The Internal Revenue Service (IRS) has recently issued Notice 2021-49 which provides some answers to questions that have been raised regarding the Employee Retention Credit (“ERC”). It provides guidance on the ERC for the third and fourth quarters of 2021, but it also touches on several questions that affect both 2020 and 2021 credit calculations.
Refresher on the Employee Retention Credit
The ERC was originally created as part of the CARES act and provided a maximum $5,000 credit per employee per year for employers severely impacted by the COVID-19 pandemic. In December 2020, the Taxpayer Certainty and Disaster Tax Relief Act of 2020 extended the ERC through June 30, 2021, increased the maximum credit to $7,000 per employee per quarter, and made the credit available for PPP recipients. In March 2021, the American Rescue Plan Act of 2021 extended the ERC through December 31, 2021. More information on the ERC can be found here. The infrastructure bill which was recently passed by the Senate could potentially repeal the ERC for the fourth quarter of 2021, however this bill has not yet been signed into law.
Definition of Full-Time Employee
The amount of wages that qualify for the ERC is dependent on whether an employer is considered a small or large employer. For purposes of the ERC in 2020, a small employer is defined as an employer who has less than 100 full-time employees based on the average number of employees in 2019. For 2021, a small employer is one that has less than 500 full-time employees.
Some have raised the question as to whether “full-time equivalents” should be included as a full-time employees. The IRS has clarified in Notice 2021-49 that full-time equivalents are not included when counting the number of full-time employees. A full-time employee for purposes of the ERC is one that works either 30 hours a week or 130 hours per month.
Treatment of Tips
The IRS has also clarified the amount of tips that count as wages eligible for the ERC. Notice 2021-49 confirms that cash tips of $20 more in a month are counted towards wages eligible for the ERC. The Notice also concludes that an employer may receive the ERC and the section 45B credit on excess social security taxes paid on tips on the same wages. This is a rare instance in the tax law where two credits can be claimed on the same wage amount.
Timing of Disallowance of Wage Deduction
The CARES Act prevents an employer from receiving a deduction on its tax return for the amount of the ERC an employer receives. Notice 2021-49 makes clear that the disallowance of the wage deduction takes place in the year of the credit. If an employer claims an ERC for 2020, they must reduce the amount of wages they deduct in 2020 by the amount of the ERC, even if they did not file and claim the ERC until 2021. If a tax return for 2020 has already been filed, Notice 2021-49 makes clear that an amended return must be filed to correct the excess deduction taken.
Wages paid to owners and their spouses
A significant outstanding question surrounding the ERC has always been whether wages paid to a company’s owner and their spouse counts as qualified wages for purposes of the ERC. When the IRS originally released its Frequently Asked Questions on the ERC, they specified that wages paid to a person related to a majority owner did not qualify for the ERC. A related person included siblings, children, parents, stepparents, step-siblings, grandparents, aunts, uncles, nieces, nephews, and in-laws. When it came to the owner and their spouse themselves, however, the guidance was silent.
Notice 2021-49 answers this question by applying the constructive ownership rules of section 267(c). Under section 267(c), a majority owner’s ownership is attributed to the members of his or her family fitting the familial relationship listed in section 267(c)(4). Those familial relationships include siblings, spouses, ancestors, and lineal descendants (i.e. children and grandchildren).
The IRS has taken the position that if a majority owner has any of these familial relationships listed in 267(c)(4), then their wages will not count as qualifying wages for the ERC. As an example, assume a husband and wife are the sole owners of their business. They have no living siblings, parents, grandparents, children, or grandchildren. In this case, the wages paid to the husband and wife would qualify for the ERC.
Under a different scenario, assume instead that a husband and wife were sole owners of their business, but they have one child. Under section 267(c)(4) attribution rules, their child would be deemed to own a majority of the company. When calculating wages for the ERC, wages paid to anyone related to a majority owner do not qualify for the credit. The wages paid to the husband and wife would no longer qualify for the ERC since the husband and wife are related to the majority owner of the company (i.e. their child).
Needless to say, the guidance provided by the IRS produces a very confusing result. Instead of looking at the business itself and who is involved in the management and control of that business, the IRS is somewhat arbitrarily looking at family structure, whether that family is involved in the business or not. This guidance impacts both the 2020 and 2021 ERC.
PPP Loan Forgiveness not included in gross receipts
In order to be eligible for the ERC, an employer must either be shut down due to a government order or have a significant drop in gross receipts in any quarter compared to the corresponding quarter of 2019. Some practitioners have questioned whether PPP loan forgiveness would be considered gross receipts when calculating whether a significant drop in gross receipts occurred. The IRS recently released Revenue Procedure 2021-33, which allows employers to exclude PPP loan forgiveness from gross receipts for purposes of calculating eligibility for the ERC.