The Employee Retention Credit (ERC), which was originally included in the CARES act has come a long way. We have followed it through good, bad, and the ugly until we decided it’s about time, this baby deserves a post of its own. Before Stimulus 4.0 passed in December 2020, the ERC wasn’t allowed for PPP recipients. That piece of legislation changed everything. It opened up the ERC to PPP borrowers and it drastically changed the calculation for the ERC beginning in January 2021. Therefore, we will refer to 2020 ERC and 2021 ERC as ERC 1 and ERC 2 respectively. We will update this article as more guidance from the IRS is released. Let’s take a look at everything you need to know about the ERC.
2020 ERC (ERC 1)
Who is eligible?
If a business (or nonprofit organization described under 501(c) of IRC and exempt from tax under 501(A)) is:
- fully or partially suspended by government order due to COVID-19 during the calendar quarter; or
- the employer’s gross receipts are below 50% of the comparable quarter in 2019 (once the employer’s gross receipts go above 80% of a comparable quarter in 2019, they no longer qualify after the end of that quarter);
- and continues to pay its workers
Credit Amount
The business can receive a credit against the payroll taxes it pays on wages equal to 50% of qualified wages paid to each employee for that quarter. The amount of qualified wages for each employee across all quarters cannot exceed $10k. So basically, you can receive up to $5k back from the Federal government for each employee during each of the qualified quarters mentioned above.
Claiming the Credit
Employers can immediately see the benefit of this by reducing their required payroll tax deposits that have been withheld from employees wages. The employer will report their total qualified wages and the related health insurance costs for each quarter on their quarterly Form 941 beginning with Q2 2020 through Q4 2020. If the employer’s employment tax deposits are not sufficient to cover the credit, the employer may receive a refund from the IRS by submitting Form 7200, Advance Payment of Employer Credits Due to COVID-19. Employers will need to ask their payroll processor how they’re going to administer this process. Alternatively, an employer can submit amended quarterly 941x forms to claim a refund after the fact.
What are qualified wages?
The business’s qualified wages depend on whether it has less than or more than 100 full-time employees (FTEs).
- If < 100 FTEs, then the the credit is based on wages paid to all employees, regardless if they worked or not. If the employees worked full time and were paid for full time work, the employer still receives the credit.
- If > 100 FTEs, then the credit is allowed only for wages paid to employees who did not work during the calendar quarter.
Employers are not required to include full-time equivalents when determining the average number of full-time employees. However, for purposes of identifying qualified wages, an employee’s status as a full-time employee is irrelevant and wages paid to an employee who is not full-time may be treated as qualified wages if all other requirements to treat the amounts as qualified wages are satisfied. This creates a very advantageous scenario where you don’t need to count part-time employees when calculating your employee count, but can still include the wages of those employees for calculating the credit.
2021 ERC (ERC 2)
For 2021, the ERC has been extended through September 30, 2021, for non-recovery start-up businesses, and through December 31, 2021, for recovery start-up businesses. The 2021 ERC has expanded benefits and new requirements.
Who is eligible?
If a business (or nonprofit organization described under 501(c) of IRC and exempt from tax under 501(A)) is:
- fully or partially suspended by government order due to COVID-19 during the calendar quarter; or
- the employer’s gross receipts are below 80% (20% decline in sales) of the comparable quarter* in 2019 (once the employer’s gross receipts go above 80% of a comparable quarter in 2019, they no longer qualify after the end of that quarter);
- and continues to pay its workers
*There’s a safe harbor that allows employers to use prior quarter gross receipts to determine eligibility. For example, if in Q1 2021 you don’t qualify, you can elect to compare Q4 2020 sales to Q4 2019 sales. Once you use this method, you’re not locked in, you can choose to use the “2019 vs 2021” method for the next quarter.
*If a business did not exist at the beginning of the same quarter of 2019, the same quarter in 2020 is substituted.
Credit Amount
The business can receive a credit against the payroll taxes it pays on wages equal to 70% of qualified wages paid to each employee for that quarter. The amount of qualified wages for each employee per quarter cannot exceed $10k. So basically, you can receive up to $7k back from the Federal government for each employee during each quarter mentioned above.
Recovery Startup Business
If an employer doesn’t qualify for the ERC under either of these two requirements, then they could qualify as a recovery startup business. A recovery startup business is an employer that:
- Began carrying on any trade or business after 2/15/20;
- Has average annual gross receipts for the 3-taxable-year period (ending with the taxable year that precedes the calendar quarter for which the credit is determined) < $1M*; and
- Does not qualify for the ERC due to the other two requirements above.
*The same aggregation rules used to determine a drop in gross receipts also apply for including sales of affiliates in this context.
A recovery startup business can claim up to a $50k ERC per quarter and they are not subject to the FTE count limitations from above. The Recovery Startup Business classification only applies for Q3 and Q4 2021 and qualification is determined on a quarter-by-quarter basis.
Claiming the ERC
Employers can immediately see the benefit of this by receiving an advance of the credit. You heard that right. In the 2020 version of the ERC, employers saw the benefit of the credit by reducing their required payroll tax deposits that were withheld from employees’ wages and receiving a refund for the excess of the credit over payroll tax withholdings. Now, the employer will receive an advance of the credit then make up any difference when filing their quarterly payroll tax returns. Employers will need to ask their payroll processor how they’re going to administer this process.
What are qualified wages?
The business’s qualified wages depend on whether it has less than or more than 500 FTEs.
- If < 500 FTEs, then the credit is based on wages paid to all employees, regardless if they worked or not. If the employees worked full time and were paid for full-time work, the employer still receives the credit.
- If > 500 FTEs, then the credit is allowed only for wages paid to employees who did not work during the calendar quarter.
The advantageous method of calculating FTEs from the ERC 1 section above still applies for the ERC 2.
*health care costs are included in wages even if no wages are paid to the employee
If an employer’s gross receipts are less than 10% of the gross receipts for the same calendar quarter in 2019 (or 2020 if not in existence in 2019), then the employer is considered a severely financially distressed employer, and the 500 FTE limit does not apply. The prior quarter safe harbor for measuring the reduction in gross receipts from above can also be used to determine whether an employer qualifies as financially distressed.
Claiming the Credit
In order to claim the employee retention tax credit, eligible employers report their total qualified wages and the related health insurance costs for each quarter on their quarterly employment tax returns, Form 941, Employer’s Quarterly Federal Tax Return, beginning with the second quarter. The credit is taken against the employer’s share of social security tax but the excess is refundable under normal procedures. Eligible employers can also request an advance of the employee retention credit by submitting Form 7200, Advance Payment of Employer Credits Due to COVID-19 for an advance credit.
Qualified Wages for the 2020 ERC and 2021 ERC
Qualified wages for both ERC 1 and ERC 2 (subject to the FTE limitations described above) include the following:
- Salaries and compensation
- Qualified health plan expenses
- Cash tips paid to any employee, provided the tips exceed $20 for the month (nothing in the statutory language prevents an employer from claiming the Section 45B tip credit and the ERC on the same tips.)
The following wages are disqualified for the ERC:
- Wages paid to related individuals such as child, brother, sister, stepsister, stepbrother, father, mother, stepfather, stepfather, niece, nephew, aunt, uncle, and son/daughter in law.
- Wages paid to a related individual (as mentioned above) that directly or indirectly own >50% of the stock, profits, or capital of the employer.
- Wages used to claim the sick and paid leave credit under the Families First Coronavirus Response Act, and vice versa.
Effect of ERC on Income Taxes
If you’re claiming the ERC, then you must reduce your wages deduction by the credit amount for the same period in which the credit was claimed. For example, if you file amended 941-Xs for Q2-Q4 of 2020, then you must reduce your wages deduction for 2020 even though you will not receive the credit until 2021. You can achieve this through an M-1 book to tax adjustment or by booking a receivable (ask your accountant). If you already filed your 2020 tax returns without making these adjustments, then you will need to amend the returns to reflect the reduction in deductions.
Effect of the Paycheck Protection Program (PPP) Loan on the ERC
Are PPP proceeds considered when calculation the reduction in gross receipts?
PPP proceeds are NOT included in gross receipts when calculating the drop in gross receipts (for determining ERC eligibility) if the employer consistently excludes the amount of the forgiveness of any PPP Loan and the amount of any ERC-Coordinated Grant from its gross receipts for each calendar quarter in which gross receipts for that calendar quarter are relevant to determining eligibility to claim the employee retention credit, including all affiliates treated as a single employer under the employee retention credit aggregation rules. If this is not followed, then the proceeds are recognized as gross receipt in the quarter in which the PPP loan is forgiven.
Wages Used for PPP and ERC
Payroll costs (as defined for PPP purposes) which include wages used to claim an ERC are NOT eligible to be forgiven as part of the PPP process. Therefore, a taxpayer may claim both the ERC and borrow a PPP loan, but they cannot do it on the SAME wages or health care costs.
If a PPP loan borrower includes wages for PPP forgiveness rather than the ERC credit, and the PPP payroll costs are not forgiven, then these wages can be claimed for the ERC.
The issue here is that by default wages are considered qualified for ERC, therefore a taxpayer has to elect out of counting these wages towards the ERC and choose to use them for PPP loan forgiveness instead. The election is done by simply not claiming the wages on the payroll tax return for the ERC.
PPP borrowers should determine whether they had any qualified wages for purposes of the ERC so they can determine whether those wages are better utilized as part of claiming an ERC or forgiven as part of the PPP. On the other hand, if payroll costs exceeded their PPP loan amounts, then this excess could be used towards claiming the ERC retroactively.
Summing it Up
As you can see there are a lot of moving parts to the ERC, but when claimed strategically it has a multitude of benefits. We highly recommend speaking with your CPA AND payroll provider before filing amended returns to claim the ERC or applying for PPP loan forgiveness.
Feel free to reach out to us if you have questions.
By Raffi Yousefian, a licensed CPA who advises and provides outsourced accounting and tax solutions for small businesses | Published 03/09/2021; Updated 02/08/2022
