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IRS Updates Guidance on Employee Retention Credits – What Employers Need To Know

May 8, 2020

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On April 29, 2020, the Internal Revenue Service (“IRS”) issued updated guidance in the form of 94 Frequently Asked Questions (“FAQs”) in connection with the employee retention credits (“ERC” or “credits”) which are available to eligible employers pursuant to Section 2301 of the Coronavirus Aid, Relief and Economic Recovery Act, Pub. L. No. 116-136 (“CARES Act”). Although the FAQs do not constitute binding legal authority for purposes of claiming the credits, they help clarify the Internal Revenue Service’s position in interpreting and implementing the ERC program under the CARES Act and provide further guidance for businesses exploring ERCs in unique employment situations, as discussed below. To learn more about the ERC program, please see our e-alert Summary of Employee Retention Credit Provision of the CARES Act (Section 2301)

Eligible Employers

The credits are available for an eligible employer of any size. An “eligible employer” for these purposes is an employer that was operating a trade or business in 2020 and that fully or partially suspended operations pursuant to a governmental order limiting commerce, travel or group meetings due to the COVID-19 pandemic or experienced a significant decline in gross receipts. A business of any size that meets these requirements may qualify for the credits, which includes tax-exempt organizations, tribal entities, and employers in U.S. territories.

However, the following employers will not be eligible for the credits: (i) self-employed individuals with respect to their self-employment earnings, (ii) household employers, as they are not considered to operate a trade or business, and (iii) federal, state or local government entities, as well as agencies and instrumentalities of those entities. For purposes of determining whether an organization is an instrumentality of one or more governmental units, the IRS uses a six-factor test set forth in Revenue Ruling 57-128, 1957-1 C.B. 311, which focuses on the organization’s purpose, functions, involvement of private interests, level of governmental control and financial resources.

Aggregation Rules 

For purposes of determining eligibility and amount of the credits, multiple entities may be treated as a single employer pursuant to the ERC aggregation rules as follows:

  • In the case of a controlled group of corporations, all employees of all corporations which are members of the same controlled group will be treated as employed by a single employer. Control is determined under Internal Revenue Code (“Code”) Section 1563(a)(1) based on a “more than 50%” threshold and includes parent-subsidiary control groups, brother-sister control groups, or a combined group of corporations.
  • In the case of partnerships, proprietorships, trusts, estates or sole proprietorships, all employees of a business under common control will be treated as employed by a single employer, based on similar rules applicable to corporations.
  • In the case of an affiliated service group, all employees of an affiliated service group will be treated as employed by a single employer. For these purposes, an “affiliated service group” means a group consisting of the first service organization (“FSO”) and any other service organization which is a shareholder in the FSO and which regularly performs services for the FSO, as further defined in Code Section 414(m).
  • Aggregation rules also apply to other types of arrangements, such as employee leasing when any person who is not an employee of the recipient provides services to the recipient pursuant to an agreement between the recipient and a leasing organization, as further defined in Code Section 414(n). This rule is intended to prevent companies from avoiding the application of the aggregation rule through the use of a separate organization.

Employers must apply aggregation rules in order to do any of the following:

  1. determine if a trade or business was partially or fully suspended pursuant to a governmental shut-down order;
  2. determine whether an employer experienced a significant decline in gross receipts;
  3. determine whether an employer had more than 100 full-time employees in 2019; or
  4. determine eligibility for ERC based on whether or not any member of the group received a Paycheck Protection Program (“PPP”) loan.

If a group of entities is subject to the ERC aggregation rules, the credits claimed by the group must be apportioned among its members on the basis of each member’s proportionate share of qualified wages that gave rise to the credit.

Based on the above, the ERC aggregation rules may benefit some businesses and disadvantage others. For example, if a parent corporation has three subsidiary corporations operating in different states, and each of the parent and subsidiaries has 50 employees, under the ERC aggregation rules, the parent and the subsidiaries must add their employees together in order to determine whether they have more than 100 employees, which would put them at a disadvantage because they would be deemed to have over 100 employees and would qualify for the credits only with respect to those wages for which the employees are not providing services. On the other hand, if a controlled group of corporations had only one subsidiary that was subject to a governmental shut-down order in that it had to partially suspend its operations, under the ERC aggregation rules the entire controlled group will be deemed to have partially suspended operations such that other subsidiary corporations may qualify for the credits.

Suspension of Operations

An eligible employer may qualify for the credits based on partial or full suspension of operations pursuant to a governmental order limiting commerce, travel, or group meetings (for commercial, social, religious or other purposes) due to COVID-19. The FAQs provide additional guidance by clarifying what constitutes a partial suspension of operations and what employers may be eligible for the credits.

The following employers are eligible for the credits based on a governmental shut-down order:

  • An employer whose workplace is closed pursuant to an order for certain purposes but remains open for other purposes, such as a restaurant with a pickup service or a retail store with a website for online shopping.
  • An employer that is required to reduce its hours pursuant to a governmental order.

The following employers are not eligible for the credits based on a governmental shut-down order: 

  • An employer who voluntarily suspends operations without a valid governmental order.
  • An employer that operates an essential business if a governmental order allows the employer to remain open. However, an employer of an essential business may be eligible for the credits if it is unable to obtain materials from its suppliers that were required to suspend operations pursuant to a governmental order.
  • An employer that operates an essential business but whose customers are subject to a governmental order.
  • An employer who closes its physical workplace pursuant to a governmental order but whose employees continue to telework.

Significant Decline in Gross Receipts

An employer may qualify for the credits if for any calendar quarter in 2020 it experienced a significant decline in gross receipts when the gross receipts for a calendar quarter in 2020 are less than 50% of gross receipts for the same calendar quarter in 2019. This qualification period ends with the first calendar quarter that follows the first calendar quarter in which the employer’s gross receipts are greater than 80% of its gross receipts in the same calendar quarter in 2019. Thus, if an employer’s gross receipts for the first, second and third calendar quarters in 2020 were 48%, 83% and 92%, the employer will qualify for the credits with respect to wages paid in the first and second calendar quarters. 

For purposes of qualifying for the credits under this test, the FAQs provide that a “significant decline in gross receipts” does not have to be COVID-19 related and has the same meaning as provided under Code Section 448(c), which includes total sales (net of returns and allowances), amounts received for services, income from investments, interest, dividends, rents, royalties, annuities (regardless of the source), but exclude loan repayments and sales taxes withheld by vendors for remittance to proper governmental authorities. Gross receipts are not affected by the cost of goods sold but are reduced by the taxpayer’s adjusted basis in capital assets sold.

The FAQs clarify that even if an employer does not determine that it had a significant decline in gross receipts in 2020 until after January 1, 2021, the employer will still be eligible for the credits, which it may claim by reporting adjustments to its employment taxes on Form 941-X. The FAQs also provide guidance on meeting the gross receipts test for employers that commenced business in 2019 or 2020. The IRS intends to issue future guidance addressing determination of the gross receipts test for tax-exempt organizations.

Qualified Wages

The credits are determined based on qualified wages paid to employees after March 12 through December 31, 2020. In the case of an employer that averaged 100 or fewer full-time employees in 2019, the credits are calculated based on qualified wages paid to all the employees. In the case of an employer with more than 100 full-time employees, the credits are calculated for wages with respect to which employees are not providing services. For these purposes, a “full-time employee” is an employee that worked an average of 30 hours per week or 130 hours per month, as determined in accordance with Code Section 4980H. In computing the credits with respect to qualified wages, employers should note the following: 

  • If an employer qualifies for the credit based on a full or partial suspension of business pursuant to a governmental order, credits are available only with respect to those wages that were paid while the order was in effect, which may be more or less than the full calendar quarter.
  • In the case of an employer that averaged more than 100 employees, qualified wages paid to an employee may not exceed an amount an employee would have been paid for working an equivalent duration during the 30 days immediately preceding the period during which an employer qualifies for the credits.
  • An employer that averaged more than 100 employees and that pays wages to hourly, non-exempt or exempt salaried employees will qualify for the credits for wages with respect to which employees are not providing services. Calculating the credits for hourly employees with a fixed work schedule should be straightforward based on the time records kept by the employer. For employees without a fixed work schedule or salaried employees, the FAQs provide that an employer may use any reasonable method to determine the hours for which the employee is not providing services, including a method used to determine an employee’s entitlement to leave under the Family and Medical Leave Act or entitlement to paid sick leave under the Families First Coronavirus Response Act. However, it is not reasonable for an employer to determine reduction in hours based on assessment of an employee’s productivity levels during the hours the employee is working.
  • An employer that averaged more than 100 employees may not treat as qualified wages amounts paid to employees for paid time off, vacations, sick days and other days off pursuant to existing leave policies.

The FAQs clarify the IRS’s view of what does not constitute qualified wages, which include the following:

  • Wages used to claim credits for qualified sick or family leave under the FFCRA.
  • Wages taken into account for paid family medical leave credits under Code Section 45S.
  • Wages paid to an employee who is included for purposes of the Work Opportunity Tax Credit under Code Section 51.
  • Payments made to former employees following a termination of employment.
  • Payments made to employees who are not subject to social security or Medicare taxes, such as a minister’s salary.
  • Wages paid to related individuals, as defined under Code Section 51(i)(1), including children, siblings, parents, and entities with more than 50% ownership.

Health Plan Expenses

Although for purposes of the ERC, qualified wages include an allocable portion of the qualified health plan expenses paid or incurred by an eligible employer, such amounts are included only to the extent that they are excluded from gross income of an employee under Code Section 106(a). For these purposes, the allocation must be made on a pro rata basis among covered employees (e.g., the average premium for all employees covered by a policy) and pro rata based on the periods of coverage. In allocating health plan expenses to wages for purposes of the credits, employers should note the following:

  • The Employer may include both employer’s and employee’s pre-tax contribution, but should not include any employee’s after-tax contributions.
  • If an employer furloughs its employees in that it stops paying them wages but continues their health care coverage, the employer will be eligible for the credits with respect to any portion of the health plan expenses paid for the furloughed employees. In its initial guidance, the IRS disallowed credits in such circumstances. However, after much public outcry and congressional disapproval on the basis that the IRS’s position did not align with congressional intent, on May 7, 2020, Secretary Mnuchin issued a letter stating that the IRS will revise its guidance and on May 8, 2020, the IRS updated Questions 64 and 65 of the FAQs accordingly.
  • For an employer that sponsors more than one plan, the health plan expenses are determined separately for each plan. In the case of a fully-insured group health plan or a self-insured group health plan, an employer may use any reasonable method to determine the allocable health plan expenses, as further provided in the FAQs.
  • Qualified health plan expenses may include contributions to health reimbursement arrangements (“HRAs”) or health flexible spending arrangements (“FSAs”), but do not include employer’s contributions to health savings accounts (“HSAs”) or Archer Medical Savings Accounts (“Archer MSAs”).

Claiming the Credits

An eligible employer may claim the credits by reporting qualified wages for each calendar quarter on its Form 941- Employer’s Quarterly Federal Tax Return beginning with the revised Form 941 for the second calendar quarter. In anticipation of receiving the credits, an employer may fund qualified wages by accessing federal employment taxes, including withheld taxes, and by requesting an advance on Form 7200 for any excess credit. The FAQs clarify that if an employer chooses to defer the employer’s portion of the social security taxes under CARES Act Section 2302 prior to claiming the credits, the employer may continue to defer such taxes and claim the credits with respect to the remaining employment tax liability.

Treatment of Credits for Tax Purposes

The FAQs provide that an eligible employer that receives credits does not include such amount in its gross income for Federal income tax purposes. Instead, an employer would reduce its deductible expenses by the amount of the credits, as provided under Code Section 280C(a).

Third-Party Payers

In the case of a common law employer that uses a third-party payer, such as a reporting agent, a payroll service provider, PEO, or CPEO, the reporting agent is not entitled to the credits regardless of whether the reporting agent is considered an “employer” for other purposes. Instead, the reporting agent will need to reflect the credits on Form 941 that it files on the employer’s behalf, and include Schedule R-Allocation Schedule for Aggregate Form 941 Filers. An eligible employer can submit its own Form 7200 to claim an advance credit.

Paycheck Protection Program

The FAQs provide that an employer would not be eligible for the credits if an employer receives a PPP loan regardless of the date of the loan. Thus, as a general rule, an employer must evaluate its relief options and choose between the PPP and the ERC. However, pursuant to the updated Frequently Asked Questions released on May 6, 2020, by the Small Business Administration, an employer that repays its PPP loan by the safe harbor deadline of May 14, 2020, will be treated as though it had not received a loan for ERC purposes. Likewise, on May 8, 2020, the IRS updated the FAQs by adding Question 79 to provide similar guidance. Thus, if such an employer is otherwise an eligible employer, the employer will be eligible for the credit. 

For more information, please contact Michael Cumming (248-203-0740 or mcumming@dykema.com), Thomas Vaughn (313-568-6524 or tvaughn@dykema.com), Alexis Schostak (248-203-0598 or aschostak@dykema.com), Asel Lindsey (210-554-5298 or alindsey@dykema.com), or your Dykema relationship attorney.

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