Explanation of the Changes to The Employee Retention Tax Credit in The New COVID Relief Bill
The Employee Retention Credit (ERC) of 2020 has been extended to 2021. This article gives a concise explanation of those changes to The Employee Retention Tax Credit in the new COVID Relief Bill. The new bill makes changes to Section 206 of Division NN of the CARES Act. These changes are made RETROACTIVE to March 12, 2020, and do NOTHING to change the computational aspects of the credit.
Rather, Section 206 opens the Employee Retention Credit (ERC) – for 2020 AND 2021 – to borrowers of a Paycheck Protection Program (PPP) loan, and walks through how a PPP borrower retroactively claims the credit for 2020.
Then, you’ll want to devote some time to reading this. It’s a detailed analysis of the original ERC as enacted by the CARES Act, and walks through the computational aspects of the credit as they existed before last week, and as they CONTINUE to exist for 2020. This analysis will be vital to your understanding of the changes made to the ERC FOR 2021 ONLY by Section 207 of the latest relief bill. It is these changes that are the subject of this article.
Assuming you are familiar with the above linked article, break down a section of the new Act – this time Section 207 – paragraph by paragraph.
Extension of The Employee Retention Credit Program
First, please read this recap of the differences between the 2020 and 2021 Employee Retention Credit
ERC Round 1
3.12.2020 - 12.31.2020
ERC Round 2
1.01.2021 - 6.30.2021
Co-exist w/PPP loan?
Yes, but not on the same exact wages
Yes, but not on the same exact wages
$10,000 per year per employee
$10,000 per quarter per employee
Rate of credit
50% of eligible credit wages
70% of eligible credit wages
Maximum amount of credit
$5,000 per year per employee
$7,000 per quarter per employee
Maximum credit per year
$5,000 per year per employee (2020)
$14,000 per year per employee (2021)
Gross receipts (GR) drop
Same as 2020
Initial gross receipts drop
Gross receipts drop > 50%
ERC eligible for quarter if gross receipts drop > 20% from same quarter in 2019. Election to use prior quarter’s gross receipts: [Safe harbor]. Look at previous quarter and compare it to same quarter in 2019 (to see if gross receipts drop by > 20%). Example: For 1Q 2021, look to 4Q 2020 & compare to 4Q 2019 (to see if GR drop)
Duration of qualification
Thru quarter after drop by <20% of gross receipts (GR). Example: 2Q 2020 drop in GR of 52% cf to GR of 2Q 2019
For quarter of qualification and any other quarter qualify for
Availability of credit for employers not in existence for part or all of 2019
For any calendar quarter, if employer not in existence at beginning of same calendar quarter in 2019, substitute 2020 for 2019
“Gross receipts” ERC wage range
Entire quarter for which qualify
Same as for 2020
Full or partial suspension
Operations suspended due to order from govt authority limiting commerce, travel or group meetings (commercial, social, religious or other)
Same as 2020
“Full or partial suspension” ERC wage range
ERC for wages only during time of suspension
Same as 2020
Do ERC wages include raises or bonuses (in excess of pay rate in place > 30 days prior to beginning of quarter)?
Yes –If had 100 (or <) FTEs in 2019, all wages count as ERC wages.
Yes –Pay raises and bonuses, if reasonable in amount, count as ERC wages (regardless of number of FTEs), subject to $10,000 per quarter per employee cap
Comp cost = Wages + employer funded health plan (excluded for employee)
Group health plan expenses count even if no wages
Wages count for ERC if not funded by forgiven PPP loan
Yes, but not on same exact wages
In allocation of wages, which tax break comes first?
ERC first, PPP second
ERC first, PPP second
All employers, both large and small, qualify for ERC
Small employer (ERC for pay to all employees, currently working or not)
Up to 100 monthly (2019) FTE employees (FTE = 30 hours/week)
Up to 500 monthly (2019) FTE employees
Large employer (ERC only for pay to employees not currently working)
Exceeding 100 monthly (2019) FTE employees
Exceeding 500 monthly (2019) FTE employees
Advance ERC Available
No - amend form 941
Yes –For employers w/ not> 500 FT employees (employed in 2019) (30/hours week = full time)
Advance credit obtainable as quarter begins
Amount of advance credit
Up to 70% of average quarterly wages in 2019 (2020 if employer no existed in 2019)
How advance credit obtained
Recovery if advance too high
Increase in employment tax for quarter
And now .... the ERC
Section 207 doesn’t wait long to do what it’s designed for: Section 207(a)(1) extends the ending date for the ERC from December 31, 2020 to June 30, 2021.
Remember and take note, that the purpose of changes to Section 206 of the Act were to expand the eligibility rules for the ERC to include borrowers of a PPP loan. Those changes – and only those changes – were retroactive to March 12, 2020. The computational changes we will discuss throughout this article only apply from January 1, 2021 through June 30, 2021; they are NOT retroactive to 2020.
Computational Changes from 2020 to 2021
Let’s take a look at what’s new for 2021, and how those rules compare to the rules for 2020.
Percentage of credit allowed
Old: For 2020, Section 2301(a) of the CARES Act allowed an employer to claim a credit of 50% of qualified wages.
New: For 2021, Section 207(b) amends Section 2301(a) of the CARES Act and increases the credit percentage from 50% to 70%.
Wages capped at $10,000 per covered period vs per quarter
Old: For 2020, Section 2301(b)(1) of the CARES Act capped the “qualified wages” that could be paid to any one employee at $10,000 for ALL quarters.
New: For 2021, Section 207(c) amends Section 2301(b)(1) of the CARES Act and increases the maximum amount of creditable, qualified wages to $10,000 for ANY quarter. Thus, in 2020, if A were paid $10,000 in Q3 and $10,000 in Q4, the resulting credit would be $5,000 (capped at 50% of $10,000 in wages TOTAL). In 2021, however, if A were paid $10,000 in Q1 and $10,000 in Q2, the resulting credit would be $14,000, 70% of $10,000 wages for EACH QUARTER).
Old: To be eligible for a credit, an employer needed to experience at least one quarter in 2020 in which 1) operations were fully or partially suspended by government order, or 2) the business experienced a precipitous drop in gross receipts. More specifically, Section 2301(c)(2)(A)(ii)(II) provided that the latter requirement was met if during 2020, the business experienced a quarter in which gross receipts were less than 50% of the receipts in the same quarter in 2019. From that point on, every subsequent quarter was also an eligible quarter until the END of the first quarter in which gross receipts exceeded 80% of the receipts from the same quarter in 2019.
New: Section 207(d)(1) makes significant changes to the gross receipts test of Section 2301(c)(2)(A)(ii)(II). For 2021, the test is satisfied for any quarter of the first half of 2021 in which gross receipts is less than 80% of the same quarter in 2019. Thus, in the first quarter of 2021, a business would compare its receipts in that quarter to the first quarter of 2019, NOT the first quarter of 2020. The comparison to 2019 rather than 2020 makes a lot more sense when we move on to Q2 of 2021, because in all likelihood, gross receipts for Q2 of 2019 will be significantly higher than those of Q2 of 2020, such that a comparison to 2019 will make it much easier to establish an eligible quarter.
Do new businesses qualify for the employee retention credit?
If, however, a business did not exist at the beginning of the same quarter of 2019, the same quarter in 2020 is substituted.
Section 207(d)(2) then gives businesses – for 2021 only – the option to elect to satisfy the gross receipts test by looking at the immediately preceding calendar quarter, and comparing that quarter to the corresponding quarter in 2019. To illustrate, an employer who could not satisfy the gross receipt test in Q1 of 2021 could nonetheless have an eligible quarter for that stretch of time by electing to compare gross receipts in Q4 of 2020 to Q4 of 2019. If there is a drop of more than 20% quarter-over-quarter, Q1 of 2021 will be an eligible quarter. At this time, it is not clear if the election is permanent; requiring the employer to then determine whether an eligible quarter exists for Q2 of 2021 by looking to Q1 receipts, but that seems illogical, as in the example above, had Q1 been an eligible quarter in its own right, the need would not have arisen to make the election for that quarter. In all likelihood, the election will be made quarter-by-quarter.
Old: For 2020, under Section 2301(c)(3)(A) of the CARES Act, the definition of “qualified wages” hinged on whether the business had more than 100 full-time equivalent employees in 2019 as determined under Section 4980H. If the business had MORE than 100 FTEs, only wages paid to employees not to provide services (NOT to work, but to remain employees of the company) during an eligible quarter were “qualified wages.” If the business had fewer than 100 FTEs, however, then ALL wages paid to employees during an eligible quarter (or eligible part of quarter if the business were only shut down for a portion of the quarter) were “qualified wages.”New: For 2021, Section 207(e) increases the threshold number of employees before a change in treatment arises from 100 to 500. Importantly, Section 207(e)(2) then strikes Section 2301(c)(3)(B) of the CARES Act, which had previously capped qualified wages paid to any one employee at what the employee would have been paid for working an equivalent duration during the 30-day period immediately before the eligible quarter in which wages were paid. Stated in English, this rule prevented an employer from artificially inflating the ERC by increasing pay to an employee during an eligible quarter. That rule no longer exists, meaning an employer could pay bonuses to an employee and increase the credit, subject to the $10,000 per quarter cap, of course.
New Rules for 2021
Section 207(g) then adds an entirely new component to the ERC regime for 2021: the ability for small employers to receive the credit – which is typically taken by reducing required payroll tax deposits — in ADVANCE.
It works like so: if an employer has fewer than 500 FTEs, it may elect for any calendar quarter to receive an advance payment of the credit for that quarter in an amount not to exceed 70% of the average quarterly wages paid by the employer in 2019.
As one would expect, the advance credit would then need to be reconciled against the actual credit, a process we’ve gotten used to with the premium tax credit received when acquiring health insurance on a state exchange. If the advance payments end up exceeding the actual credit due, the employer’s payroll tax is increased for the calendar quarter by the excess.
Let’s look at two examples to illustrate how the computational aspects of the law change from 2020 to 2021.
Example: Employee Retention Credit in 2020
In 2020, X Co. has gross receipts for Q2, Q3 and Q4 of $100,000, $120,000 and $150,000. In 2019, X Co. had gross receipts for Q2, Q3 and Q4 of $210,000, $155,000 and $180,000. Gross receipts in Q2 dropped by more than 50% when compared to Q2 of 2019, and were then at 77% for Q3 and 83% for Q4. Because eligible quarters for 2020 start once receipts drop by more than 50% and continue until the END of a quarter in which receipts exceed 80% of the receipts for the same quarter in 2019, each quarter is an eligible quarter. X Co. has fewer than 100 FTEs, and during those quarters, paid salary to employees in the following sums:
In Q2, X Co. has $24,000 in qualified wages ($8,000 + $10,000 + $4,000 + $2,000). B is topped out and disqualified for the rest of 2020, because in 2020, the maximum amount of qualified wages for any one employee is $10,000 for ALL quarters.
In Q3, X Co. has $8,000 in qualified wages ($2,000 + $0 + $4,000 + $2,000). A is now topped out and disqualified for the rest of 2020.
In Q4, X Co. has $4,000 in qualified wages ($0 + $0 + $2,000 + $2,000). C was topped out during the quarter.
The total credit is $18,000 (50% * $36,000).
Example: Employee Retention Credit in 2021
In 2021, X Co. has gross receipts in Q1 of $140,000 in Q1 and Gross receipts in Q1 and Q2 of 2019 were $180,000 and $210,000 respectively. Because gross receipts for each of Q1 and Q2 in 2021 were less than 80% of the receipts for the same quarters in 2019, both quarters are eligible quarters. During Q1 and Q2, X Co. paid its employees as follows:
In Q1, X Co. has $28,000 in qualified wages ($8,000 + $10,000 + $4,000 + $6,000).
In Q2, X Co. has $27,000 in qualified wages ($7,000 + $10,000 + $4,000 + $6,000). As opposed to 2020, B has eligible wages even after being paid $10,000 in a previous quarter, because the limit is now $10,000 per employee PER QUARTER.
The total credit is $38,500 (70% * $55,000). The credit is DOUBLE what it was for 2020, despite the fact that 2021 has only two qualifying quarters, while 2020 had three.
Three big Employee Retention Credit changes from 2020 to 2021
There are three big changes to note that took effect when the calendar moved from 2020 to 2021:
If Section 207 of the Act had not changed the law, Q1 of 2021 would NOT have been an eligible quarter for X Co. In Q4 of 2020, gross receipts exceeded 80% of the receipts for Q4 of 2019; thus, in order to “restart” a run of eligible quarters, gross receipts for Q1 of 2021 would have needed to be less than 50% of the receipts for Q1 of 2019, which was not the case. Section 207 provides that for 2021 only, however, to be an eligible quarter, the gross receipts must be less than 80% of the receipts for the same quarter in 2019. Because that was the case for both Q1 and Q2 of 2021, both quarters are eligible quarters.
The change in the limit on qualified wages is hugely impactful. In 2020, the cap was $10,000 per employee for ALL quarters, causing A, B and even C to eventually have their wages capped out. Fast forward to 2021, however, and the limit increases to $10,000 per employee for ANY quarter; as a result, only B is subject to any limitation at all (both quarters).
Section 207 of the Act increases the credit rate from 50% to 70%. It is worth noting that if X Co. were so inclined, it could elect to receive the 2021 in advance, up to 70% of the average quarterly wages for 2019.
Let’s take a look at one other example to drive home the consequences of a different change in the computational aspect of the law from 2020 to 2021:
Example. Employer P is a local chain of full-service restaurants in State X that averaged 250 FTEs in 2019. State X forced P to discontinue sit-down service to customers for Q2 and Q3 of 2020. P continues to pay its kitchen staff to come in and prepare food every day. It also pays its wait staff to stay at home and not work. Even though P had its operations partially suspended, because P has more than 100 FTEs for 2019, only those wages paid to employees NOT TO WORK are eligible for the credit. The amount P pays its kitchen staff to cook are not eligible for the ERC. The wages paid to the wait staff, however, are eligible wages.
Fast forward to 2021...
And the wages paid to BOTH the wait staff and the kitchen staff are eligible wages, because beginning in 2021, the change in treatment of wages does not kick in until P has more than 500 FTEs.
For all of 2021, borrowers of a PPP loan –either an original loan or a second round of borrowing are eligible to claim an ERC credit. But careful consideration is necessary to ensure that wages are not duplicated – i.e., both eligible for the ERC and forgiven as part of the PPP process – and that the tax benefits from both programs are maximized.
Changes to the ERC: Treatment of Taxpayers who Originally Borrowed PPP Loans and Were Barred from Claiming the ERC
If we were going to summarize in one sentence what Section 206 of the Act endeavors to accomplish, it would be this: “All of you who borrowed a PPP loan can now go back and claim the ERC for 2020.”
That’s it; that’s all. But implementing that idea is easier said than done, primarily for this reason: the backbone of both the PPP and ERC is payroll costs: PPP loans must be spent primarily on payroll in order to be forgiven, and as we just learned, the ERC is predicated on qualified wages.
The problem that arises, then, is an obvious one. Congress will let us have BOTH the PPP and ERC for 2020, but not on the same dollars of payroll costs. And it’s the safeguards that are necessary to prevent double dipping that makes Section 206 of the Act – should you dare to read it – so cumbersome.
No More Prohibition on Claiming BOTH the PPP and ERC
Let’s start with the biggest news first: Section 206(c)(2)(B) strikes Section 2301(j) from the CARES Act. Section 2301(j) had previously provided that “if an eligible employer receives a covered loan under paragraph (36) of section 7(a) of the Small Business Act (a PPP loan), such employer shall not be eligible for the credit under this section.”
With that gone, the next question is one of effective dates: at what point was Section 2301(j) removed from the CARES Act? Section 206(e) provides that, in general, the amendments made by this section take effect as if included in the provisions of the CARES Act to which they relate. Thus, it certainly appears that PPP borrowers are now eligible for an ERC back to the beginning of the program – March 12, 2020. It’s just a matter of how to claim that credit.
Treatment of Allocable Health Care Costs
Section 206(b) reorganizes Section 2301 of the CARES Act, and as we’ll discuss later, this drafting may cause a problem for certain taxpayers. This section begins by striking Section 2301(c)(3)(C), which had previously included in the definition of “qualified wages” eligible for the ERC the allocable share of qualified health plan expenses paid to an employee along with the qualified wages.
That does NOT mean, however, that a taxpayer claiming the ERC no longer gets to increase qualified wages by allocable health care costs. Instead, Section 206(b)(2) then MOVES the former Section 2301(c)(3)(C) to Section 2301(c)(5)(B). More importantly, it changes the language in this section to align with the favorable interpretation by the IRS that allocable health care costs are eligible for the credit EVEN IF no wages are paid to the employee; i.e., an employee is on furlough. The previous language in Section 2301 required wages to be paid to an employee before health care costs could be allocated to the wages and a credit claimed against them. That is no longer the case.
Section 2301(c)(5)(A) will now read: “In general, the term wages means wages (as defined in section 3121(a) of the Internal Revenue Code of 1986) and compensation (as defined in section 3231of such Code), and
Section 2301(c)(5)(B) will now add to the definition of wages in (c)(5)(A) allocable health care costs.
In summary, the inclusion of health care costs in qualified wages has been moved from Section 2301(c)(3)(C) to Section 2301(c)(5)(B). Stick that in the back of your brain; it will matter soon.
Coordination between PPP and ERC
Now that Section 2301(j) has been removed from the CARES Act and PPP borrowers can claim the ERC, we’ll need some ground rules to avoid claiming a credit and forgivable expenses for the same amounts.
Section 206(c)(1) amends Section 7A(a)(12) of the Small Business Act, which was formerly Section 1106 of the CARES Act. This new Section 7A(a)(12) – after amendment by the PPP provisions of the latest bill – includes in forgivable PPP expenses “payroll costs” as defined in Section 7(a)(36) of the Small Business Act. Section 206(c) amends the definition of forgivable PPP payroll costs by adding, “Such payroll costs shall not include qualified wages taken into account in determining the credit allowed under Section 2301 of the CARES Act or qualified wages taken into account in determining the credit allowed under subsection (a) or (d) of section 303 of the Taxpayer Certainty and Disaster Relief Act of 2020.”
The ordering rule of payroll costs
Stated in another way, this Section 206(c) established an important ordering rule: any payroll costs – W-2 wages or health care costs – for which a taxpayer claims an ERC (or a new disaster ERC as allowed by the latest bill) are NOT eligible to be forgiven as part of the PPP process. Thus, while a taxpayer may BOTH claim the ERC and borrow a PPP loan, they cannot do it on the SAME wages or health care costs, and the priority goes to the ERC rather than the PPP.
Under Section 206(c)(2), Section 2301(g)(1) will now allow a taxpayer to elect to not include certain wages and allocable health care costs in the computation of the ERC credit. Clearly, this would be done so as to preserve those costs for PPP forgiveness.
Section 2301(g)(2) is then further amended to require the SBA to issue guidance providing that if a taxpayer elects under Section 2301(g)(1) to count wages for PPP forgiveness rather than the ERC credit, if it turns out that PPP payroll costs are NOT forgiven, the payroll costs can STILL be treated as qualified wages for purposes of the ERC.
Putting it all together
Assume a taxpayer borrowed $100,000 as a PPP loan on April 3, 2020. During the second and third quarters of 2020, the taxpayer has “eligible quarters” and is thus eligible for the ERC. Over the 24-week covered period, the taxpayer spends $80,000 on W-2 wages and qualified health care costs and $20,000 on rent. Included in those wages are $40,000 of qualified wages eligible for the ERC. The taxpayer would rather have the $40,000 in payroll costs forgiven than claim an ERC on those amounts. The general rule of new Section 7A(a)(12), however, provides that the $40,000 of qualified wages are eligible for the ERC, and are NOT eligible to be forgiven.
The taxpayer may then elect, however, under Section 2301(g)(1) to treat the $40,000 of qualified ERC wages as “payroll costs” for purposes of PPP forgiveness. If the loan is fully forgiven, no ERC can be claimed on the $40,000 of wages. It appears, however, that if the loan is eventually not forgiven, Section 2301(g)(2) and future guidance from the SBA will allow the $40,000 of qualified wages to revert BACK to the ERC and be eligible for the credit.
And for those PPP borrowers who have not yet applied for forgiveness, do we now have ANOTHER factor to consider? If a borrower has enough “payroll costs” to satisfy both the ERC and PPP programs, can they have their cake and eat it too?
For example, assume a taxpayer borrowed $100,000, but in the 24-week covered period that also comprised eligible quarters, incurred $180,000 of W-2 and payroll costs, with $50,000 of the costs also meeting the definition of “qualified wages” for the purposes of the ERC. Even with the general rule that the $50,000 of qualifies wages are not forgivable PPP costs, the taxpayer would still have $130,000 of forgivable payroll costs; more than enough to achieve full forgiveness.
Understanding "Qualified Wages"
But you can see where this is heading: very few business owners bothered to understand the concept of “qualified wages” because once the business got its hands on a PPP loan, the ERC was not available. But now, with the ERC being brought back for 2020 even for PPP borrowers, it is necessary for every borrower to quickly get a handle on 1) whether they had an “eligible quarter” for ERC purposes during 2020, and then 2) quantify the “qualified wages” so as to make a determination whether those wages are better utilized in claiming an ERC or forgiven as part of the PPP, or if they have enough total payroll costs to get the best of both worlds.
OK, Great. But how do we Claim the Retroactive Credit?
Allowing PPP borrowers to claim the ERC doesn’t mean a whole lot if we don’t understand 1) when the changes are effective, and 2) if the changes are retroactive, how the taxpayer claims the retroactive benefits.
Clearly, the changes are intended to be retroactive. To that end, as discussed previously, Section 206(e) provides a general rule that ALL the changes above are to be implemented as if they were part of the initial CARES Act passed in March of 2020. That would, of course, seem to mean that PPP borrowers can still claim the credit for the past nine months. But how? Those credits, which would have reduced payroll tax deposits or generated a refund on Form 7200, would have been claimed as part of payroll tax filings over the previous three quarters. What can be done now?
The logical conclusion is that this is intended to be simple: every business owner can go back, review 2020 for eligible quarters and qualified wages, decide which costs to leave out of the PPP forgiveness or whether to elect to move the costs from the ERC to the PPP, and then claim the credit on the final eligible costs, presumably by filing amended Forms 941X for the 2nd and 3rd quarters of 2020. That makes sense, right?