March 1st IRS Notice Provides Essential Guidance And Safe Harbors For The Employee Retention Credit

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On Monday, March 1st, the IRS released 102 pages of well-written and reasoned guidance on the Employee Retention Credit (ERC) in the form of Notice 2021-20. While further guidance will be forthcoming as to the application of these rules for 2021, the provisions of the Notice provide considerable guidance in a number of areas, as evidenced by the length of this article.

For 2020, Employers can receive a credit for 50% of Qualified Wages paid to their employees up to a maximum credit of $5,000 for the year. In order to be eligible for the credit the business must meet one of the following two tests:

  1. The operation of the business is fully or partially suspended due to orders from a government authority limiting commerce, travel, or group meetings due to COVID-19, in which case the credit applies for Qualified Wages paid during the period of suspension. OR
  2. Gross receipts are less than 50% of the gross receipts for the same quarter in the previous year, in which case the credit will continue to apply up until the end of the quarter in which gross receipts are 80% of the gross receipts for the same quarter in the previous year.

In 2021, the credit is increased to 70% of Qualified Wages and limited to $7,000 of credit for each quarter. In addition, the gross receipts test only requires a 20% drop in gross receipts in order to qualify when comparing the first two quarters of 2021 to the same quarter in 2019.

IRS Notice 2021-20 gives dozens of examples of what businesses can qualify to receive the Employee Retention Credit if more than a “nominal portion” of its business operations are fully or partially suspended by a governmental order that limits “commerce, travel, or group meetings (for commercial, social, religious, or other purposes) due to the coronavirus disease 2019 (COVID-19).”

If more than a nominal portion of the business’s operations are suspended, then the Employee Retention Credit can be claimed regardless of whether the employer had a reduction in revenue during the calendar quarter when the shutdown or reduction of operations occurred, and will apply to any qualifying shutdown or reduction in operations that occurred after March 12, 2020, up through January 1, 2021.

The Notice also provides much-needed guidance on the interaction of the Employee Retention Credit with the Paycheck Protection Program (PPP) Loans. Previously, if a business received a PPP loan, the business was not allowed to also claim the Employee Retention Credit. The Economic Aid Act eliminated this rule, and instead provided that businesses could claim both the Employee Retention Credit and receive a PPP loan just that the business could not count the same wages for PPP loan forgiveness and the Employee Retention Credit. The Notice provides guidance on how employers can “elect out” of claiming the Employee Retention Credit so that the wages can count towards PPP loan forgiveness or vice versa.

Some of the more prominent guidance issued under IRS Notice 2021-20 is as follows:

1. Good News for PPP Borrowers Who Will Claim the Credit

The most relevant section of the Notice for most people deals with the intersection of the Employee Retention Credit and loans under the Paycheck Protection Program. Wages used to qualify for PPP loan forgiveness are disallowed from being treated as Qualified Wages under the ERC, and visa-versa. Prior to this Notice, borrowers had no guidance as to how these two programs interacted and what accounting was necessary to keep the two separate.

The good news is that the Notice makes this process relatively simple in that the “election” is made simply by not claiming the ERC on the Form 941 Federal Employment Tax Return. The Notice further states that to the extent wages are included as a payroll cost on the PPP loan forgiveness application, the business is deemed to have made the “election” out of claiming the ERC with respect to such wages.

In welcome news to many PPP borrowers, the Notice provides that a business will only be deemed to make the election out of claiming ERC for the minimum amount of wages that will result in loan forgiveness taking into account any other eligible expenses reported on the PPP loan forgiveness application. This means that borrowers that reported more payroll costs than necessary to achieve full PPP loan forgiveness no longer need to be concerned with amending a PPP loan forgiveness application to remove the excess payroll costs, since the deemed election out of ERC only applies to the minimum amount of wages needed to achieve full forgiveness. This is illustrated by the following example contained in the Notice:

Example: Employer A received a PPP loan of $100,000. Employer A is an eligible employer and paid $100,000 in qualified wages that would qualify for the employee retention credit during the second and third quarters of 2020. In order to receive forgiveness of the PPP loan in its entirety, Employer A was required, under the Small Business Administration (SBA) rules, to report a total of $100,000 of payroll costs and other eligible expenses (and a minimum of $60,000 of payroll costs). Employer A submitted a PPP Loan Forgiveness Application and reported the $100,000 of qualified wages as payroll costs in support of forgiveness of the entire PPP loan. Employer A received a decision under section 7A(g) of the Small Business Act in the first quarter of 2021 for forgiveness of the entire PPP loan amount of $100,000.

Employer A is deemed to have made an election not to take into account $100,000 of the qualified wages for purposes of the employee retention credit, which was the amount of qualified wages included in the payroll costs reported on the PPP Loan Forgiveness Application up to (but not exceeding) the minimum amount of payroll costs, together with any other eligible expenses reported on the PPP Loan Forgiveness Application, sufficient to support the amount of the PPP loan that is forgiven. It may not treat that amount as qualified wages for purposes of the employee retention credit.

A second example illustrates how the deemed election out applies when non-payroll costs are reported in addition to excess payroll costs, again saving PPP borrowers from having to amend PPP loan forgiveness applications to remove excess wages:

Example 4: … Employer C submitted a PPP Loan Forgiveness Application and reported the $200,000 of qualified wages as payroll costs, as well as $70,000 of other eligible expenses, in support of forgiveness of the PPP loan. Employer C received a decision under section 7A(g) of the Small Business Act in the first quarter of 2021 for forgiveness of the entire PPP loan amount of $200,000. In this case, Employer C is deemed to have made an election not to take into account $130,000 of qualified wages for purposes of the employee retention credit, which was the amount of qualified wages included in the payroll costs reported on the PPP Loan Forgiveness Application up to (but not exceeding) the minimum amount of payroll costs, together with the $70,000 of other eligible expenses reported on the PPP Loan Forgiveness Application, sufficient to support the amount of the PPP loan that was forgiven. As a result, $70,000 of the qualified wages reported as payroll costs may be treated as qualified wages for purposes of the employee retention credit.

In addition, in the event that wages are reported as payroll costs on the PPP loan forgiveness application (and thus deemed to have made the election out of claiming the ERC with respect to those wages) and PPP loan forgiveness is subsequently denied for all or a portion of the loan then such wages may subsequently be taken into account for purposes of claiming the ERC. The Notice provides several useful examples on the taxpayer-friendly coordination between the ERC and PPP loans.

2. 10% Threshold Test for Determination of Partial Suspension of Business Opportunities

One key element of this Notice is the definition of “partially suspended” for purposes of closing a workplace due to government order. The Notice provides that if an employer’s workplace is closed, but may remain open for limited purposes, those operations may be considered “partially suspended” if “the operations that are closed are more than a nominal portion of its business operations and cannot be performed remotely in a comparable manner.” (Q&A 17).

The IRS deems a portion of an employer’s business operations to be “nominal” if either:

(1) “the gross receipts from that portion of the business operations is not less than 10 percent of the total gross receipts (both determined using the gross receipts of the same calendar quarter in 2019), or

(2) the hours of service performed by employees in that portion of the business is not less than 10 percent of the total number of hours of service performed by all employees in the employer’s business[.]

This provides a threshold test to help make the determination if the closure order has more than a “nominal” impact on the business. The Notice provides several other examples, some that were previously included in the IRS FAQs on the ERC, on when a business is considered to be “fully or partially suspended”.

One example discusses a restaurant whose in-door dining has been suspended due to a state order but still operates a drive-through / carry-out operation. That restaurant’s business is “partially suspended” because the in-door dining accounts for more than a nominal portion of the business’ operations. The Notice goes on to explain that even restaurants that have a limited capacity due to social distancing guidelines will be considered “partially suspended.”

When making this determination, it is important to consider all the facts and circumstances affecting the business, its employees, and the state. The Notice notes that government orders requiring individuals to stay at home (thus causing a reduction in demand for the business) will not be considered to be full or partial suspensions of business operations, though the business may still qualify under the above-mentioned gross receipts test.

Additionally, employers who voluntarily reduce business hours or suspend operation due to Covid-19 are not eligible for the employee retention credit on the basis of a full or partial suspension of business operations. (Q&A 14).

3. Definition of Orders From an Appropriate Governmental Authority

It is important to note that only “orders from an appropriate governmental authority” may be taken into account. The Notice provides that this includes orders from the Federal government, or the state or local government that has jurisdiction over the business’s operations. The Notice further states that statements from a government official, including comments made during a press conference, do not rise to the level of a governmental order for this purpose.

When determining whether an employer is able to continue comparable business operations (or whether they are fully or partially suspended), the IRS has provided the following non-exhaustive list of factors that should be considered:

  • Employer’s Telework Capabilities. Determine whether an employer has adequate support (IT and otherwise) such that operations can continue via work from another location.
  • Portability of Employees’ Work. Determine the amount of portable work, or work otherwise adaptable to be performed from a remote location, within an employer’s trade or business operations.
  • Need for Presence in an Employee’s Physical Work Space. Evaluate the role that the employer’s physical workspace plays in an employer’s trade or business (may be critical and necessary, beneficial but not necessary, or merely convenient). If the employer’s physical workspace is so critical to its trade or business operations that tasks central to the trade or business’s operations are unable to be performed remotely, then this factor alone indicates that the employer is not able to continue comparable operations. Examples of workspace that is critical include laboratories or manufacturing involving special equipment or materials that cannot be accessed or operated remotely.
  • Transitioning to Telework Operations. If an employer can conduct comparable operations via telework, but the employer’s operations did not previously allow for telework or allowed for only minimal telework, then some adjustment period is expected, and, generally, the employer’s operations are not considered partially suspended during that period. However, if an employer incurs a significant delay (for example, beyond 2 weeks) in moving operations to comparable telework (for example, implementing telework policies or providing employees with equipment to telework), then the employer’s trade or business operations may be deemed subject to a partial suspension during that transition period.

4. No Work Requirement for Large Employers

While employers who had no more than 100 employees during 2019 are able to receive the credit for wages paid to employees who actually worked in the business, employers who had an average of more than 100 employees during 2019 may only consider wages paid with respect to an employee who was not providing any services whatsoever due to COVID-19. In addition, large employers cannot claim a credit to the extent that wages paid to an employee exceed the amount that the employee would have been paid for working an equivalent duration during the 30 days immediately preceding the period in which the qualified wages are paid or incurred. If an employee of a large employer was paid for 20 hours a week and only provided services for 12 hours a week, then the large employer should qualify for wages attributable to the other 8 hours.

This portion of the Notice reads as follows:

Section 2301(c)(3)(A)(i) of the CARES Act provides that if an eligible employer averaged more than 100 employees during 2019 (large eligible employer), qualified wages are those wages paid by the eligible employer with respect to which an employee is not providing services due to circumstances described in section 2301(c)(2)(A)(ii)(I) of the CARES Act (relating to a full or partial suspension of the operation of a trade or business due to a governmental order) or section 2301(c)(2)(A)(ii)(II) of the CARES Act (relating to a significant decline in gross receipts). For large eligible employers, section 2301(c)(3)(B) of the CARES Act limits qualified wages that may be taken into account to the amount that the employee would have been paid for working an equivalent duration during the 30 days immediately preceding the period in which the qualified wages are paid or incurred.

It is noteworthy that this threshold increases to 500 employees for 2021, meaning that a lot more employers will be able to claim the credit for 2021 than for 2020.

5. Calculating Gross Receipts

Gross receipts are both defined and calculated differently depending on whether the employer is a tax-exempt entity.

Businesses that are not tax-exempt employers use the meaning of “gross receipts” as given in Section 448(c) of the IRC. Under this Section, gross receipts are “gross receipts of the taxable year and generally [include] total sales (net of returns and allowances) and all amounts received for services.” (Q&A 24). For example, gross receipts for a non-tax-exempt employer include:

  • Total sales (net of returns and allowances) and all amounts received for services.
  • Any income from investments and from incidental or outside sources.
  • Interest (including original issue discount and tax-exempt interest within the meaning of section 103 of the Code)
  • Dividends
  • Rents
  • Royalties
  • Annuities

Gross receipts are not reduced by costs of goods sold, but may be reduced by basis in any capital asset sold. In addition, gross receipts do not include the repayment of a loan, or amounts received with respect to sales tax if the tax is legally imposed on the purchaser of the good or service, and the taxpayer merely collects and remits the sales tax to the taxing authority.

Businesses that are tax-exempt use the definition of “gross receipts” as given under Section 6033 of the IRC. This Section defines gross receipts as “the gross amount received by the organization from all sources without reduction for any costs or expenses including, for example, cost of goods or assets sold, cost of operations, or expenses of earning, raising, or collecting such amounts.” (Q&A 25). Gross receipts for tax-exempt employers include:

  • Gross receipts from all operations, and not only from activities that constitute unrelated trades or businesses.
  • Amounts received by the organization from total sales (net of returns and allowances)
  • All amounts received for services, whether or not those sales or services are substantially related to the organization’s exercise or performance of the exempt purpose or function constituting the basis for its exemption.
  • Investment income, including from dividends, rents, and royalties
  • The gross amount received as contributions, gifts, grants, and similar amounts
  • The gross amount received as dues or assessments from members or affiliated organizations.

The definitions of Gross Receipts and rules that apply thereto are further discussed in the White Paper that can be received by emailing [email protected] with ERC in the subject line.

6. Claiming the Credit

An employer that qualifies to claim the employee retention credit for qualified wages must report those wages and the amount of credit to which it is entitled on the designated lines of the federal employment tax return in order to benefit.

The credit can be claimed on the Form 941 federal employment tax return and eligible employers can either (1) reduce their deposits of federal employment taxes up to the amount of the anticipated credit, (2) request a refund if the credit exceeds the amount of payroll taxes required to be paid, or (3) request an advance of the amount of the anticipated credit by filing Form 7200.

Employers that did not previously claim the ERC for qualified wages on Form 941 must file an amended Form 941-X for the applicable quarter in which the wages were paid in order to retroactively claim the credit.

There is also a special fourth quarter rule that only applies if wages paid in the second or third quarter of 2020 were reported as payroll costs on a PPP loan forgiveness application, and forgiveness of the loan is subsequently denied. In this case, the employer may include the wages paid in the second or third quarter on the fourth quarter Form 941 in order to retroactively claim the credit. This special rule is optional, and the employer may instead follow the normal procedure for filing Form 941-X to amend the second or third quarter return to claim the ERC on the qualified wages.

The Notice contains the following examples to illustrate these procedures:

Example 1: Employer D is an eligible employer and paid qualified wages during the second quarter of 2020 but did not claim an employee retention credit on its second quarter 2020 Form 941. Employer D did not receive a PPP loan. If Employer D subsequently decides to claim the credit to which it is entitled for the second quarter of 2020, Employer D should file a Form 941-X for the previously filed second quarter 2020 Form 941 within the appropriate timeframe to make an interest-free adjustment or claim a refund. Employer D should not use a subsequent Form 941 to claim an employee retention credit for qualified wages paid in the second quarter of 2020.

Example 2: Employer E received a PPP loan of $200,000. Employer E is an eligible employer and paid $250,000 of qualified wages that would qualify for the employee retention credit during the second quarter of 2020. Employer E submitted a PPP Loan Forgiveness Application and reported the $250,000 of qualified wages as payroll costs in support of forgiveness of the entire PPP loan. Employer E received a decision under section 7A(g) of the Small Business Act in the first quarter of 2021 for forgiveness of the entire PPP loan amount of $200,000.

Employer E is not deemed to have made an election with respect to the excess $50,000 of qualified wages that are included in the payroll costs reported on the PPP Loan Forgiveness Application. Accordingly, Employer E may take into account the $50,000 of qualified wages for purposes of the employee retention credit. If Employer E decides to take the $50,000 into account to claim the credit to which it is entitled for 2020, Employer E should file a Form 941-X for the previously filed second quarter 2020 Form 941 within the appropriate timeframe to make an interest-free adjustment or claim a refund for the second quarter, as appropriate. Under these facts, Employer E should not use a subsequent Form 941 to claim an employee retention credit for qualified wages paid in the second quarter of 2020.

Example 3: Same facts as Example 2, except that Employer E’s PPP loan is not forgiven by reason of a decision under section 7A(g) of the Small Business Act. If Employer E decides to claim the credit to which it is entitled for 2020 with regard to the $250,000 of qualified wages, Employer E may file a Form 941-X for the previously filed second quarter Form 941 within the appropriate time frame to make an interest-free adjustment or claim a refund for the second quarter in 2020. Alternatively, Employer E may use the special fourth quarter rule with respect to the $200,000 of qualified wages included in the payroll costs reported on the PPP Loan Forgiveness Application since the PPP loan was not forgiven, but not with respect to the excess $50,000 of qualified wages even though those amounts were included in the payroll costs reported on the PPP Loan Forgiveness Application.

The Notice also provides the following guidance with respect to using the “special fourth quarter” rule:

If an eligible employer received a PPP loan, and reported qualified wages paid in the second and/or third quarter of 2020 as payroll costs on its PPP Loan Forgiveness Application, but the loan was not forgiven by reason of a decision under section 7A(g) of the Small Business Act, then the eligible employer may take the qualified wages reported as payroll costs on its PPP Loan Forgiveness Application into account for purposes of the employee retention credit and claim the employee retention credit on those qualified wages on the fourth quarter Form 941. An eligible employer may also claim the employee retention credit on the fourth quarter Form 941 with respect to any qualified health plan expenses paid in the second and/or third quarter of 2020, for which the employer had not claimed the employee retention credit.

If an eligible employer elects to use this special fourth quarter rule, the eligible employer should add the employee retention credit attributable to the second and/or third quarter qualified wages and qualified health plan expenses on line 11c or line 13d (as relevant) of the original fourth quarter Form 941 (along with any other employee retention credit for qualified wages paid in the fourth quarter). The eligible employer should also:

  • Include the amount of these qualified wages paid during the second and/or third quarter (excluding qualified health plan expenses) on line 21 of the original fourth quarter Form 941 (along with any qualified wages paid in the fourth quarter);
  • Enter the same amount on Worksheet 1, Step 3, line 3a;
  • Include the amount of these qualified health plan expenses from the second and/or third quarter on line 22 of the fourth quarter Form 941 (along with any qualified health plan expenses for the fourth quarter);
  • Enter the same amount on Worksheet 1, Step 3, line 3b. Eligible employers are not required to use this special fourth quarter rule.

Eligible employers may instead choose the regular process of making an interest-free adjustment or filing a claim for refund for the appropriate quarter to which the additional employee retention credit relates using Form 941-X for the previously filed Form 941.

Conclusion

Hats off to the Internal Revenue Service for providing this well written and thorough 71-question, 102 page Notice which has answered important questions and established important safe harbors regarding the Employee Retention Credit, including who qualifies as eligible employers, what constitutes a partial suspension of business and what qualified wages consist of in mostly a taxpayer-friendly manner. There will be much more to learn as we continue to analyze the Notice and as further guidance is released on the ERC for 2021, so stay tuned!

Saturday, March 20th at 11 AM EDT, I will host a 30-minute free webinar about the updates to PPP, ERC, Restaurant Revitalization, and Shuttered Venue rules. An invite can be received by emailing [email protected] with “Update” in the subject line.

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