The Employee Retention Credit (ERC) has been one of the more widely used tax incentives introduced by Congress to provide pandemic relief to employers. Below is a brief timeline of what has played out over the past 20 months involving the ERC:
- March 2020: The CARES Act unveiled the ERC, but the credit received little attention from middle-market employers when enacted, as most of these employers sought Paycheck Protection Program (PPP) loans instead. Nonetheless, larger employers (those with more than 500 employees) were generally not eligible for PPP loans and, rather, claimed ERC benefits if they paid their employees not to work.
- December 2020: Congress then made significant changes to the ERC and PPP – a major revision allowing companies to claim both the ERC and PPP. As a result, the ERC was reenergized, and many employers took advantage of the credit for 2020 and 2021.
- March 2021: Next, Congress and the Administration passed the third major COVID-19 relief bill with the “American Rescue Plan” (ARP). The ARP made further changes to the ERC, including (1) extending the credit for the third and fourth quarters of 2021; and (2) establishing a new type of ERC, the “Recovery Startup Credit” (RSC).
- November 2021: Last, Congress passed the infrastructure bill. While this included few tax measures, one change ushered in further revisions to the ERC. The legislation repealed the ERC for the fourth quarter of 2021, which was unusual, as it was already halfway through the quarter. While the ERC was eliminated for the fourth quarter, it was retained for the RSC. Thus, employers could still claim the RSC during this period.
You might be familiar with the ERC but not so much the RSC. So, let’s explore it. The new law defines a “recovery startup business” as an employer:
- that began carrying on any trade or business after February 15, 2020;
- for which the average annual gross receipts of the employer for the three-taxable year period, ending with the taxable year that precedes the calendar quarter for which the credit is determined, does not exceed $1 million; and
- that is not otherwise an eligible employer due to a full or partial suspension of operations or a decline in gross receipts.
A recent example of a startup business that qualifies as an RSC is a new franchise that starts its first operation. Another example includes an entrepreneur that decides to raise capital to develop and build a disruptive technology solution in the healthcare industry. Let’s look at each of these qualifications a little closer:
What does this all mean? First, a recovery startup business must have begun its trade or business after February 15, 2020. The IRS indicates that employers should look to the general guidance under Section 162 for the definition of a trade or business; however, the statute does not define this in great detail. Notice 2021-49 states, “a taxpayer has not begun carrying on a trade or business until such time as the business has begun to function as a going concern and performed those activities for which it was organized.” This is a facts-and-circumstances analysis, so business owners will need to look at the steps they took and the dates their business started to engage in those functions and see if their business meets the definition. Please note: this would apply not only to a trade or business, but also to a tax-exempt organization.
What is not addressed in the IRS guidance is whether a new company, formed as part of an acquisition of an existing business after February 15, 2020, would qualify as a recovery startup business. Therefore, any business that was formed after February 15, 2020 to acquire the assets of an existing business should analyze whether it might qualify as a recovery startup business.
Next, let’s analyze the average gross receipts test. On the surface, this requirement is a little confusing. How does a business that started after February 15, 2020 have three years of prior gross receipts? The IRS unfortunately did not elaborate on this conundrum in Notice 2021-49. A possible explanation is if the employer was in business for those years but just expanded by starting a new trade or business after February 15, 2020. Presumably, the employer would use any gross receipts it had for periods prior to the third and fourth quarters of 2021 for this $1 million test. If an employer has not been in business for at least three years, generally they would average the gross receipts for the number of years their business has existed. Further, any gross receipts reported for less than a full year of operations would presumably be annualized to determine if the new business is under the $1 million gross receipts threshold. There is always the possibility that the IRS will expand its ERC guidance and address this issue.
The third requirement restricts a startup business that can qualify as a recovery startup business. If an employer otherwise qualifies for the ERC under either: (1) the full or partial government shutdown test; or (2) the significant reduction in gross receipts test, they must use that ERC calculation. If an employer does not qualify for the regular ERC rules, they could qualify under the RSC rules. This overlap can only occur in the third quarter of 2021, as the regular ERC is not available in the fourth quarter.
For example, in the third quarter of 2021, ABC Company, which initiated operations in June 2020 and has average annual gross receipts of less than $1 million, generated a regular ERC of $200,000. It also determined it qualified for the $50,000 RSC in the third quarter. In this case, ABC would be allowed the regular ERC of $200,000. But, in the fourth quarter of 2021, ABC would be eligible for the RSC of up to $50,000.
You may have heard of sizable ERC benefits that employers have generated this year – with wages of up to $10,000 per employee per quarter permitted in 2021 (resulting in a max ERC of $7,000 per employee per quarter). The RSC provides the amount of ERC in the third or fourth quarter of up to $50,000 per quarter. Based on its qualifying wages, if a startup business calculates a credit of $75,000 in a quarter, it would be capped at $50,000. Alternatively, if the startup business determines a credit of only $40,000, this $40,000 is all it would be eligible for in that quarter.
Issues with the Recovery Startup Credit
In 2020, a small employer is any employer with 100 employees or less – but for 2021, a small employer is any employer with less than 500 employees. The importance of the designation as a small versus a large employer is significant. A small employer is eligible for the ERC for all wages paid to their employees whether employees are working or not. However, large employers are only entitled to the ERC for wages paid to employees not working. For purposes of the RSC, the statute is unclear if a recovery startup business is treated as a large or small employer. The IRS announced in Notice 2021-49 that wages paid by a recovery startup business are to be treated as wages from a small employer for ERC purposes. This is a favorable determination.
You may recall that a tax-exempt organization is considered a trade or business as it relates to the ERC and is, therefore, entitled to the credit. Ultimately, tax-exempt organizations are eligible for the RSC if they operate according to their tax-exempt status. Please note: a not-for-profit organization employer would measure their gross receipts for ERC purposes as provided by the IRS in Notice 2021-20.
Below, we provide links to the following resources for your reference:
The ERC has been a significant stimulus allowing businesses to continue operations and retain employees amid challenges. While it was curtailed by the recent infrastructure bill, it is still available through the end of 2021 for recovery startup businesses. This is something every startup business should evaluate.
Keep this in mind as you file your fourth quarter 2021 Form 941 before the due date, January 31, 2022. This timely filing could expedite receipt of this credit for you.
Please contact your Sikich advisor if you need assistance in obtaining this credit or evaluating your eligibility.