employer could qualify for some of the ERC if it continued to pay employees their full wage, even though the employees were only working, say, half their normal schedules.
The next step in the ERC calculation is to determine what qualifying expenses were incurred during that entire quarter (if using the gross receipts method) or the period of the shutdown (if using the shutdown test). Generally, wages and health insurance expenses qualify for the credit calculation. Remember that the most you can gain from a credit in 2020 is $5,000 per employee, as employers are limited to 50% of the first $10,000 of an employee’s qualifying payroll expenses.
The final component to this calculation is to determine if any of these qualifying expenses were already claimed for another credit under the Families First Coronavirus Response Act (FFCRA) or PPP forgiveness. You also have to consider wages and benefits used to calculate the R&D credit, as most expenses cannot be claimed under this program and the ERC.
Employee Retention Credit – 2021 tax year
The 2021 ERC rules created more opportunities for employers. Three significant changes expanded both eligibility and the amount of credit that could be generated.
- Under the Gross Receipts test, the decline in gross receipts that caused eligibility was reduced to 20% when compared to the same quarter in 2019. Under the alternative quarter test, an employer qualifies for the subsequent quarter if the previous quarter dropped more than 20%. This rule came into play for 2021’s first quarter, where there was a 20% or greater drop in the last calendar quarter of 2020.
- The credit amount was expanded to allow for up to $7,000 per quarter/per employee. The calculation changed to permit 70% of the first $10,000 of qualifying payroll expenses for each employee each quarter.
- The definition of small employer expanded to be an employer with 500 or less employees in 2019. This change significantly increased the number of employers eligible for the ERC and the amount of the credit they were entitled to.
Please note that the ERC was only effective for most employers during the first three quarters of 2021. There is one exception that we will discuss later.
Beyond the above three changes, the same methods to qualify apply: either an employer must meet the 2021 gross receipts test, or they must meet the standard of a full or partial suspension of operations due to a government order. Impacted employees and their payroll expenses only qualify under the latter test during the period of time that the government order caused the suspension. Documentation should be retained in the event the ERC claim is audited to support not only the nature of the government order, but the duration of the order.
Recovery Startup Businesses – 2021 tax year
In the Spring of 2021, President Biden signed the American Rescue Plan that introduced the ERC rules specific to a new category of business: a Recovery Startup Business.
To qualify as a Recovery Startup Business, a separate set of rules apply:
- The entity began carrying on a trade or business after February 15, 2020.
- Its average annual gross receipts for the three-year tax period ending with the tax year that precedes the calendar quarter, for which the ERC is determined, does not exceed one million dollars.
- It was not an otherwise eligible employer due to a full or partial suspension of operations or a decline in gross receipts.
The rules only apply for the third and fourth quarters of 2021. The business can earn credit on 70% of the first $10,000 of payroll expenses per employee in each quarter, but the total credit allowed for each quarter cannot exceed $50,000. Employees that own 50% or more of the business do not qualify for this credit.
IRS backlog of unprocessed ERC claims
A June 2022 IRS report indicated that the IRS had 218,000 payroll returns (Form 941-X) to process, which declined by 3,000 from the previous week. Many of these amended payroll returns contain ERC refund claims. More recently submitted claims seem to be processed in shorter timeframes; however, there are many claims that await processing.
Recent Government Accountability Office (GAO) report
This past May, GAO reported that of the 2020 ERC claims it had reviewed, to date approximately 120,000 different employers submitted claims for a total of $10.9 billion. Food service and accommodations, retail, and manufacturing sectors collected 40% of the total 2020 ERC claims. Of the GAO sample of ERC claims submitted, GAO estimated a 12.33% error rate. The GAO expects much of the compliance activity to be handled after the amended returns are filed and the credits are paid.
Timeline to file for the ERC
There is still time to determine your eligibility for the ERC and file a refund claim. Quarterly payroll tax returns can be amended for up to three years. All quarterly returns for the calendar year 2020 are considered to be filed on April 15, 2021. Thus, amended returns for 2020 can be filed on or before April 15, 2024.
For 2021, amended payroll returns can be filed on or before April 15, 2025.