Employee Retention Tax Credits
By Justin Ash, CPA
Employee Retention Credits (ERC) provide employers with much needed relief after more than two years of a global pandemic. The ERC functions as government stimulus in the form of a tax credit. The refundable credits add up quickly, considering the typical maximum benefit is $26,000 per employee (if an employer is eligible for all quarters). When the first government shutdown orders of the pandemic were announced in March of 2020, it was in the best interest of society as a whole for employers to keep employees employed. Congress authorized the ERC tax credits for employers that did.
There are two ways to qualify, but under either scenario the base upon which credits are calculated is the wages paid to employees during the worst of the pandemic (2020 – 2021). If an employer had no employees during 2020 and 2021, they are not eligible for ERC credits and independent contractors are not considered employees for this purpose.
The first, and easiest, method to qualify is documenting a significant reduction in gross receipts in a particular quarter compared to the same quarter in 2019. During 2020, a company needed to experience a 50% drop to qualify and in 2021 a 20% drop. This is the easier method because producing an income statement by quarter and calculating the percentage drop is all that is required.
The second method occurs if a business was subject to a government shutdown order and experienced a full or partial suspension of operations. Both of those criteria must be satisfied to qualify, and this is difficult to document. However, many businesses satisfy these requirements due to the nature of their business. For example, in upstate New York every restaurant and bar was subject to the Governor’s shutdown order and altered their operations to survive. Several restaurants with about 50 employees were eligible for nearly $500,000 in refundable credits.
The above eligibility criteria are quite basic. There are a litany of special circumstances and exceptions that must be examined to obtain the maximum benefit. In early 2020, legislation was expedited in an effort to get pandemic relief into the hands of businesses when they desperately needed it. Around the same time, the rules for PPP loans were finalized and government stimulus payments announced. Guidance for all of these complex and hastily assembled relief provisions was constantly changing. The result was inaccurate information. At first, it was thought non-profits were not eligible for the ERC credits but that guidance quickly changed. Still, many non-profits are under the impression that they don’t qualify when indeed they do. Now Congress has made it easy to qualify by purposefully wording the criteria to apply broadly.
Once employers get past the complex requirements and determine they are eligible, they still face a complicated set of rules regarding how to calculate eligible wages. One problematic detail is how to offset PPP loan forgiveness with ERC eligible wages. Employers can benefit from both programs, they just can’t use the same expenses for both (per the no double-dipping rule). There are ways to strategically allocate the PPP costs and ERC eligible wages in order to maximize the benefits. Documenting that the employer incurred non-payroll PPP costs (like rent, utilities, and personal protective equipment) that equal 40% of the total PPP loan funds preserves the maximum amount of wages to be used for both programs. Another example is including health insurance costs in eligible wages and excluding related party wages for certain employers. All of these complex moving parts can be frustrating for employers.
Real examples
1. An electrical equipment wholesaler/retailer experienced a drop in gross receipts of around 40% in 2020. That is not a large enough drop to qualify under the significant reduction of gross receipts test. However, the employer was subject to the Governor’s shutdown order mandating they limit the number of customers in the store at any given time and that non-essential employees stay home (which resulted operating with a skeleton crew). The employer experienced a partial suspension of operations because it was not possible to obtain inventory to resell. The combination of these factors qualified the employer.
To document the employer’s eligibility for the credits, we needed proof they could not obtain the raw materials to resell. We obtained reports from the employer’s purchase order system indicating the lead time for a conduit was about three weeks in 2019, but in 2020 was more than three months. This employer was eligible for about $190K in refundable credits they were not aware they were entitled to.
2. A dental office experienced an increase in total gross receipts, clearly failing the significant reduction of gross receipts test. In upstate New York, the Governor mandated that dentists were only allowed to perform certain procedures. Due to that rule the employer was subject to both a government order and a partial suspension of operations.
We obtained copies of the language in the Governor’s order relating to the special rules for dental offices and guidance issued by the NY society of dentists. The total refundable credits available to this dental practice was over $260,0000.
3. A non-profit employer that experienced a 60% drop in gross receipts during several quarters was aware they were eligible for credits. Their payroll company calculated credits totaling about $80K but management was surprised they weren’t eligible for more. Upon review, it was determined the payroll company never received any information regarding PPP loans that had been fully forgiven, nor asked about it. IRS rules dictate the benefit of both programs must be compared. After a review of all the documents, it was found the employer was eligible for twice as many quarters as the payroll company stated and the actual amount of the credits exceeded $360,000. While payroll companies are great at processing payroll, this is a reminder they are ill-equipped to interpret tax law and apply the appropriate complex limitations to keep clients out of IRS audits.