Alert / Employee Benefits
An IRS rewards program: The employee retention tax credit

Updated April 20, 2020

For employers that don’t qualify for or receive the Paycheck Protection Program (PPP) loan discussed in our companion alert, the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) added a second avenue to earn rewards for retaining employees: the Employee Retention Credit (ERC).

The ERC is a fully refundable tax credit rewarding certain larger employers for paying employees while on leave or furlough due to the coronavirus. It also rewards certain smaller employers for paying any employee, whether active or on leave or furlough. The ERC is available for a period slightly broader than the last three quarters of 2020. The tax credits equal 50% of certain wages (and certain health plan expenses allocated to those wages) that employers pay to or on behalf of their employees, up to a maximum of $5,000 in credits per employee who receives those wages.

Lockton comment: A fully refundable credit means that if the employer can’t recoup the amount of its earned credit through, for example, an offset of payroll tax liabilities due the IRS, the IRS will send the employer the difference in cash.

Employers eligible for ERC: Downturn in operations or in gross receipts

Employers eligible for the ERC are those that carry on a trade or business during calendar year 2020, including a tax-exempt organization, and that either:

  • Fully or even partially suspend operations during any calendar quarter in 2020 due to orders from an appropriate governmental authority limiting commerce, travel or group meetings due to the coronavirus pandemic, or
  • Experience a significant decline in gross receipts during any such the calendar quarter, due to the COVID-19 virus.

Lockton comment: Governmental employers and self-employed individuals are not eligible for this credit.

The operation of a trade or business can be considered partially suspended if an appropriate governmental authority imposes restrictions upon the business operations by limiting commerce, travel or group meetings due to the COVID-19 virus, such that the business cannot operate at its normal capacity.

Example: To reduce the spread of the COVID-19 virus, a state governor issues an executive order closing all restaurants, bars and similar establishments in the state. However, the executive order allows those establishments to continue food or beverage sales to the public on a carryout, drive-through or delivery basis. This results in a partial suspension of the operations of any such business that typically would serve customers on a sit-down basis as well.

A significant decline in gross receipts occurs beginning with the first calendar quarter in 2020, where the employer’s gross receipts are less than 50% of its gross receipts for the same calendar quarter in 2019. The significant decline ends with the calendar quarter following the first calendar quarter for which the employer’s 2020 gross receipts are greater than 80% of its gross receipts for the same calendar quarter during 2019.

Example: An employer’s gross receipts were $100,000, $190,000 and $230,000 in the first, second and third calendar quarters of 2020, respectively. Its gross receipts were $210,000, $230,000 and $250,000 in the first, second and third calendar quarters of 2019, respectively. Thus, the employer’s 2020 first, second and third quarter gross receipts were approximately 48%, 83% and 92% of its 2019 first, second and third quarter gross receipts, respectively.

The employer had a significant decline in gross receipts commencing on the first day of the first calendar quarter of 2020. The decline ended on the first day of the third calendar quarter of 2020 (the quarter following the quarter for which the gross receipts were more than 80% of the same quarter in 2019). The employer is entitled to a retention credit with respect to the first and second calendar quarters.

Note that although status as an eligible employer takes into account a business downturn affecting even the first calendar quarter in 2020, the calculation of the actual tax credit – as noted below – depends on wages paid on or after March 13, 2020, and on or before Dec. 31, 2020.

Determining the maximum amount of the ERC

The credit equals 50% of certain wages, referred to as “qualified wages,” that an eligible employer pays to employees in calendar quarters in 2020. Qualified wages include certain health plan expenses allocable to those wages. As noted earlier, the maximum credit in 2020 for qualified wages paid to any one employee is $5,000.

Example: An eligible employer pays Employee A $8,000 in qualified wages in Q2 2020 and $8,000 in qualified wages in Q3. The credit available to the eligible employer for the qualified wages paid to Employee B is equal to $4,000 in Q2 and $1,000 in Q3 due to the overall limit of $10,000 on qualified wages and $5,000 in tax credits, per employee for all calendar quarters.

Qualified wages: The cornerstone of the calculation

Qualified wages can include only certain wages paid by an eligible employer to employees on or after March 13, 2020, and on or before Dec. 31, 2020. The definition of qualified wages differs depending on the size of the employer during 2019. In determining size, we look to the number of the employer’s full-time employees for Affordable Care Act (ACA) employer mandate purposes (i.e., those averaging at least 30 hours of service per week, or 130 hours of service per month).

Lockton comment: The CARES Act requires all employers considered a single employer under the tax code's controlled-group rules or affiliated-service-group rules to be considered a single employer for purposes of the retention credit. While normally a controlled-group determination looks to see whether there is at least 80% common ownership, in this case, merely 50% common ownership is enough to compel aggregation of the employers.

If the employer averaged more than 100 ACA full-time employees in 2019, qualified wages are the wages paid to an employee for time that the employee is not providing services due to either (1) a full or partial suspension of operations by order of a governmental authority due to the COVID-19 virus, or (2) a significant decline in gross receipts. For these employers, qualified wages taken into account for an employee may not exceed what the employee would have been paid for working the period the employee would have worked during the 30 days immediately preceding the period of economic hardship.

Lockton comment: So, qualified wages for larger employers basically amount to paid leave or furlough. Note, however, that if the employer is claiming a tax credit for providing an employee with paid sick or extended family leave under the Families First Coronavirus Response Act, the employer can’t claim those same wages for purposes of the ERC.

If the eligible employer averaged 100 or fewer ACA full-time employees in 2019, qualified wages are the wages paid to any employee during any period of economic hardship caused by the full or partial suspension of operations or significant decline in gross receipts as described above.

Lockton comment: The statute speaks to paying "qualified wages" for periods (in the case of an employer or aggregated group of employers with more than 100 ACA full-time employees) for which the employee was not working. Presumably these "wages" may include salary paid to non-hourly employees, for periods during which the salaried employee was not performing services.

The CARES Act says qualified wages include “so much of the eligible employer’s qualified health plan expenses as are properly allocable to such wages.” These health plan expenses are amounts paid by the employer, and pretax by employees, to fund a group health plan, the benefits of which are tax free to employees. The Act hints that health plan expenses should be allocated pro rata among covered employees, and pro rata for the period for which qualified wages were paid.

Lockton comment: So, for example, if the employer’s cost of providing a health plan to employees amounts to $12,000 per year per covered employee, and the employee receives qualified wages for one month in 2020, it seems reasonable to assume that $1,000 in employer-paid health plan benefits would be included in the qualified wage calculation.

Claiming the ERC

Employers claim the ERC by offsetting the amount they’re due against the employer portion of social security taxes or, in the case of railroad employers, the portion of taxes imposed under the Railroad Retirement Tax Act that corresponds to Social Security taxes (we’ll refer to these taxes as merely “Social Security taxes”).

Lockton comment: Because the ERC is a refundable tax credit, if for any calendar quarter the amount of the credit the eligible employer can claim exceeds the employer’s portion of Social Security taxes on all wages paid to all employees, then the excess is treated as an overpayment. The overpayment, to the extent it is not offset against other tax liabilities of the employer on its employment tax return, is refunded to the employer.

Here are the mechanics of the employer’s claim to the ERC: The employer will report its total qualified wages and the related ERC for each calendar quarter on its federal employment tax returns, usually Form 941, Employer's Quarterly Federal Tax Return.

Lockton comment: Form 941 is used to report income and Social Security and Medicare taxes withheld by the employer from employee wages, as well as the employer’s portion of Social Security and Medicare tax.

In anticipation of receiving the credits, eligible employers can fund their qualified wage payments by holding back federal employment taxes, including taxes withheld from employees, that the employer would otherwise be required to deposit with the IRS. Alternatively, the employer may request an advance of the credit from the IRS.

Thus, if the employer pays qualified wages to its employees in a calendar quarter before it is required to deposit federal employment taxes with the IRS for that quarter, the employer may reduce the amount of federal employment taxes it actually deposits with the IRS for that quarter by half of the amount of the qualified wages paid in that calendar quarter (remember the tax credit is equal to 50% of the qualified wages paid, up to a maximum of $5,000 per employee, for the year). The employer then accounts for the reduction in deposits on its Form 941 for the quarter.

Example: An eligible employer paid $10,000 in qualified wages (including qualified health plan expenses) to an employee and is therefore entitled to a $5,000 ERC. The employer is otherwise required to deposit $8,000 in federal employment taxes, including taxes withheld from all employees on wages paid during the same quarter. The eligible employer has no paid sick or family leave credits under the FFCRA. The eligible employer may keep up to $5,000 of the $8,000 in payroll taxes the employer was going to deposit, and it will not owe a penalty for keeping the $5,000. The employer will later account for the $5,000 it retained when it files Form 941 for the quarter.

Claiming advance tax credits

Because quarterly payroll tax returns are not filed until after qualified wages are paid, some eligible employers may not have sufficient federal employment taxes set aside (for deposit with the IRS) to fund the qualified wages they intend to make. The IRS, however, has established a procedure for obtaining an advance of the refundable credits by filing Form 7200.

Example: An eligible employer paid $20,000 in qualified wages in Q2 of 2020 and is therefore entitled to an ERC of $10,000. The employer is otherwise required to deposit $8,000 in federal employment taxes, including taxes withheld from all employees, on wage payments made during the same quarter. The employer has no paid sick or family leave credits under the FFCRA. The eligible employer can keep the entire $8,000 of taxes it was otherwise required to deposit, as a portion of the credits it is entitled to claim on Form 941. The employer may then file a request for an advance credit for the remaining $2,000 by completing Form 7200.

Conclusion

The Employee Retention Credit can provide much needed help for employers struggling against the financial headwinds of the coronavirus and that are not able to qualify for a Paycheck Protection Program loan. Employers will want to stay tuned for yet more help from Congress, as there is already talk of a second $2 trillion relief package in the offing.

 

Not legal advice: Nothing in this Alert should be construed as legal advice. Lockton may not be considered your legal counsel, and communications with Lockton's Compliance Services are not privileged under the attorney-client privilege.

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