IRS Issues New Guidance on the Employee Retention Credit
Aug 6, 2021
On August 4, 2021, the IRS released Notice 2021-49 (the “Notice”), which includes 34 additional pages of guidance clarifying the application of the Employee Retention Credit (“ERC”). Technically, the Notice applies to wages paid in the third and fourth quarters of 2021, which are governed by §3134 (enacted March 11, 2021). It also includes a section that addresses “miscellaneous issues” applicable to the ERC for both 2020 and 2021.
Note that the latest iteration of the infrastructure bill (H.R. 3684), if enacted in its present form, would eliminate the ERC for Q4 2021 for all businesses except recovery startup businesses.
The 2020 ERC and the ERC for the first two calendar quarters of 2021 are governed by the CARES Act (enacted March 27, 2021) and by prior IRS guidance. The IRS first issued guidance on the ERC in the form of FAQs and two notices, Notice 2021-20 (relating to 2020 ERC) and Notice 2021-23 (relating to ERC for Q1 and Q2 2021). The notices are more recent than the FAQs and incorporate the information provided in the FAQs.
Notice 2021-49 provides some new guidance and clarifies some of the existing and thorny issues that arose under the 2020 ERC and the ERC for the first two quarters of 2021. Recognizing that most readers want just the basics, here they are in bullet format.
- Full-time employees: The ERC generally tests the size of the employer using a monthly average in 2019, and for this purpose, it counts only full-time employees. It was unclear whether the rules counted only full-time employees, or whether it also included full-time equivalents, like the PPP. The Notice clarifies that it includes only full-time employees, meaning those employees that work 30 hours/week or 130 hours/month. The Notice also confirmed that once an employer qualifies for the ERC, qualified wages include those paid to all employees, not just full-time employees.
- Timing of wage deduction disallowance: While the receipt of the ERC itself is not includible in gross income, the wages giving rise to the ERC are subject to expense disallowance, effectively making the amount of the ERC taxable. The open question is when to disallow the expenses. For example, if an employer claimed the 2020 ERC by filing Form 941-X in January 2021, and it received the funds from the IRS in April 2021, should the wages giving rise to the ERC be disallowed in 2020 or in 2021. We took a stand in a published article back in March 2021 and said the expense disallowance should occur in 2020, and we are happy to report the IRS agreed with us. The Notice states that expense disallowance occurs in the year the qualifying wages are paid, not the year in which the ERC is claimed or received. Thus, wages giving rise to the 2020 ERC are disallowed in 2020, and wages giving rise to the 2021 ERC are disallowed in 2021. This will cause many taxpayers to have to file amended tax returns or administrative adjustment requests if they already filed their 2020 tax returns. For a more nuanced analysis addressing cash basis and accrual basis taxpayers, see our prior published article.
- Gross Receipts Safe Harbor: In Notice 2021-20, the IRS offered a taxpayer-favorable safe harbor for businesses acquired in 2020, but in subsequent guidance it did not extend the safe harbor to businesses acquired in 2021. Now, the Notice extends it so for businesses acquired in 2021, acquirors are permitted to include the 2019 gross receipts of the acquired business in its gross receipts calculation, making it more likely to qualify for the ERC. It would have been hard to qualify for the ERC if an acquiror had to include the gross receipts from the new business in 2021 but was not permitted to include the pre-acquisition gross receipts from 2019. The Notice fixed this and now allows for an apples-to-apples comparison.
- Interaction with other COVID-related government assistance programs: The wages giving rise to the ERC cannot be used to support loan forgiveness on a PPP loan; in other words, double dipping is not permitted. The Notice refers to §3134(h)(1) and states that taxpayers cannot double dip with the shuttered venue operators grant or the restaurant revitalization grant, and they must retain documentation to support the amount of the ERC claimed.
- Wages paid to relatives of shareholders/partners: This has always been a sticky wicket, and we have fielded countless questions from accountants around the country on this issue. The question is whether wages paid to greater-than-50% shareholders/partners of a business, and their “relatives,” can count as qualifying wages for purposes of the ERC. The ERC does incorporate preexisting ownership attribution rules in the tax code, but the IRS previously gave short shrift to the issue and it was unclear how detailed an analysis was required. The Notice clears this up and states unequivocally that the ownership attribution rules apply with full force. Here is a simplified takeaway:
- If a greater-than-50% shareholder/partner has a living “relative,” then the shareholder’s/partner’s wages are not qualifying wages (because the constructive ownership rules apply to attribute the stock/partnership interest to the relative, and then back to the shareholder/partner).
- “Relatives” include children, grandchildren, siblings, step-siblings, parents, grandparents, step-parents, nieces, nephews, aunts, uncles, son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, sister-in-law, or a dependent of the taxpayer who lives in the same household.
- If a greater-than-50% shareholder/partner has no living “relative,” then the shareholder’s/partner’s wages are qualifying wages.
- Even though spouses are not included in the list of “relatives,” if a greater-than-50% shareholder/partner has a living relative, and such relative is also related to the spouse, then the spouse’s wages are not qualifying wages (because the constructive ownership rules attribute the stock/partnership interest to the Relative, and then to the spouse).
- If a greater-than-50% shareholder/partner has no living “relative,” then the shareholder’s/partner’s spouse’s wages paid are qualifying wages.
- Tips and §45B credit: The issue is whether tips are included in qualifying wages and thus eligible for the ERC, and whether including them in the ERC calculation would prevent an employer from also claiming credits under §45B, commonly referred to as the “tip credit.” The Notice confirms that the same tips that treated as wages may be used to support the ERC and the tip credit under §45B.
Overall, the Notice is helpful and favorable to taxpayers, and thankfully should not require tens of thousands of taxpayers to have to amend their ERC calculations. If you would like to discuss your specific circumstances and whether you qualify for the ERC, please reach out to your Withum advisor.
SBA Financial Assistance Services
Can My Startup Business Receive the Employer Retention Credit?