This alert has been revised to reflect updated guidance provided by the Small Business Administration and the IRS.
On April 29, 2020, the IRS provided guidance on the employee retention credit (ERC), by significantly expanding upon a list of “frequently asked questions” (FAQ) posted on its website. The FAQ now includes 94 questions covering an array of topics, including the determination of eligible employers and qualified wages, and how the credit interacts with other relief provisions provided by the Coronavirus Aid, Relief, and Economic Security (CARES) Act and Families First Coronavirus Response Act (FFCRA).
This alert focuses on certain key areas where the IRS provided new or updated guidance.
The ERC is a fully refundable payroll tax credit made available by the CARES Act to employers, including not-for-profits, that had their operations fully or partially suspended as a result of a government order limiting commerce, travel or group meetings (the “suspension test”). The credit is also provided to employers who have experienced a greater than 50% reduction in quarterly receipts, measured on a year-over-year basis (the “gross receipts test”).
The ERC is equal to 50% of qualified wages, not to exceed $10,000 per employee, paid by the employer from March 13, 2020, through the end of the calendar year. Qualified wages paid by an employer with 100 or fewer employees generally include all wages paid during the economic hardships described above; for employers with more than 100 employees, qualified wages are limited to wages paid to employees while they are not performing services. Qualified wages can also include qualified health plan expenses paid by the employer.
Key takeaways from the IRS FAQ
Determining eligibility under the suspension test
- Essential employers that have not been ordered to fully or partially shut down generally are not considered to have a suspension of operations. An employer that operates an essential business most likely will not qualify under the suspension test if the governmental order allows the employer to remain open, even though nonessential businesses being shut down by the order may have an effect on the employer’s operations. Exceptions are available for employers whose:
1. Facts and circumstances indicate their operations have in effect been suspended due to an inability to obtain critical goods or materials because their suppliers have been shut down, or
2. Hours of operation have been reduced due to a governmental order.
- An essential employer will not qualify under the suspension test solely because its customers are subject to a government stay-at-home order. Consider a gas station that is not required to close its location or suspend its operations because it is deemed to be essential. However, its business has suffered significantly because its community is under a governmental order that limits travel and requires residents to stay at home except for certain essential needs. The gas station is not eligible for the ERC under the suspension test. However, if its gross receipts declined by more than 50%, it could be eligible for the ERC under the gross receipts test.
- Employers required to close their physical locations, but able to maintain comparable operations through telework are not considered to have a suspension of operations. This can have implications to an employer deemed “nonessential,” but because they are able to continue their operations remotely at a comparable level, they do not pass the suspension test.
It is unclear what constitutes operations comparable to the business’ operations prior to the closure, but a nonessential employer would likely need to show a significant impact on their ability to perform its operations remotely (e.g., entire functions shut down or a significant reduction in the employer’s capacity to perform operations at a normal level).
It is important to note that the IRS repeatedly emphasizes during its discussion of the suspension test-related issues that employers who are ineligible for the credit on this basis may still be considered an eligible employer if it passes the gross receipts test.
Paycheck Protection Program (PPP) loan recipients are ineligible for the credit
The CARES Act provides that taxpayers cannot benefit from both a PPP loan and the ERC, but, prior to the issuance of these FAQ, it was unclear whether the ERC could be claimed for periods prior to borrowing. The FAQ states that PPP loan recipients cannot claim the ERC regardless of 1) the date of the loan, and 2) whether and when the loan is forgiven. Further, if an employer in an aggregated group is a PPP loan recipient, the entire group is rendered ineligible for the credit.
However, on May 6, 2020, the Small Business Administration updated its list of Paycheck Protection Program Loans Frequently Asked Questions to provide that employers who repay their PPP loans pursuant to a safe harbor by May 14, 2020, will be deemed to have never received the loan and, therefore, eligible for the ERC. For additional details on this safe harbor, please see our previous alert.
Impact of aggregation
The CARES Act provided that a controlled group of entities as determined under the Internal Revenue Code’s aggregation rules will be considered a single employer when determining eligibility for the ERC, but it was unclear on how the facts and circumstances of one or more component controlled group members would affect the group as a whole. The expanded IRS FAQ addresses several questions in this area:
- A single business entity operating in multiple locations whose operations have been suspended in one or more jurisdictions, but not others, will qualify under the suspension test. This could be a huge boost to employers with a national or regional presence under this circumstance, as they would qualify under the suspension test with respect to all of its operations in all locations.
- A single employer in a controlled group qualifying under the suspension test qualifies the entire aggregated group. The FAQ provides that an entire aggregated group’s operations are deemed fully or partially shut down, if merely one of its members’ operations are suspended by a governmental order. For example, consider a restaurant chain that is an aggregated employer group of multiple facilities in various locations. If one restaurant is ordered closed by a governmental order, the entire chain will be considered an eligible employer under the suspension test, even if multiple restaurants are located in jurisdictions not subject to any government restrictions.
- The gross receipts test considers the revenue of the entire aggregated group. Consider two entities, X and Y, that are a brother-sister controlled group. Both entities had 2019 second-quarter gross receipts of $500,000. X is in an area hard hit by COVID-19, and its 2020 Q2 gross receipts were only $150,000, 30% of its 2019 Q2 figure. Y is located in an area not as heavily affected by the virus, and its 2020 Q2 gross receipts were $400,000 (80% of its 2019 Q2 figure). Despite X experiencing a significant decline in gross receipts on its own, since the group’s 2020 Q2 gross receipts were 60% of the 2019 Q2 amount, neither entity is eligible for the ERC.
Determination of qualified wages
- For employers eligible for the ERC due to a full or partial suspension in its operations, qualified wages are limited to the period the order is in force. If the order was effective for only a portion of the calendar quarter, the employer can still claim the credit, but only for wages paid during the period the order is in force. Consider a business partially shut down by a governmental order While the business qualifies under the suspension test in both the first and second quarters, the ERC would not be available for wages paid prior to March 13, 2020, or after April 30, 2020.
- Eligible employers with more than 100 employees may not treat vacation, holidays, sick days or other leave under preexisting policies as qualified wages. The IRS reasons these wages were accrued during a prior period in which the employees provided services and, therefore, cannot be considered wages while the employee did not work. Conversely, since all wages paid by eligible employers with 100 or fewer employees are considered qualifying wages, such paid leave can produce an ERC.
- Qualified wages are determined on a pre-tax basis. Federal income and payroll taxes withheld or imposed do not reduce an employer’s qualified wages paid.
- Healthcare expenses may be treated as qualified wages. Employers with 100 or fewer employees can generally allocate health plan expenses to qualifying wages paid and treat such health plan expenses as qualifying wages. The IRS updated the FAQ to provide this is true even if an employer continues a furloughed or laid-off employee’s healthcare coverage, but does not continue to pay wages to the furloughed or laid-off employee.
Employers with more than 100 employees that furlough their workers or reduce their hours, but continue to provide them with healthcare coverage may treat health plan expenses allocable to the time that the employees are not working as qualified wages. To illustrate, a business qualifying under the suspension test reduces its employees’ hours by 50%, but continues to pay 60% of their wages and 100% of their health plan expenses. The business’ qualifying wages consist of both the 10% of wages paid to its employees while they are not working and the 50% of the health plan expenses, as they are allocable to the time the employees are receiving benefits, but are not providing services.
It is important to note that each section of the FAQ is prefaced with the following: “This FAQ is not included in the Internal Revenue Bulletin, and therefore may not be relied upon as legal authority. This means that the information cannot be used to support a legal argument in a court case.” Though not primary authority, the FAQ does provide a window to the IRS’ view of the matters covered in the absence of official guidance, which we hope is forthcoming. That said, there is no guarantee that these positions will be the same as those reflected in any formalized guidance. In closing, the IRS recommends taxpayers retain records supporting their ERC computations for at least four years.
We continue to review the FAQ and monitor developments in this area.
Please reach out to your Baker Tilly tax advisor to discuss how these changes may impact your tax situation.