Update on the Employee Retention Credit (ERC): Part Two

In addition to the reminders in Part 1 of this blog, the IRS recently issued Notice 2021-49 and Rev Proc 2021-33 that provide several clarifications on ERC issues and opportunities with the credit for both 2020 and 2021. The following ideas are included in the IRS’s guidance:

• Determining Full-Time Employees for ERC Purposes. As noted, the distinction between a small employer and a large employer is based on the number of employees. The number of employees is determined by the number of “full-time employees” at the company as defined by the Affordable Care Act (ACA) provisions for minimum essential health care coverage (under Section 4980H). A full-time employee means “an employee, who with respect to any calendar month in 2019, had an average of at least 30 hours of service per worker or 130 hours of service in the month.”
  The rules for ACA purposes indicate that “full-time equivalents” (FTEs) are added to the number of full-time employees. FTEs is a term measuring the number of full-time employees based on hours worked, rather than the specific number of employees. Each part-time employee is a fraction of one FTE based on the number of hours they have worked.
  The IRS in Notice 2021-49 indicated that in determining whether an employer is a small employer for ERC purposes, companies “are not required to include full-time equivalents.”  This is a favorable interpretation by the IRS and may allow employers near this 500-employee threshold to qualify as a small employer, rather than a large employer, and maximize the ERC benefit.
  Example: XYZ Company had 400 full-time employees and 500 part-time employees in 2019, who converted to 200 FTEs based on the hours worked. Under ACA rules, XYZ would have 600 total employees (400 + 200) but Notice 2021-49 would only include the 400 full-time employees for ERC purposes. Thus, XYZ would be classified as a small employer.
  The IRS notice goes on to provide that in determining eligible wages for ERC purposes, the employee’s status as full-time “is irrelevant and wages paid to an employee who is not full-time may be treated as qualified wages if all other ERC requirements are satisfied.” Therefore, in the above example, XYZ Company gets the best of both worlds: The part-time employees are not counted as full-time employees for ERC purposes, and wages paid to the part-time employees can be included as eligible wages for ERC purposes.
• ERC and Overlap with Tips and Wage Credit. Many employers, especially in the food and hospitality industry, employ workers that receive tips that are generally treated by the employer as wages. The IRS clarified in Notice 2021-49 that tip wages can be treated as wages that are eligible for the ERC. Further, legislation enacted by Congress indicated that an employer could not claim the ERC and several other credits, such as the Work Opportunity Tax Credit, on the same wages. Congress, however, neglected to include the FICA tip credit in this limitation. As a result, the IRS announced that an employer could claim the ERC and FICA tip credit on the same wages. Whether Congress intended this to be treated this way or not, it is a favorable outcome for impacted employers.
• Timing of Disallowed Wage Deduction for ERC Wages. While the ERC provides a significant benefit in a refundable payroll credit, Congress tempered these savings by disallowing a wage deduction for the ERC claimed by an employer. Employers still benefit by receiving the ERC but must reduce their wage expense deduction by the amount of the ERC. There was some uncertainty about when to make the ERC wage disallowance – whether it would be when the wages were paid or when the employer filed and claimed the ERC. The IRS determined that the ERC wage deduction is to be made when the wages are incurred. This may result in an employer filing an amended tax return or an Administrative Adjustment Request (an amended filing used for partnerships).
• Related Individuals. It is not unusual to have various family members work for a closely held business. However, the tax rules with family members can be complex in many cases – and the ERC is no exception. “Exception” is the operative term here, as there can be a web of exceptions in trying to navigate whether family members can be included for ERC purposes. The IRS offered a lengthy analysis on family members as well as several helpful examples in Notice 2021-49 (pages 25-31). Please refer to the IRS discussion and examples for further details.
• Alternative Quarter Election. As noted, an employer can use either the actual gross receipts of a quarter or the prior quarter results under the alternative quarter election in determining the reduction in gross receipts. The use of this election for the prior quarter only relates to that quarter – it does not bind the employer for any other quarters in the 2021 year. Employers are free to use either method for each quarter, and this is considered another favorable, flexible treatment offered by the IRS in this notice.
• Employers can Elect to Exclude Non-taxable Income from PPP Loan Forgiveness from Gross Receipts. As part of the gross receipts analysis, the question has come up about whether tax-exempt income for the forgiveness of PPP loans (and other tax-exempt government grants, such as the Economic Injury Disaster loan, the Restaurant Revitalization Grant and the Shuttered Venue Operators Grant) should be included in gross receipts for these calculations.
  The IRS announced in Rev Proc 2021-33: Those gross receipts should include tax-exempt income from the debt forgiveness of PPP loans. While this is not necessarily favorable treatment, the IRS went on in Rev Proc 2021-33 to allow employers to elect not to include this debt forgiveness income in its gross receipts for ERC purposes. There is no election to file with the IRS, it is just something that employers would factor into their ERC calculations and document in their tax files. Nonetheless, this should assist employers with their ERC analysis. Finally, if an employer previously analyzed whether they qualified for the ERC in 2020/2021 and showed they did not qualify for the ERC, the employer should reexamine their analysis and determine if they might instead qualify for the ERC by excluding the PPP loan debt forgiveness income in their calculations.