Employee Retention Credit
By Lauren Olán, Esq, LLM
There are a lot of companies that have popped up recently promoting Employee Retention Credit (“ERC”) refunds, and in a frenzy to get to market, have contacted many companies to harvest ERCs, many times with little to no regard to whether the taxpayer qualifies. In this article, we unpack the rules, which are complex, to help taxpayers understand if they qualify for the ERC.
In March 2020, Congress passed The Coronavirus Aid, Relief, and Economic Security Act (CARES Act), purportedly to relieve some of the economic fallout caused by the COVID pandemic. As a component of the business-directed COVID relief, the CARES Act established the Employee Retention Credit (“ERC”). ERC is a refundable employment tax credit meant to help with the costs of keeping staff employed during the pandemic. While the ERC brought an extremely valuable benefit for those businesses most affected during shutdowns, there is an abundance of confusion surrounding how to claim the credit and who qualifies for ERC. Much of this confusion comes from the fact that the ERC has been amended three separate times. Confusion is further promulgated by ERC mills, as highlighted in published IR-2022-183. The IRS warned employers in IR-2022-183 to be wary of third parties who are advising employers to claim ERC even when an employer may not qualify. In this article, we will walk through the several amendments of the ERC, advanced issues with ERC, and discuss the ongoing issues with ERC fraud and unsubstantiated claims.
1. The First Appearance of ERC: the CARES Act of March 2020.
When the CARES Act was passed in 2020, it established the basic eligibility framework and the basic tests for the ERC. At the time, the eligible period to evaluate was March 13, 2020 thru December 31, 2020. An eligible employer that meets the eligibility requirements can claim the credit on their employment tax return, which would offset the employer’s portion of Social Security tax. The percent of qualified wages eligible for the credit is 50% and the maximum credit is $5,000 per employee for the entire year, NOT per quarter.
An eligible employer is any employer operating a trade, business, or a tax-exempt organization, but not governments (including their agencies and instrumentalities). Small employers, those with 100 or less full-time employees in 2019, could be eligible under both the revenue and the non-revenue provisions, which are explained below. The wages paid are eligible whether the employees were paid to provide services or paid to not work. Large employers, those with greater than 100 full-time employees in 2019, however, only qualify if the employees were paid not to work and can qualify under either the revenue or non-revenue provisions.
The two basic tests for ERC eligibility are that the employer (1) must have had experienced a significant decline in gross receipts (the “Revenue Provision”) OR (2) experienced a full or partial suspension of operation in a given quarter (the “Non-Revenue Provision”). The Revenue Test provides that a significant decline in gross receipts begins when there is a decline of 50%+ in a given quarter compared to the same quarter in 2019.
While this was an attractive credit, the rules still were not greatly understood, and many employers were opting to apply for the SBA-backed Paycheck Protection Program (PPP) loan instead.
2. The First Amendment to the ERC: the Relief Act of 2021.
The first amendment to the ERC came on December 27, 2020, with the passing of The Taxpayer Certainty and Disaster Tax Relief Act of 2020 (Relief Act). The Relief Act extended the eligibility for the ERC into June 2021, established the 2021 eligibility rules and introduced us to the Alternative Quarter Election.
While there was no change to how the credit would be claimed on the employment tax return, the percent of qualified wages and the maximum credit DID change. For quarters in 2021, the percent was increased to 70% and the maximum credit was increased to $7,000 per employee per quarter.
The Relief Act expanded the definition of an eligible employer for 2021 quarters to include certain governmental employers that are: (1) organizations described in Section 501(c)(1) and exempt under 501(a), and (2) colleges or universities or whose principal purpose is to provide medical or hospital care. The definitions of small employers and large employers was also modified. A small employer for 2021 are those with 500 or less full-time employees in 2019 and a large employer are those with greater than 500 employees in 2019.
The existence of the revenue and non-revenue provisions remained and had a change in what constitutes a significant decline for the revenue provision. For 2021 quarters, a significant decline in gross receipts begins when there is a decline of 20%+ in a given quarter compared to the same quarter in 2019. The added Alternative Quarter Election which provides that an employer would be allowed to look at the prior quarter, instead of the given quarter, and compare to that same quarter in 2019 to determine if there was a decline in gross receipts.
The Relief Act also provided a rule for employers who were not in existence in 2019 to determine whether there was a decline in gross receipts by comparing the 2021 quarter to its gross receipts to the same quarter in 2020. Additionally, these employers would also be allowed to use the Alternative Quarter Election. An example of this would be if the employer qualified for the ERC in the fourth quarter of 2020, then they could qualify in the first quarter of 2021.
3. The Second Amendment to the ERC: the American Rescue Plan Act of 2021.
The ERC was again amended on March 11, 2021, with the enactment of The American Rescue Plan Act. This amendment again extended the ERC from July 1, 2021 to December 31, 2021, established special categories of businesses/employers, and changed how the credit would offset employment tax. The amendment further expanded the credit by making employers eligible for both ERC and PPP loans, with the limitation that wages cannot be double counted for the two. This became a game changer for many businesses and provided a lot of additional relief.
The two new special categories we were introduced to by the amendment were Recovery Startup Businesses and Severely Financially Distressed Employers. Recovery Startup Businesses are employers who do not otherwise meet the already established eligibility requirements. These are employers that (1) began carrying on a trade or business after February 15, 2020 AND (2) had average annual gross receipts under $1 million for the 3 taxable year period ending with the taxable year that precedes the quarter the credit is determined. These businesses would have the credit made available to them for the third and fourth quarter of 2021.
The second special category, Severely Financially Distressed Employers, are those employers that are eligible with gross receipts that are less than 10% of the gross receipts in a given quarter compared to the same quarter in 2019.
An eligible employer will still claim the credit on their employment tax return; however, it would now offset the employer’s portion of Medicare tax, not Social Security tax. The percent of qualified wages eligible for the credit and maximum credit remained unchanged. For the third and fourth quarter of 2021, Severely Financially Distressed Employers can treat all wages as qualified wages during the quarter they are severely financially distressed. Additionally, Recovery Startup Businesses are limited to a $50,000 credit per quarter.
4. The Final Amendment to the ERC: the Infrastructure Investment and Jobs Act (IIJA).
The final amendment to the ERC came on November 15, 2021, with the enactment of the Infrastructure Investment and Jobs Act (IIJA). The greatest change the IIJA brought is that it retroactively removed the ERC extension to the fourth quarter of 2021 for most employers. The fourth quarter is now only available for wages paid by a Recovery Startup Business. This resulted in numerous employers having to amend their employment tax returns to remove this quarter.
The IIJA further refined the definition of a Recovery Startup Business by removing the requirement that it is not otherwise meet the eligibility requirements (full or partial suspension or decline in gross receipts). The Act also provided that because there was unavailability of decline gross receipts, the rules for Severely Financially Distressed Employers would not apply for the fourth quarter.
5. Advanced Issues: Safe Harbors created under IRS Notice 2021-20.
While the revenue provision provides for specific percentages to work with, the non-revenue provision of the ERC looks more at the facts and circumstances when evaluating whether an employer is eligible for the ERC. To help with this, the IRS provides two safe harbors under IRS Notice 2021-20. These two safe harbors are commonly known as the 10% Tests.
The first safe harbor is a “more than nominal portion” test. If a business component constituted “more than nominal portion” (10%) of either (1) gross receipts or (2) total employee service hours during 2019 and was operationally shut down, the business can qualify for the ERC. The second safe harbor is a “more than nominal effect” test. If the effect of government orders or restrictions has a “more than nominal effect” (10%) on the operations of a business, this business can qualify for the ERC.
6. Advanced Issues: Additional Qualifications for Aggregation and a Supply Chain Qualification.
The ERC also includes additional qualifications for aggregation and a supply chain qualification. Once aggregation for multiple businesses is determined, all aspects of ERC eligibility analysis must be applied as if the group is a single employer. The IRS also allows the definition of full-time employees to include an employee who worked either 30 hours a week or 130 hours a month.
The Supply Chain Qualification is an extremely narrow qualification that is not often used to qualify for ERC. To qualify for the ERC under this, the following must be met: (1) the supplier cannot make deliveries of goods to the employer due to a government order, (2) employer is unable to purchase equivalent goods from another supplier, AND (3) employer must experience a “more than nominal effect” as a result.
7. Fraud and Unsubstantiated Claims.
Since the ERC can provide up to $26,000 per employee in credits, the rate of fraud in claiming this credit has greatly increased. The IRS continues to warn businesses of third-party schemes that advise employers to claim the ERC when they may not even qualify. As recent as March 7, 2023, the Acting IRS Commissioner Doug
O’Donnell stated that “while this is a legitimate credit that has provided a financial lifeline to millions of businesses, there continue to be promoters who aggressively mislead people and businesses into thinking they can claim these credits.” Even tax professionals are noting that they are continuously pressured by people who want to claim the ERC when they are not even eligible.
While there has been an emergence of pop-up providers (started by private equity, banks, venture capital and hedge funds) that have the best of intentions, many of these providers do not have the proper background in these types of tax credits to accurately advise employers. The providers are doing things such as not applying the 10% tests, not properly applying Supply Chain qualifications, and improperly backing out non-qualified wages. It is important to consult a trusted accounting professional if you are interested in the ERC.
Those employers who may have claimed the ERC in error, have not amended their employment tax returns due to the ERC amendments, or have not even claimed the credit because they do not know where to start, should consult a tax professional to get the most out of the ERC credit.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advise. You should consult your own tax, legal and accounting advisors before engaging in any transaction.