While most business professionals have at least a passing understanding of the PPP, far fewer have spent time looking at the ERC. This post provides additional details. GYF will also present a free webinar on January 21, 2021, that will cover both the ERC and PPP changes under the CAA. REGISTER HERE
The Consolidated Appropriations Act, 2021 (CAA) was signed by the President on December 27, 2020 (see related post). One of the major tax changes included in this bill is in Section 206, which allows businesses to retroactively borrow a Paycheck Protection Program (PPP) loan and also be eligible to claim an Employee Retention Credit (ERC) for 2020 (see related post). Before the CAA was passed, the Coronavirus Aid, Relief and Economic Security (CARES) Act, did not permit employers to utilize both benefits.
About the ERC
The ERC was part of the original incentives included in the CARES Act, enacted on March 27, 2020. This tax credit was intended to encourage businesses to keep employees on their payrolls despite the pandemic-related challenges they were facing. (see related post) However, the ERC did not receive a lot of fanfare because the CARES Act did not permit those who received PPP loans to make use of both stimulus provisions.
In effect, under the CARES Act, PPP loans and the ERC operated as mutually exclusive economic incentives. Due to the popularity of the PPP loans, few employers chose to take advantage of the ERC. However, a key element of the CAA is that qualified borrowers/employers may now be allowed to utilize both relief programs.
Unlike the PPP, the ERC is not limited by the number of employees and is a “refundable” payroll tax credit that is allowed against certain “qualified wages” attributable to employees during the pandemic.
To qualify for the ERC, employers must have either:
- Had their business fully or partially suspended during at least one quarter in 2020, OR
- Had a precipitous drop in gross receipts for quarters in 2020, relative to the same quarters in 2019
In 2020, if a particular business experienced a quarter in which it met either requirement above, the employer could claim a maximum credit of $5,000 per employee who was paid qualified wages. The definition of “qualified wages” was subtly different if the business had more than 100 full-time equivalent employees. (more detail below)
Changes to the ERC Under the CAA
Before we move forward in this discussion, it is important to note that the enhancement of the ERC under the CAA is an income tax provision to be made part of the Internal Revenue Code, which will be administered by Treasury and the Internal Revenue Service. In contrast, under the PPP, relief provisions in the form of forgivable loans are administered by the Small Business Administration.
The ERC provisions were due to expire on December 31, 2020, but two critical Sections (206 and 207) of the CAA extend and change the tax credit as it was first set forth in the CARES Act. Certain changes are retroactive to enactment of the CARES Act, but most apply only with respect to wages paid during the first two calendar quarters of 2021. Note that there is a third CAA Section (303) related to the ERC, but that section addresses businesses in a non-COVID-19 disaster area and is too specific for this discussion.
In looking at Sections 206 and 207, it is important to note the impact that each has on the determination of the ERC. Section 206 defines who may claim the credit – but does not address the mechanical computation for the period March 12, 2020 through December 31, 2020. Section 207 works to extend the credit until July 1, 2021, and also changes the mechanical computation rules for determining the ERC in 2021. It is important to note that the credit is computed differently for 2020 and 2021. Interestingly, Congress did not deem it appropriate to change the computational aspects of the ERC for 2020.
Section 206 – Eligibility
The major effect of the changes contained in Section 206 is to open, for the first time, the opportunity to claim the ERC to the thousands of businesses that had originally elected to go the PPP route in calendar year 2020.
As noted above, in 2020, the ERC was available for any for-profit business or tax-exempt organization that paid wages between March 12, 2020 and December 31, 2020. Those wages that qualified under the 2020 rules had to be paid during a calendar quarter in which the business was either: (1) fully or partially suspended during at least one quarter in 2020, or (2) had a precipitous drop in gross receipts for quarters in 2020, relative to the same quarters in 2019. Only one of these two requirements needed to be met for the business to be eligible to claim the ERC under the CARES Act.
In interpreting the first requirement, for any quarter in 2020, the businesses’ operations must have been “fully or partially suspended” during the quarter due to “orders from an appropriate governmental authority limiting commerce, travel or group meetings (for commercial, social, religious, or other purposes) due to COVID-19.” If a business or not-for-profit organization experienced such a closure, the quarter in which the closure occurred will constitute an “eligible quarter.”
The credit associated with this occurrence would be allowable only on those wages paid during the part of the quarter that the closure was in force. In other words, the credit was available only for wages paid during a period when the business was not operating or not operating at normal capacity, i.e., “a partial shutdown.”
Thus, a 2020 governmental shutdown that spanned two calendar quarters, beginning in March and extending into May, would result in two quarters being eligible for the credit determination. However, if the closure was for the last two weeks of March, all of April, and one week in May, only those wages paid during that those actual weeks the business was closed will qualify for the credit.
As to the second qualifying condition in 2020, the “drop in gross receipts” test is wholly mechanical. Under this requirement, the 2020 quarterly gross receipts from the trade or business must have been less than 50% of the gross receipts attributable to the same calendar quarter in 2019. Once the trade or business experienced a decline in gross receipts in 2020, all quarters qualified as eligible quarters until the end of that quarter in which the trade or business returned to a level of at least 80% of what gross receipts were in the same quarter in 2019.
Example of Gross Receipts Calculation
- Assume 2019 gross receipts of $360,000, $400,000, $400,000 and $420,000, respectively, in quarters 1, 2, 3 and 4.
- If the second quarter of 2020 saw a drop in gross receipts to $150,000, that quarter will qualify for the ERC computation (<50% of the same quarter in 2019).
- If the gross receipts in the third quarter of 2020 were $280,000 (70% of the 2019 third quarter gross receipts), that quarter will qualify because it is still <80% of gross receipts for that same quarter in 2019.
- If the fourth quarter 2020 gross receipts were $390,000 (93% percent of the 2019 fourth quarter gross receipts), that quarter will also qualify because it is in that quarter that business operations generated gross receipts equal to at least 80% of the prior year’s fourth quarter gross receipts.
Under these rules, if either of the two requirements set forth above are met, qualified wages paid during that quarter (or in the case of the first requirement, that portion of the quarter during which wages are considered), the employer will be permitted to claim the credit… subject to one final nuance.
The final consideration in calculating the ERC for 2020 is the distinction made under the CARES Act for employers that averaged more than 100 full time equivalent employees (FTEs) during calendar year 2019. As originally enacted under the CARES Act, for employers with average FTE counts in excess of 100, the credit is available only on wages paid to employees during an eligible quarter in which those employees did not provide any services to the employer. In other words, Congress was looking to incentivize employers who had been shut down or who suffered a significant drop in gross receipts, but still continued to pay their employees as a means of protecting against an economic downturn.
This important distinction is critical in assessing the availability of the ERC for 2020 wages. If an employer averaged more than 100 FTEs in 2019, and the business was shut down by a governmental body, only wages paid to employees who did not work qualify for the credit. Employees that were able to continue to work remotely will not qualify, even though the business may have been closed.
On the other hand, employers that averaged less than 100 FTEs in 2019 will be able to obtain a credit for all qualifying wages paid to both employees who continued to work and those that did not work during the closure or period in which the drop in gross receipts occurred.
Section 206 – 2020 Credit Calculation
The final step in the determination of the ERC for 2020 is the actual calculation, which simply requires applying a 50% credit rate to a maximum amount of eligible wages of $10,000, resulting in the maximum credit of $5,000 per employee.
Calculating the credit for 2020 can be reduced to three mechanical steps (which were not changed under the CAA):
- Determine if there was an “eligible quarter(s)” in 2020, based on the “full or partial suspension of operations” requirement or the “drop in gross receipts” requirement
- Review average FTE count in 2019 (dictates whether the 2020 credit is based only on employees that did not work or includes all employees)
- Compute the credit at 50% of eligible wages up to a cap of $10,000 of applicable wages (resulting in a maximum credit of $5,000)
Section 206 – Retroactive Applicability
Perhaps the most important change to the ERC under Section 206 of the CAA, is that it allows the 2020 credit to be taken retroactively, back to March 13, 2020. In effect, this change allows all qualifying employers who previously borrowed monies under the PPP (and were not permitted to claim the ERC under the CARES Act provisions), to take advantage of the credit retroactively for the period between March 13, 2020 and December 31, 2020.
While the change is helpful and certainly welcome by employers, there is a challenge in taking advantage of the credit. This challenge is associated with employer payroll costs. Any employer who has borrowed funds under the PPP is well aware of the term “payroll costs,” and how those costs are integral to obtaining loan forgiveness for the PPP loans. The minimum requirement for PPP loan forgiveness is that at least 60% of the proceeds obtained under such loans must be spent on payroll costs.
Therein lies the rub. The base financial information for both the PPP loan forgiveness and the ERC calculation is payroll costs, and Congress has chosen not to allow consideration of the same wages for both purposes.
The issue, then, is how best to present an employer’s request for PPP loan forgiveness. If they elected to use a 24-week covered period for expending their PPP borrowings, in most cases they will have spent far in excess of the 60% requirement on payroll costs. In fact, in many cases that we have observed, more than 100% of the PPP proceeds has been spent on payroll. In requesting PPP loan forgiveness, it is likely best to substantiate the minimum 60% of the proceeds to have been spent on payroll, so long as the borrower can demonstrate that the remaining 40% of the proceeds were used for other permissible costs. Such an approach ensures preservation of maximum wages for purposes of the ERC.
Section 207 – 2021 Credit Calculation
With respect to the 2021 Employee Retention Credit, Section 207 of the CAA changes the above-noted rules in favor of employers and significantly expands the benefits associated with the ERC. Specifically, the enhancements include:
- Increases the ERC rate from 50% of qualifying wages to 70% of qualifying wages
- Changes the trigger point for determining the qualification of gross receipts for a given quarter from 50% to 20%
- Provides a new safe harbor allowing employers to use the prior-quarter gross receipts to determine eligibility
- Increases the maximum creditable wage limitation from $10,000 per year to $10,000 per quarter
- Increases the 100-average-FTE employee delineation to 500 FTEs
- Permits employers with 500 or fewer FTEs to advance the credit at any point during the quarter based on the wages paid in the same quarter in the prior year
- Provides a means for employers not in existence in the prior year to claim the credit
These Section 207 changes, as well as those in Section 303, will be addressed in more detail in an additional posting very soon.
Clearly, the enhancements offered by the CAA with respect to the ERC are significant and merit careful consideration. We will continue to post detailed information about this credit and other matters of importance on our website. In the meantime, if you have questions, comments or thoughts, please feel free to contact Bob Grossman, Don Johnston or Mike Weber at 412-338-9300.