Employee Retention Credit FAQs Released For 2020 Claims

On March 1, the IRS issued guidance for employers claiming the employee retention credit (ERC) under the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), as modified in December 2020 by the Taxpayer Certainty and Disaster Tax Relief Act of 2020 (Relief Act). The ERC is designed to help eligible businesses keep employees on their payroll by offering a credit against employment taxes when qualified wages and healthcare expenses are paid during the COVID-19 pandemic. The guidance under Notice 2021-20 clarifies and describes retroactive changes to the ERC under the new law for employers seeking to claim the credit for 2020 in the form of frequently asked questions. The IRS has stated that it will address calendar quarters in 2021 in later guidance.

Under the 2020 ERC rules, 50% of qualified wages and healthcare expenses (up to $10,000 of wages per employee in 2020) are fully refundable if paid by businesses that experienced a full or partial suspension of their operations or a significant decline in gross receipts. Prior to the Relief Act, employers that had received Paycheck Protection Program (PPP) loans were not eligible to claim the ERC. Now, employers with PPP loans can retroactively claim the ERC, however, the same wages cannot be used for both benefits. Q&A 49 of the notice outlines the IRS’ position on the interaction of the ERC with PPP loans for 2020.

Insight

Unfortunately, borrowers who have already received PPP loan forgiveness do not have the same planning opportunities that are available to borrowers who have not yet filed the SBA application, Form 3508 series, for forgiveness.

An eligible employer can elect which wages are used to calculate the ERC and which wages are used for PPP loan forgiveness. Generally, the election is made by not claiming the ERC on the federal employment tax return for the quarter. If the IRS adhered to this general rule, it would nullify the retroactive effective date of the credit. Therefore, in lieu of the general rule on how an employer would elect the wages used for ERC (i.e., by not claiming the ERC on the federal employment tax return for the quarter), the notice provides for a deemed election for any qualified wages that are included in the amount reported as payroll costs on the PPP Loan Forgiveness Application, unless the included payroll costs exceed the amount needed for full forgiveness when considering only the entries on the application.  

For example, a business that borrows $100,000 of PPP loans and has both payroll and nonpayroll costs that far exceed the borrowed amount but reported payroll costs of $100,000 on their application to simplify the forgiveness process, cannot use any of the $100,000 of payroll cost to claim the ERC. This is notwithstanding the fact that 100% forgiveness may have been achieved by reporting only $60,000 of payroll costs and the remaining $40,000 from nonpayroll costs.   

While the text of Q&A 49 appears to treat the minimum amount of payroll costs required for PPP loan forgiveness (i.e., 60%) as being the deemed election, the examples make it clear that the entire $100,000 in payroll costs reported on the PPP application cannot be included in ERC calculations. The IRS’ examples do not address the documented nonpayroll expenses that were excluded from the PPP application but were retained in the borrower’s files in accordance with the SBA’s instructions. 

The notice also formalizes and expands on prior IRS responses to frequently asked questions and addresses changes made since the enactment of the Relief Act. It contains 71 frequently asked questions regarding the following topics:

  • Eligible employers
  • Aggregation rules
  • Governmental orders
  • Full or partial suspension of trade or business operations
  • Significant decline in gross receipts
  • Maximum amount of employer’s ERC
  • Qualified wages
  • Allocable qualified health plan expenses
  • Interaction with PPP loans
  • Claiming the ERC
  • Special issues for employees regarding income and deduction
  • Special issues for employers regarding income and deduction
  • Special issues for employers that use third-party payers
  • Substantiation requirements

 

INTERPLAY OF PPP AND ERC WITH THE R&D TAX CREDIT

 

The Consolidated Appropriations Act, 2021 (CAA), a coronavirus relief package enacted on December 27, 2020, contains a number of provisions to assist businesses and individuals that have suffered economically from the coronavirus pandemic. Included in the CAA are beneficial provisions for businesses that obtained or qualify to obtain a loan under the Paycheck Protection Program (PPP) and employers that qualify for the Employee Retention Credit (ERC). The CAA also addresses the interplay for businesses that intend to claim both the ERC and the research and development (R&D) tax credit. Specifically, the CAA:

  • Confirms that business expenses (that normally would be deductible for federal income tax purposes) paid out of forgiven PPP loans may be deducted for federal income tax purposes, thus rejecting the position previously taken by the Internal Revenue Service (IRS) that expenses paid with forgiven PPP loan proceeds are not deductible for income tax purposes.
  • Clarifies that wages taken into account in determining a taxpayer’s 2021 ERC may not be considered in determining the R&D tax credit. Taxpayers, therefore, may deduct and take an R&D tax credit for expenses that otherwise qualify as qualified research expenses (QREs).

 

Deductibility of expenses paid with forgiven PPP loan proceeds

Before the CAA was enacted, Section 1106(i) of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) provided that any PPP loan forgiveness will be excluded from gross income, and IRS Notice 2020-32 clarified that costs paid using forgiven PPP loan proceeds are not deductible for income tax purposes, even if otherwise deductible.

The R&D tax credit requires that expenditures be deductible to qualify as QREs. Consequently, wages paid with forgiven PPP loan proceeds were not eligible to be QREs. Under the previous guidance, many taxpayers’ R&D credits were reduced as a result of PPP loan forgiveness; the CAA eliminates this unfortunate result by allowing expenses paid with forgiven PPP loan proceeds to be deductible.
 

Changes to ERC that impact R&D tax credit

The ERC, introduced under the CARES Act and expanded under the CAA, is a refundable payroll tax credit for wages and health plan expenses paid or incurred by an employer whose operations were either fully or partially suspended due to a COVID-19-related governmental order or where the employer experienced a significant reduction in gross receipts.

The ERC is limited to $10,000 in qualified wages and health plan expenses per employee per quarter for the first two quarters of 2021. Health plan expenses for purposes of the ERC include both the employer and employee paid portions (if paid with pre-tax salary reduction contributions). Pre-tax health plan expenses are not eligible as qualified wages for purposes of the R&D tax credit (i.e., they will not reduce the credit).

Additionally, the CAA increased the ERC’s threshold for treatment as a “large employer” from 100 to 500 employees for 2021. As a result, more employers may be able to include all qualified wages for employees during an eligible quarter, regardless of whether the employee provided services to the company during that period. This change could have a significant impact on the R&D tax credit because more employees who are providing services may qualify for the ERC.
 

Insights

Wages for employees involved in qualified research who are included in PPP loan forgiveness applications will no longer reduce a taxpayer’s QREs or have a negative impact on the R&D tax credit.
 
Taxpayers that are eligible for the ERC and that claim R&D credits should analyze their ERC and R&D-credit qualified wages to mitigate the impact on both credits. To lessen the negative impact on the 2021 R&D credit, taxpayers should claim as ERC-eligible qualified health plan expenses and qualified wages expenses that are not potentially QREs as well, e.g., expenses related to employees who did not perform any R&D-creditable “qualified service.”

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