New Employee Retention Credit Guidance in IRS Notice 2021-49
Co-authored by Stanley Rose
The IRS recently issued guidance clarifying some ambiguities of the Employee Retention Credit (“ERC”). What it lacks in terms of a flashy name (“Notice 2021-49”), it more than makes up for with its length and complexity, and the purpose of this article is to provide a brief overview of its content.
First, some context: The ERC was created by the CARES Act in early 2020. A previous BNN article describes the original characteristics of the credit, but it has gone through a number of changes since its creation. In its current form applicable to 2021 outlays, it generally works as follows:
Employers can become eligible for the credit in a quarter using any one of four alternative ways:
- By carrying on a trade or business during calendar year 2020, if operations were fully or partially suspended during a 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 COVID-19;
- By experiencing a significant decline in gross receipts as a result COVID-19 disruptions. In turn, a qualifying decline in a quarter may be achieved in one of two ways:
(a) For any of the first two quarters in 2021, earning revenues in that quarter that were 80% or less than those earned in the same quarter in 2019, or
(b) Performing the same test as in (a) above, but using the immediately preceding quarter, compared to its corresponding quarter in 2019.
In other words, a quarter can qualify by looking to its own quarter or the previous quarter, in either case looking for a 20% drop in revenue compared to what it experienced exactly two years earlier. Note that 2020 is omitted in the comparisons immediately above; the focus instead is on a “normal” year (2019) vs. an impacted year (2021). However, if a business did not exist in a 2019 quarter, its 2020 counterpart may be used in the computation.
- By meeting the criteria of a “recovery startup business,” which is one that began operations after February 15, 2020 and has average annual gross receipts of $1 million or less;
- As a “financially distressed employer,” which is an employer of any size with gross receipts less than 10% of the gross receipts of the same calendar quarter in 2019.
The credit is generally equal to 70% of the first $10,000 of wages and certain employer health plan expenses paid during the qualifying quarter to employees, although qualifying expenses are subject to integration with certain other COVID-related incentives. For “large” employers (those with a headcount of 500 or more), qualifying wages are amounts paid only to those who were unable to work as a result of the pandemic. For employers with a smaller than 500 headcount, wages paid to working and nonworking employees are eligible.
The credit is obtained primarily via a reduction in the employer’s share of payroll taxes as reported by filing Form 941 (Form 7200 can be used to obtain an advance credit after reducing the employer’s payroll tax liability for required tax deposits). As a so-called “refundable” credit, any excess of the credit over those tax amounts not only wipes out the otherwise-due FICA or Medicare tax payable to the IRS, but also creates a refund due to the employer.
What Notice 2021-49 brings to the table
Much of Notice 2021-49 reintroduces what Congress laid out in the American Rescue Plan Act of 2021. But it also tackles several questions the IRS and Treasury Department received on the ERC. In an IRS news release that accompanied the notice (IR-2021-165), we find a list of those issues that we will address below. Some resolutions are clearly favorable to taxpayers, while others produce a stingier result.
- Full-time employee vs. full-time equivalents: Recall that “large” employers can include wages in the credit computation only for employees who were displaced. The notice explains that for purposes of the 500-employee headcount that distinguishes a “large” employer from smaller taxpayers, employers do not have to include full-time equivalents. However, just because those employees are (favorably, from the employer’s perspective) excludable from the headcount doesn’t mean their wages must be removed from the costs on which the credit is based (70% of wages, up to the limit). Instead, those wages continue to qualify as long as other aspects of the credit are met.
- Treatment of tips: The notice explains that tips that are treated as wages (generally those that reach or exceed $20 received by any one employee during a month) should also qualify as wages for purposes of the ERC. Also, there are many instances in the Internal Revenue Code (“IRC”) and related federal tax laws that prevent outlays which generate one benefit from also creating another. Section 45B of the IRC has for some time included a so-called Tip Credit. The notice clarifies that the same dollars used to generate the Tip Credit may also be used to generate the ERC. This greenlight to go “double-dipping” is rare, and quite taxpayer-friendly.
- Reduction of wage deduction – timing and potential amended returns: Some history is in order to understand this issue. Originally, the 2020 iteration of the ERC was not available for taxpayers who received a PPP loan. Because PPP loans (especially those that were forgiven) were generally much more beneficial, many employers did not utilize the ERC. Just before Christmas 2020, Congress threw taxpayers a stocking stuffer, allowing them to pair ERC and PPP benefits together, as long as the same expenditures were not used to generate both benefits. This led to many taxpayers requesting 2020 ERCs during early 2021. However, there also is a prohibition (that was not undone by Congressional gift-giving) against deducting wages (on an income tax return) that were used to generate the ERC. (You can choose the deduction or the credit, but not both for the same outlay.) This left taxpayers in a quandary: If the credit is received during 2021, but the related wage expense was generated in 2020, on which return should the taxpayer report the wage deduction reversal – 2020 or 2021? Most were hoping to have the convenient option of reporting it on their 2021 returns, but Notice 2021-49 (released, by the way, just a few short weeks before the extended filing deadline for most entities’ 2020 tax returns) requires the adjustment to be made on 2020 returns. Specifically, taxpayers are to reduce the wage and qualified health plan expense deduction reported on 2020 tax returns by the amount of the retention credit generated, similar to rules applicable under Section 280C. For those who already filed 2020 returns, this will require filing an amended return, or administrative adjustment request (AAR), if applicable.
- Wages paid to majority owners and spouses: Arguably, the least taxpayer-friendly feature of the notice is the IRS conclusion regarding whether wages paid to more than 50% owners of an entity, or to the spouses of those owners, are eligible for the ERC. The statutory law created by Congress is always a higher source of authority than the IRS/Treasury Department’s rules, but it is an understatement to say that it often is difficult to understand what Congress meant with its choice of words. In this instance, the statutory text is ambiguous at best, and when that is the case, the next-highest source of authority controls, and Notice 2021-49 became that source. In it, the IRS leads us through a roundabout discussion of several sections of the IRC, including those addressing other credits and related party/constructive ownership rules, and determines that wages paid to majority owners and their spouses generally are not qualifying wages for purposes of the ERC. However, the path they took to get there also produces an odd exception.
The IRS arrives at their conclusion (that payments to majority owners and their spouses generally do not constitute qualifying ERC wages) through an analysis that appears to be technically correct, but very twisted. Rather than identifying authority that directly prevents the wages from qualifying when paid by a controlled entity to its owner or owner’s spouse, it uses long-established family attribution rules to view the entity as essentially controlled by members of the owner’s family. Those rules are combined with others curbing benefits derived from payments to related parties, thereby denying qualification of the owner’s (or spouse’s) wages. However, this indirect path also leads the IRS to conclude that a limited exception exists in cases where the majority owner has no living relatives. Because the only path to denial goes through relatives, the absence of those relatives cuts off that path. This greatly oversimplifies the IRS’s very complex analysis and, for the majority of the time, the wages paid to majority owners and their spouses will not generate incremental amounts of the ERC.
The material discussed above provides only an overview of portions of Notice 2021-49, focusing primarily on two taxpayer-friendly passages, and two less-than-friendly ones. Favorably, the presence of full-time equivalents proves helpful to taxpayers in multiple ways, and the ERC can be combined with the preexisting Tip Credit. Unfavorably, many taxpayers will have to file amended 2020 returns if they retroactively claimed the 2020 ERC (after the rules preventing pairing with PPP loans were lifted), and most wages paid to majority shareholders and their spouses are ineligible for the ERC.
The information above is based on guidance already issued. However, we are aware of potential legislation that could impact it further. Specifically, the infrastructure bill being kicked around Washington includes language that would terminate the ERC at the end of next month, instead of its scheduled expiration date of December 31, 2021. We will update you further as any such changes materialize.
For more information or a discussion on how this may impact you, please contact your BNN advisor at 800.244.7444.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.