Employee retention credit receives clarification from new IRS guidance

Editor’s note: This article was first published in August 2021 when Revenue Procedure 2021-33 and IRS Notice 2021-49 were first issued. With the passage of the Infrastructure Investment and Jobs Act, the expiration of the employee retention credit was accelerated, and this article has been updated to reflect that.

The Internal Revenue Service (IRS) has issued two pieces of new guidance that clear up several questions about the employee retention credit (ERC) that have been plaguing taxpayers trying to claim the tax credit on their 2020 and 2021 payroll tax returns. This new guidance answers some questions that date back to the enactment of the original credit in March 2020 and clarifies eligibility requirements and calculations for the credit through the third and fourth quarters of 2021. This occurred at the same time that Congress passed legislation to shut down the ERC for most businesses on September 30.

PPP loan forgiveness, grants, and “gross receipts”

Since the ERC was originally enacted in 2020, taxpayers have been asking for clarification on the impact that other COVID-19 relief might have on a business’s gross receipts. Employers can qualify for the ERC in several ways. One method requires that an employer experienced a “significant decline in gross receipts” between the quarter in which eligibility is sought and the same quarter of 2019. Until the IRS released this guidance, taxpayers weren’t sure if COVID-19 relief amounts received from the government — such as Payroll Protection Program (PPP) loan forgiveness, shuttered venue operator grants, and restaurant revitalization grants — should be included in “gross receipts” when calculating a “significant decline.”

In Revenue Procedure 2021-33, the IRS created a special safe-harbor rule that allows taxpayers to exclude amounts received from the COVID-19 relief programs listed above from the calculation of “gross receipts” solely for the purpose of determining ERC eligibility. The safe harbor makes it clear that the amounts are still counted as gross receipts for all other tax purposes. By not mentioning any COVID-19 relief programs aside from the three listed above, the guidance implies that grants or loan forgiveness from any other program will continue to count as gross receipts for the ERC.

The IRS created a special safe-harbor rule that allows taxpayers to exclude amounts received from the COVID-19 relief programs.

Employee tips as “qualified wages”

IRS Notice 2021-49 answered several additional questions that had caused uncertainty for taxpayers hoping to claim the ERC. The notice confirmed tips received by employees count as “qualified wages” for employers calculating credit amounts and that employers could claim both an ERC and a FICA tip credit for the same tips.

The notice confirmed tips received by employees count as “qualified wages” for employers calculating credit amounts.

Treatment of owner wages

The new guidance is not so favorable for wages paid to those who own more than 50% of a business. In general, anybody related to a more-than-50% owner by blood or by marriage can’t be included in the ERC. Constructive ownership rules also apply when determining who is a more-than-50% owner. However, the rules don’t directly disqualify the owner from the ERC unless the constructive ownership rules are looked at broadly. The notice did exactly that, and concluded that the owner can’t be included in the ERC if that individual has a living sibling, spouse, ancestor, or lineal descendant (because that living family member will constructively own more than 50% of the business and the legal owner will be related to the constructive owner). So, wages paid to any person in the family of a more-than-50% owner, including the owner, are usually going to be disqualified from the ERC calculation.

Is the ERC taxable income?

The notice also clarifies a timing issue related to adjusting wage expenses for the ERC. Employers can’t deduct wages that were used in the ERC calculation from taxable income up to the amount of the ERC. The new guidance states that an employer who deducted wages that were also the basis of an ERC claim must adjust income in the year the wages were paid, not the year the law was enacted or the refund claim was filed. Therefore, if an employer files a refund claim for an ERC for a quarter in 2020, the adjustment to taxable income equal to the ERC must also be included on its 2020 federal income tax return, even if that refund claim is filed in 2021 or later. Amended returns will be necessary for businesses that didn’t include adjustments on their 2020 returns.

ERC guidance for Q3 and Q4

The notice also provides information on two areas of expansion for the ERC in the third and fourth quarters of 2021. “Recovery startup businesses” become eligible for the ERC and “severely distressed employers” get to expand the amount of wages that they include in the ERC calculation. Recovery startup businesses are those that began operations after Feb. 15, 2020, and had less than $1 million in annual gross receipts. If they meet the criteria in the law, they calculate the ERC based on the same definition of “qualified wages” used by other eligible employers. The ERC for these businesses is limited to $50,000 per quarter.

Notice 2021-49 provides that some businesses may qualify as “severely distressed employers” in the third and fourth quarters of 2021 if they experience a 90% decline in gross receipts compared to 2019 (see below for subsequent expiration of fourth quarter). The notice provides examples of businesses that qualify as severely distressed and sets forth a process for those businesses to treat all wages paid to employees during that quarter as “qualified wages” for purposes of calculating the ERC.

Expiration of the ERC

With the passage of the Infrastructure Investment and Jobs Act (the Infrastructure Act), the expiration of the ERC was accelerated from Dec. 31, 2021 to Sept. 30, 2021. Only recovery startup businesses remained eligible to claim the ERC until Dec. 31, 2021. Our article from November 2021 has an in-depth discussion of the ERC expiration and how retroactive claims will work.

If you have any questions about how this new guidance on the ERC affects your business, please contact your Plante Moran advisor.