Updated on May 8 to reflect Treasury’s change in position allowing an employer to treat qualified health plan expenses paid by an employer on behalf of furloughed employees to whom the employer pays no wages as qualified wages.
The IRS updated the FAQs on its website (available here), providing guidance regarding who is eligible to claim an employee retention credit (ERC) added by the CARES Act, how the ERC is calculated and interacts with other provisions, and other issues.
As we described in earlier alerts (available here and here), the ERC is a fully-refundable payroll tax credit for employers equal to 50 percent of the “qualified wages” paid by employers starting March 13, 2020 and ending December 31, 2020, up to a maximum of $10,000 per employee for a maximum credit of $5,000 per employee.
The new, very detailed, FAQs confirm practitioners’ expectations regarding many issues related to the ERC, provide some unhappy answers, and address previously-unanswered questions. As noted on the IRS website, the FAQs are not legally binding and cannot be relied on as authority. The IRS could change some of the answers and add additional FAQs.
Employers Eligible for the ERC
Eligible employers are businesses that carry on a “trade or business” during calendar year 2020 and tax-exempt organizations that operate in 2020 and that either:
- Have operations that were fully or partially suspended during any calendar quarter in 2020 due to orders from an appropriate governmental authority limiting commerce, travel, or group meetings due to COVID-19; or
- Experience a significant decline in gross receipts during the calendar quarter.
If a business that is an eligible employer averaged more than 100 full-time employees in 2019, the wages that qualify for the ERC are the wages paid to an employee for time that the employee is not providing services due to one of the two circumstances described above. If a business that is an eligible employer averaged 100 or fewer full-time employees in 2019, all wages paid to any employee during a period of economic hardship that satisfies one of the two tests described above can qualify for the ERC.The updated FAQs confirm that (i) self-employed individuals and (ii) household employers are not eligible employers for ERC purposes (although self-employed individuals who employ other individuals in a trade or business would be eligible with respect to those employees).
Trade or Business
For purposes of the ERC, the IRS will interpret “trade or business” to have the same meaning as the general definition in the Internal Revenue Code (Code) (Section 162) other than the trade or business of performing services as an employee. Therefore, to be a trade or business, an activity must be carried on for profit and with regularity and continuity, based on the facts and circumstances. A tax-exempt organization described in any subsection of Section 501(c) of the Code is deemed to be engaged in a “trade or business” with respect to all operations of the organization.
Under the CARES Act, “governmental employers,” including agencies and instrumentalities of governments, are not eligible for an ERC. Previously unanswered was what is an “instrumentality” in this context. The FAQs provide that the IRS will apply the long-standing test first applied in Rev. Rul. 57-128, 1957-1 C.B. 311, which sets forth six factors for determining whether an entity is an instrumentality, none of which is determinative by itself:
- Whether the organization is used for a governmental purpose and performs a governmental function;
- Whether performance of the organization’s function is on behalf of one or more states or political subdivisions;
- Whether there are any private interests involved, or whether the states or political subdivisions involved have the powers and interests of an owner;
- Whether control and supervision of the organization is vested in a public authority or authorities;
- If express or implied statutory or other authority is necessary for the creation and/or use of such an instrumentality, and whether such authority exists; and
- The degree of financial autonomy and the source of its operating expenses.
Thus, to determine whether it is eligible for an ERC, a quasi-governmental entity will need to analyze the facts and circumstances, taking into account the above factors.
Employer Aggregation Rules
For ERC purposes, all entities that are treated as a single employer under Code Sections 52(a) or (b) or Sections 414(m) or (o) are considered one employer.
The Code Section 52 and 414 rules are extremely complicated and require a detailed analysis of the ownership and interaction between entities. At a very high level, the following must be aggregated: parent-subsidiary groups, brother-sister groups, combined ownership groups, and affiliated service groups.
These complicated rules are important in the context of the ERC because, even though employers of all sizes are eligible for an ERC, multiple entities can be treated as a single employer for purposes of other rules (described below):
- Determining whether the employer has a trade or business operation that was fully or partially suspended due to orders related to COVID-19 from an appropriate governmental authority.
- Determining whether the employer has a significant decline in gross receipts.
- Determining whether the employer has more than 100 full-time employees.
- Rules that preclude an employer from claiming an ERC if any member of the aggregated group received a PPP loan.
If an aggregated group is eligible to claim an ERC, the ERC is allocated based on the relative amount of qualified wages paid by each member.The recipient of a PPP loan is not an eligible employer for purposes of the ERC. The FAQs explain that every employer among an aggregated group of employers under the aggregation rules for the ERC credit (not the aggregation rules for PPP loans) is ineligible for the ERC if any member of the aggregated group obtained a PPP loan.
Governmental Orders – When is a Business Fully or Partially Suspended?
The FAQs address previous open issues regarding what is necessary to satisfy the first potential test for the ERC—i.e., whether a trade or business’ operations are fully or partially suspended during a calendar quarter due to an order from an appropriate governmental authority limiting commerce, travel, or group meetings.
The FAQs first make clear that only an official government order—related to COVID-19—is sufficient for these purposes. An informal statement, even if made by a public official, does not constitute a governmental order for ERC purposes. Assuming that an official governmental order is in place, the FAQs provide that the following businesses will be deemed to be eligible employers by virtue of experiencing a full or partial suspension of business operations:
- A business deemed essential with respect to some of its business operations but not with respect to other operations will be deemed to experience partial shutdown with respect to the operations that must be closed;
- A business required to reduce its hours due to a governmental order;
- A business with operations that are fully or partially suspended as a result of the inability to obtain critical goods or materials from its suppliers that were required by a governmental order to suspend operations;
- A business that has multiple operations will be an eligible employer even if only some of its locations are closed;
- An employer that is aggregated under the rules described above will be an eligible employer even if only one member of the aggregated group has its operations suspended by a governmental order; and
- A business that is subject to suspension, but that has such a suspension lifted by the government, will be an eligible employer for the period during which it was forced to close.
On the other hand, the following will not be deemed eligible employers for ERC purposes:.
- An essential business that is allowed to remain open, even if the governmental order affects operations of the essential business without requiring it to be closed;
- A business whose customers are required by governmental order to stay home and therefore is unable to maintain regular operations; and
- A business that is required to close a physical location, but that can continue regular operations through remote work.
Note that these businesses still may be able to claim an ERC if they experience a significant decline in their gross receipts under the test described below, even if they are not deemed fully or partially suspended. Therefore, as governmental orders begin to expire or are lifted in many states/localities, a business still may qualify for an ERC if it experiences a significant decline in gross receipts.
Significant Decline in Gross Receipts
An employer is considered to have a significant decline in gross receipts for the period (i) beginning with the first calendar quarter in 2020 for which its gross receipts are less than 50 percent of gross receipts from the same calendar quarter in 2019 and (ii) ending with the earlier of (a) January 1, 2021, or (b) the first calendar quarter after the quarter for which its gross receipts are greater than 80 percent of gross receipts for the same calendar quarter in 2019.
For example, if a business’s gross receipts during the first three quarters of 2020 were 40 percent, 70 percent and 85 percent, respectively, of its gross receipts for the first three quarters of 2019, the business would have a significant decline in gross receipts beginning on the first day of the first calendar quarter of 2020 (the first calendar quarter in 2020 in which the gross receipts of the business were less than 50 percent of the same quarter in 2019) and ending on the first day of the third calendar quarter of 2020 (the first quarter following the quarter for which the gross receipts of the business were more than 80 percent of the same quarter in 2019). Thus, the business would be entitled to an ERC with respect to qualified wages paid during the first and second calendar quarters in 2020.
The term “gross receipts” means “total sales (net of returns and allowances) and all amounts received for services.” In addition, gross receipts include any income from investments, and from incidental or outside sources. Therefore, for example, gross receipts include interest, dividends, rents, royalties, and annuities, even if such receipts are not derived in the ordinary course of the taxpayer's trade or business. Gross receipts generally are not reduced by cost of goods sold, but generally are reduced by the taxpayer’s adjusted basis in capital assets sold. 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.
The FAQs address several specific issues with respect to how a significant decline in gross receipts is calculated:
- A business does not need to demonstrate that such a decline is directly related to COVID-19;
- Entities that are aggregated under the rules described above are treated as a single employer when determining whether there was a significant decline in gross receipts;
- A business that started in 2019 should use the first quarter in which it did businesses as the baseline for quarters prior to its start date. For example, if a business started in the third quarter of 2019 and had $100 of gross receipts during the third quarter of 2019, it should use $100 as its 2019 gross receipts for the first, second, and third quarters and its actual receipts for the fourth quarter. A business that started business in the middle of a calendar quarter should make a reasonable estimate of what its receipts would have been for a full quarter.
- If a business acquired another business during 2020 (and therefore had an increase in total gross receipts), such a business may reasonably estimate what its 2019 gross receipts would have been if it had acquired such business during 2019.
- Guidance as to how a tax-exempt organization calculates its gross receipts is forthcoming.
Determining the Qualified Wages for Calculating the Credit
The ERC is 50 percent of the qualified wages up to a cap of $10,000 (the maximum credit for qualified wages paid to any employee is $5,000). Qualified wages (including qualified health plan expenses properly allocable to wages paid) are (1) all wages paid by an employer during a qualifying period if the employer had 100 or fewer average full-time employees in 2019 or (2) wages paid to employees not performing services by an employer during a qualifying period if the employer had more than 100 average full-time employees in 2019. Qualified wages are calculated without regard to any federal taxes imposed or withheld.
Qualified health plan expenses paid on behalf of employees not receiving any wages by any employer (no matter how many average full-time employees the employer had in 2019) are not eligible wages. For qualified health plan expenses to count as eligible wages, the wages must be paid on behalf of employees to whom the employer otherwise pays wages. (Lawmakers, including U.S. Senator Chuck Grassley (R-Iowa and Chair of the Senate Finance Committee) and U.S. Representative Richard Neal (D-MA and Chair of the House Ways and Means Committee), have written a letter to U.S. Treasury Secretary Steven Mnuchin, asking him to reverse this IRS position.) UPDATE: Treasury advised Senator Grassley and Representative Neal that it was revising the FAQs to allow qualified health plan expenses paid by an employer on behalf of employees not receiving any other wages will be qualified wages.
If an employer pays wages to an employee, (1) for an employer with 100 or fewer average full-time employees in 2019, all of the employee’s health plan expenses paid by the employer count as qualified wages and (2) for an employer with more than 100 average full-time employees in 2019, only the health plan expenses allocable to time the employees are not working count as qualified wages. Contributions to health savings accounts and Archer medical savings accounts are not eligible wages but qualified wages include both the portion of qualified health plan costs paid by the employer and the portion paid as part of a pre-tax salary reduction by employees.
To determine if an employer had more than 100 or 100 or fewer average full-time employees in 2019, a "full-time employee" is an employee who, with respect to any calendar month in 2019, had an average of at least 30 hours of service per week or 130 hours of service in the month.
An employer that averaged 100 or fewer employees during 2019 can claim an ERC for wages paid to its employees after March 12, 2020 and before January 1, 2021 during any period in the calendar quarter in which the employer experiences an economic hardship due to one of the two circumstances described above. An employer that averaged more than 100 full-time employees may claim an ERC only for wages paid to employees after March 12, 2020 and before January 1, 2021 for the time employees are not providing services.
An employer determines its average number of full-time employees by dividing the number of such employees by the number of months during 2019 that it was open. A business that did not open until 2020 uses its average monthly employees during 2020 for purposes of the 100 full-time employee rule. Entities aggregated under the rules described above are treated as single employer for purposes of determining whether they have more than 100 full-time employees.
For an employer that averaged more than 100 full-time employees during 2019, qualified wages for the ERC are further limited in that they may not exceed what the employee would have been paid for working an equivalent duration during the 30 days immediately preceding the economic hardship.
Although qualified wages for an employer with more than 100 average full-time employees in 2019 under the rules described above include only those wages paid to employees for time they are not being paid services, employees do not need to be wholly inactive. For example, if an employer pays an employee who typically works 40 hours per week their full salary but the employee is required to work only 20 hours per week, the wages paid to such employee for 20 hours of not working are eligible for the credit. With respect to persons who typically work irregular schedules, employers can use a reasonable method to determine the number of hours for which an employee is being paid not to provide services. This rule applies to hourly and salaried employees but does not allow employees to claim the credit simply as the result of an employee being less productive (i.e., if an employee is paid for 40 hours of work but only has 30 hours of work to perform, the employer is not entitled to the credit for the excess 10 hours).
Finally, the following do not constitute qualified wages when paid by an employer that averaged more than 100 full-time employees during 2019:
- Wages paid to employees pursuant to a pre-existing vacation, sick, and other personal leave policy;
- Payments, including severance payments, made to a former employee following termination of employment;
- Payments that are exempt from social security and Medicare taxes – e.g., payments to statutory nonemployees (direct sellers, licensed real estate agents, and certain companion sitters), payments to certain aliens employed in the United States, and wages paid to a minister;
- Wages paid to related individuals, including an employer’s (a) child or descendant of a child, (b) brother, sister or step-brother or sister, (c) parents or the parents’ ancestors, (d) step-parents, (e) niece or nephew, (f) or son-in law, daughter-in law, father-in law, mother-in law, brother-in law or sister-in law. For this purpose, if a more than 50% owner of a corporation or partnership that is the employer bears a relationship described in the prior sentence, wages paid to such persons by the employer corporation or partnership are not eligible wages;
- Wages for which the employer receives a credit for qualified sick and/or family leave wages pursuant to the FFCRA;
- Wages taken into account for the credit for paid family medical leave under Code Section 45S; and
- Wages paid to an employee that are included for purposes of the Work Opportunity Tax Credit under Code Section 51.
How Does an Employer Claim an ERC?
An eligible employer claims an ERC on its federal employment tax return, usually IRS Form 941. An eligible employer can fund an ERC by accessing federal employment taxes required to be deposited with the IRS and/or requesting an advance of the ERC from the IRS on an IRS Form 7200. An employer will not be subject to failure to deposit penalties if it follows the IRS procedures for claiming the credit. See Notice 2020-22 (here) and our e-alert regarding that notice (here). An employer that paid qualified wages in the first quarter of 2020 should report those wages on its IRS Form 941 for the second quarter of 2020.
If an eligible employer uses a reporting agent to file its IRS Form 941, the reporting agent should reflect the ERC on the employer’s IRS Form 941 with information it gets from the eligible employer. If the eligible employer is a common law employer, it is entitled to the ERC even if it uses a third party payor such as a PEO, CPEO, reporting agent, or payroll service provider. If an eligible employer that uses a CPEO or 3504 agent to report its employment taxes on an aggregate Form 941, the CPEO or 3504 agent will report the ERC on its aggregate IRS Form 941 and Schedule R. An eligible employer can submit its own IRS Form 7200 to claim an advance ERC and the employer should provide a copy of the IRS Form 7200 to the CPEO, PEO or 3504 agent. If the eligible employer uses a PEO, the PEO will report the ERC on an aggregate Form 941 and separately report the ERC allocable to employers for which it is filing the aggregate IRS Form 941 on Schedule R but the PEO is not required to complete schedule R with respect to employers for which it is not claiming an ERC.
A payroll reporting agent may sign an IRS Form 7200 for a client for which it has authority by an IRS Form 8655. The signatory must be the payroll agent’s Principal or Responsible Officer listed on the responsible agent’s e-file application.
An employer that is aggregated with other employers (under the rules described above) for purposes of determining if it experienced a significant decline in gross receipts and for purposes of, among other things, determining if it has more than 100 employees should claim the credit on its own employment tax return without aggregating. The eligible credit for such an employer is the employer’s proportionate share of the credit based on the employer’s relative share of the qualified wages giving rise to the credit.
Deductibility of Wages That Form the Basis of the ERC
Wages paid by an employer to an employee remain taxable to the employee to the same extent they otherwise would be taxable even if such wages form the basis of an ERC. Similarly, such wages are deductible by the employer but the employer’s deduction is reduced by the amount of the ERC taken with respect to such wages.
Please contact any member of Ballard Spahr's Tax Group if you have any questions about claiming an ERC or any other tax matters.
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This alert is a periodic publication of Ballard Spahr LLP and is intended to notify recipients of new developments in the law. It should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own attorney concerning your situation and specific legal questions you have.