Retroactive Changes to the Employee Retention CreditBy
Several pieces of legislation have made changes to the refundable payroll tax credit since its inception in 2020.
The employee retention credit (ERC) was originally created in the Coronavirus Aid, Relief, and Economic Security (CARES) Act of 2020 (P.L. 116-136). A refundable payroll tax credit rather than an income tax credit, the ERC was originally applicable to wages paid after March 12, 2020, through the end of 2020. Eligible employers are those that had a full or partial suspension of their business due to a governmental order or whose business had a significant decline in its gross receipts. This credit was designed to encourage these employers to keep employees on the payroll in circumstances when the employer would otherwise suspend the employees’ services without pay.
The gross receipts decline necessary for a business to qualify was 50% for the quarter in 2020 compared to the corresponding quarter in 2019. The credit was originally 50% of qualified wages paid to an employee, up to a maximum of $10,000 in wages for the year. This resulted in a maximum potential credit of $5,000 per employee. Several pieces of subsequent legislation have made changes to the ERC, and the Internal Revenue Service (IRS) has issued guidance to clarify the credit’s requirements and implementation.
CONSOLIDATED APPROPRIATIONS ACT
The ERC was extended and modified by the Consolidated Appropriations Act (CAA) of 2021 (P.L. 116-260). This included prospective changes as well as taxpayer-friendly retroactive changes that were effective as if they had been included in the CARES Act. It also extended the ERC from January 1, 2021, through June 30, 2021.
One of the primary CAA changes was to increase the credit percentage from 50% of qualifying wages to 70% of qualifying wages. Another change was to increase the maximum level of an employee’s qualifying wages from $10,000 per year to $10,000 per quarter. So, assuming the employee qualified for three quarters in 2021 and had $10,000 or more in wages per quarter, the employer could qualify for $21,000 of credit in total with respect to that employee. In 2020, these same conditions would have given rise to a credit of only $5,000.
In addition, the required percentage drop in gross receipts was also modified to a 20% drop in gross receipts compared to the same quarter in 2019 rather than the 50% that had been required in 2020. So, a business that had recovered significantly from 2020 to 2021 but was still operative at 80% or below of its 2019 level could still qualify.
The CAA changes also allow taxpayers to elect to compare the prior calendar quarter to the corresponding prior calendar quarter of 2019. For example, a taxpayer wishing to qualify for the third quarter of 2021 could compare the second quarter of 2021 to the second quarter of 2019. If the taxpayer wasn’t in business in 2019, then the gross receipts comparison is made between 2021 and 2020 (rather than 2019) and the elective use of the prior calendar quarter isn’t available.
Another significant change was the ability of employers with 500 or fewer employees to take the credit on potentially all employees and not just wages paid to those employees not working. Originally this ability was limited to employers with no more than 100 employees.
The taxpayer-friendly retroactive changes in the CAA included the ability to take the ERC even if the taxpayer had received a Payroll Protection Plan (PPP) loan. Originally the ERC wasn’t allowed if the taxpayer had taken a PPP loan. The PPP program allowed businesses to obtain loans that could be forgiven if certain conditions were met, the most significant being that 60% of the amount forgiven was based on payroll costs. The modification allowed the ERC for the qualifying wages that were paid but that weren’t used to claim tax-free loan forgiveness under the PPP loan program. A second taxpayer-friendly change was the ability to claim the credit for group health plan expenses even in cases in which these were the only wages paid to employees.
ARP AND INFRASTRUCTURE ACT
The American Rescue Plan (ARP) Act of 2021 extended the ERC through December 31, 2021, and created new provisions for what it terms “a recovery start-up business.” The Infrastructure Investment and Jobs (Infrastructure) Act (P.L. 117-58), however, subsequently included a retroactive provision related to the ERC that negatively affects taxpayers because this law wasn’t enacted until November 15, 2021. This change eliminated the credit after September 30, 2021, except in the case of a recovery start-up business.
This is significant since it’s rare for retroactive changes with a negative effect on taxpayers to be enacted. In general, changes with negative impact are made on a prospective basis. It should be noted that the draft of the legislation had been in existence prior to the end of September 2021, so taxpayers that were following the legislative developments wouldn’t have been surprised by the retroactive effect.
The ARP Act defines a recovery start-up business as one that began conducting business after February 15, 2020, has average annual gross receipts not exceeding $1 million, and which, for that calendar quarter, doesn’t have more than 20% reduction in gross receipts nor had its operations fully or partially suspended by an appropriate government order. A business using this classification to claim the ERC in the last two calendar quarters of 2021 is limited to $50,000 per quarter. The ARP Act also created the new classification of a severely financially distressed employer, which requires gross receipts of the calendar quarter to be less than 10% of those for the corresponding quarter in 2019.
The IRS has also issued administrative guidance to help clarify the ERC’s rules and qualifications. These include Notice 2021-20, Notice 2021-23, and Notice 2021-49.
Self-employed individuals aren’t eligible for the credit for their earnings, but they may be eligible if their business has employees. It’s important to note that wages paid to certain related parties, even in the case of corporate entities, may not qualify for the credit. The employer isn’t entitled to an expense deduction for amounts that are claimed as a credit.
This credit wasn’t extended into 2022. Yet there are employers, particularly those who obtained PPP loans, who may not have taken advantage of the credit in 2020 or 2021 when originally available. An employer with qualifying expenses who didn’t originally claim the ERC should consider filing Form 941-X to claim the credit.
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