CHICAGO – NOVEMBER 1: Current federal tax forms are distributed at the offices of the Internal … (+)
The employee retention credit (ERC) started out slow but keeps going strong, even to the present day. When it was first enacted on March 27, 2020 as part of the CARES Act, it received little fanfare because taxpayers that received a forgivable loan under the paycheck protection program (PPP) were prohibited from claiming the ERC. When that prohibition was lifted nine months later by the Consolidated Appropriations Act, 2021, claims for the ERC exploded. Then, Congress added fuel to the fire and kept making the rules more generous as time went on.
One unfortunate side effect of the ERC explosion has been the proliferation of tax credit companies offering dubious advice in exchange for outsize fees. Be especially wary of the ones that overstate their credentials or ability to provide advice regarding the ERC. Some claim to have received special training from the IRS (they have not) and others claim to have special knowledge regarding the law for one reason or another (they do not – detailed information about the ERC is available to anyone with an internet connection). One company claims that its ideas are “proprietary” and refuses to discuss them in front of outside advisors.
The written advice some of these companies provide to their clients is lacking. We have seen instances where a company provides the same boilerplate tax memo to multiple clients, notwithstanding that the clients were engaged in different businesses and their eligibility depended on different factors. The memos are more than 20 pages in length but as far as we could tell, only two or three lines of text are different. There is no description of the facts and no analysis of the factors in IRS Notice 2021-20, Q&As 11-22 (the ERC claims at issue were all predicated on a partial suspension of business operations). The memos are so generic that they most likely would not qualify as tax advice that clients can rely on to assert reasonable cause to avoid penalties.
Some of these advisors also promise indemnification and audit support if their clients are audited by the IRS. These promises are hollow. First, the indemnification relates only to the fees paid to the advisor; the client remains on the hook to repay the entire amount of the ERC to the IRS, and for any interest and penalties that may apply. Second, the indemnification provisions typically require the clients to allow the advisor to control the audit, which is something many clients may not want to do at that time. Also, no mention is made in the retainer agreements that audit support is included in the ERC fee, though typically that is promised orally. Last, the retainer agreements often state something to the effect that the advisor is not providing tax or accounting advice. Yes, the advisor is providing advice that the client is eligible for a tax credit – the ERC, and the advisor is calculating the amount of the credit, but the advisor states that it is not providing tax or accounting advice. Huh?
Let’s now review the general rules of the ERC and then explore some of the areas where the IRS is likely to inquire of all taxpayers on audit.
WASHINGTON, DC – APRIL 15: The Internal Revenue Service (IRS) building stands on April 15, 2019 in … (+)
In general, there are two eligibility tests for the ERC for 2020 and for the first three calendar quarters of 2021 – the gross receipts test and the suspension of operations test. The benefit of the gross receipts test is that it is objective – taxpayers need only show a decline in gross receipts of more than 50% in any calendar quarter in 2020, or more than 20% in any of the first three calendar quarters in 2021. See generally Notice 2021-20, Q&As #23-28. The reason for the decline in gross receipts is irrelevant. There are nuances to the definition of gross receipts – e.g., PPP loan forgiveness proceeds are excludible, and to the calendar quarters that can be used for measurement purposes, but for our purposes here it is enough to note the general rules. Another nice thing about the gross receipts test if that if it is met for a particular calendar quarter, then the taxpayer can include in the ERC calculation wages and health plan expenses paid during the entire calendar quarter, and in some cases the taxpayer can automatically qualify for a second quarter as well.
The suspension of operations test is a subjective test. See generally Notice 2021-20, Q&As #11-22. It is the test that is used when a taxpayer does not meet the gross receipts test. It generally requires the taxpayer to establish the following:
1. The taxpayer suffered a full or partial suspension of business operations due to a governmental order that limited commerce, travel, or group meetings due to COVID-19.
2. The taxpayer’s employees were not able to work comparably through telework.
3. The full or partial suspension of operations had more than a nominal effect on the taxpayer’s business operations.
If there is a full or partial suspension of business operations, then the taxpayer generally can include in the ERC calculation only those wages and health plan expenses paid during the period of the suspension.
As you can see, there is a real benefit to qualification under the gross receipts test – it is objective and it includes wages/health plan expenses for the entire calendar quarter of eligibility. Many taxpayers, however, do not meet the gross receipts test and must rely on the suspension of operations test, which is subjective and includes wages/health plan expenses only for the period of the suspension.
In those instances where we have seen tax credit firms provide overly optimistic advice, it has been in their interpretation of the suspension of operations test. Some of them take an extremely broad interpretation of that test and use its subjectivity as a sword. When discussing with clients the advice they received from one of these shops, and whether it makes sense, we generally focus on the following questions:
- Did they identify a governmental order (see Q&A #10) that limited the business’s commerce, travel, or group meetings due to COVID-19 – it is not enough to focus on the impact to the business; identification of the governmental order is a necessary first step in the analysis.
- Did they determine whether the effect on the business was more than a nominal (see Q&As #17-18).
- Did they analyze whether the employees of the business were able to work comparably through telework (see Q&As #15-16).
- If their advice is accurate, would it apply to every business in the country from March 13, 2020 through the end of Q3 2021, and if so, do you think that is what Congress intended? This last question give clients pause, because it forces them to focus on the big picture.
What Issues Can We Expect The IRS To Audit?
Even if you are happy with the advisor you used to prepare your ERC claim, you are not out of the woods. The IRS is expected to begin auditing ERC claims in the coming months and it has 3 years from the filing date of the relevant Form 941 tax return to assert deficiencies, and 5 years in the case of ERC claims for the third and fourth calendar quarters of 2021 (see §3134(l)).
Here is where we think the IRS will focus its audit activity:
Determination of Small vs. Large Eligible Employer
1. Did the taxpayer calculate correctly the number of full-time employees (FTEs) in 2019? Recall that an FTE for this purpose is an employee that worked 30 hours/week or 130 hours/month, and that a monthly average for 2019 is required. Recall also that this calculation is different from the full-time equivalent calculation for the PPP.
2. Did the taxpayer correctly determine whether the employer was a small eligible employer or a large eligible employer? Recall that the test for a small eligible employer is as follows: (i) for the 2020 ERC, did the taxpayer have 100 or fewer 2019 FTEs and (ii) for the 2021 ERC, did it have 500 or fewer 2019 FTEs. See question #15 below for qualifying wages applicable to each, and see Notice 2021-20, Q&A #38, for certain exclusions applicable to large eligible employers.
Gross Receipts Test
3. Did the taxpayer calculate gross receipts correctly, as such term is defined in §448(c) (or §6033 for tax-exempt entities)? Recall the taxpayer should use the same method of tax accounting, cash or accrual, that is used for tax purposes for the relevant tax year.
4. Did the taxpayer rely on the safe harbor for business combinations in 2020 and in 2021? See, e.g., Notice 2021-20, Q&A #28.
Suspension of Operations Test
5. Did the taxpayer identify a governmental order that limited its commerce, travel, or group meetings due to COVID-19?
6. Were the taxpayer’s employees able to work comparably through telework?
7. Did the full or partial suspension of operations had more than a nominal effect on the taxpayer’s business operations? Consider the 10% safe harbor in Notice 2021-20, Q&A #11.
8. Did the partial suspension of operations result from a reduction in demand? See Notice 2021-20, Q&A #13.
9. Did the taxpayer apply the aggregation rules correctly? These rules are complex and they should be applied only by an experienced advisor.
10. Did the taxpayer apply aggregation for purposes of (i) the gross receipts test, (ii) the suspension of operations test, (iii) the calculation of the number of FTEs, and (iv) in determining the maximum credit amount per employee? See Notice 2021-20, Q&A #7.
11. Did the taxpayer ensure it did not use wages in the ERC calculation that were used for the PPP, i.e., it did not double dip the wages? Recall there are other credits, such as FFCRA paid family/sick leave credits, that must be considered too.
12. Did the taxpayer exclude from qualifying wages severance and other post-termination payments made to former employees? See Notice 2021-20, Q&A #39.
13. Did the taxpayer include the correct qualifying wages for small eligible employers (all wages paid during the relevant period) and for large eligible employers (only wages paid not to provide services during the relevant period)?
14. Did the taxpayer exclude qualifying wages for self-employed individuals, greater-than-50% owners, and “related individuals”? Recall that constructive ownership rules apply here and that the “related individual” determination is quirky and can produce unexpected results.
15. Did the taxpayer apply the $10,000 qualifying wage limit per employee correctly — $10,000 for March 13, 2020 through December 31, 2020, and $10,000 for each of the first three calendar quarters in 2021?
16. Did the taxpayer apply the appropriate percentage limitation to the amount of qualifying wages – 50% in 2020, and 70% in each calendar quarter in 2021?
17. If the taxpayer qualified for the ERC as a recovery startup business, did it meet the definition of such term in §3134(c)(5)?
18. Did the taxpayer maintain adequate records to substantiate its ERC calculation and the amount of qualifying wages?
19. Did the taxpayer disallow the wage/health plan expenses that were used for the ERC on its appropriate federal income tax returns? Recall that such expenses must be disallowed on the tax return for the tax year in which they were paid, not the year in which the ERC was applied for or received.
The rules for the ERC are detailed and complex, and claims for the ERC are filed under penalties of perjury. If a business is concerned with the analysis underlying its claim, then now is the time to have it reviewed. Do not wait until the IRS comes knocking, because at that point it may be too late.