The ERTC! The Employee Retention Tax Credit is quite possibly the most misunderstood tax credit in recent times!
by Joshua Jenson, CPA aka JJ the CPA
Hopefully by now you have heard about the Employer Retention Tax Credit (ERTC). In a nutshell, it is an up to $26,000 refundable payroll tax credit, per employee, when totaling the maximum credit of both 2020 and 2021. If we melt this down, it’s a simple calculation: Multiple the qualifying wages during the qualifying period by the applicable tax credit percentage. The biggest takeaway is that if an employer has not yet obtained the tax credit, they can get cold hard cash (aka a check) back from the IRS! A little bit of salt on that is, presently it may take nine to twelve months for the money to arrive, but the check will be in the mail eventually. That’s not too bad though, so let’s keep going!
A qualifying employer is easily looking at a huge benefit as the tax credit is 50% of qualifying wages in 2020, and a whopping 70% of qualifying wages in 2021. While the maximum qualifying wages per employee is $10,000 for all of 2020, it is that same $10,000 maximum in 2021, but for each of the first three quarters in 2021 (1). This leads to a maximum credit of $5,000 per employee in 2020, and $21,000 per employee in 2021. That’s a staggering $26,000 possible refundable tax credit per employee.
Take note the maximum $10,000 in qualifying wages includes all employee’s compensation subject to social security and Medicare payroll taxes plus the employer paid health insurance not otherwise used for other payroll tax credits (tip tax credit excluded) or Paycheck Protection Program (PPP) loan forgiveness.
Wait! This is sounding pretty good. What’s the catch? I knew you’d ask. Well, it’s a double dampener because the credit obtained is a reduction of deductible wages on the income tax return, with a spicey kicker of the IRS requiring this reduction be applied to the year in which the wages were incurred or paid (2). I already hear you on this, but regardless of when the ERTC is applied for, let alone when the check is cashed, this rule applies. You are right, even if the check is received in 2023, for example, if it was based on wages in 2020, the IRS dictates the business is to amend their 2020 tax return and report the reduction in wages.
Now if you are asking do you really want this headache, keep in mind this is real money back to you or your client’s (business) pocket. Present the facts, and let your client decide.
Hold up! So, you have a client ready to proceed, but before we go any further, let’s talk about your fees, shall we. Right now, you may be thinking, to make this worth your while you need to ensure you are compensated fairly. Absolutely! Value billing, flat fees, hourly billing or however you normally charge your client for your fees are all acceptable by the AICPA. Wait. Can you hear that? Because I just sounded the alarm, and I have the bull horn on. “Attention fellow CPAs!” Do NOT allow you or your firm to become a cautionary tale by charging a contingency fee related to these services. I get it, we can easily find ourselves back in fifth grade where we heard “but mom, everyone is doing it.” Let me stop you right there because you know we aren’t just anyone. We are Certified Public Accountants, and we are the most trusted profession in the world behind the clergy, which in part is because of the Code of Professional Conduct we are held to by the American Institute of CPAs. And that Code only allows a CPA to charge a contingency fee related to an amended return if there is a reasonable expectation that a substantive review will be made by the IRS (3). While CPAs also must adhere to IRS Circular 230, which only allows contingency fees for services related to matters being challenged or audited by the IRS (4), some are nonetheless charging contingency fees based on a 2014 U.S. District Court case (5) in which a CPA succeeded in charging a contingency fee despite the IRS’ challenge as the facts lead to the Courts determination that IRS Circular 230 provisions did not apply to that CPA. Nonetheless, Ed Karl, CPA, CGMA, Vice President – AICPA Tax Policy & Advocacy makes it clear (6), CPAs must adhere to the AICPA Code of Professional Conduct regardless, and that contingency fees related to filing a Form 941-X are not allowed as there is no expectation that the IRS will challenge or otherwise perform a substantive review of the amended return for the simple fact that the only two tasks the IRS will most likely perform when processing a Form 941-X is to double check the math and match the figures on the amended return to the originally filed Form 941.
Well, what do you think so far? Yep, more than you might have bargained for. So, if you don’t normally perform payroll services to your client, you need to establish your fees, and be sure to have them sign a separate engagement letter for this service, because you will need to roll up your sleeves before you start flipping these burgers.
So, let’s get to some of the basics. How does an employer first qualify for this juicy tax credit? Well, shoot. There’s nothing basic about this, because before you digest this, be sure to really understand that this is an either/or qualification as an employer does not need to have both qualifying events occur. Next, be sure to fully comprehend that when determining if a business is classified as essential or non-essential, that is never, ever a factor if the qualifying event is due to a reduction in gross receipts. You are right, I let the cat out of the bag. These two exclusive qualifying events are:
A reduction in gross receipts from any quarter available compared to the same quarter in 2019, with a more than 50% reduction required in 2020 and a more than 20% reduction required in 2021
A partial or full shutdown due to state, city, county, or otherwise official governmental order (governmental suggestions or recommendations don’t count).
Now I want to pause right here and make sure you are following the recipe because if the qualifying event is due to a reduction in gross receipts, it is the entire quarters wages that are included, but if it is due to a partial or full shutdown, then only the wages during the specific days of the governmental order are included (7).
If the employer qualifies due to a reduction in gross receipts, the determination of gross receipts is the method used for income tax reporting purposes and excludes tax exempt income related to PPP as well as SVO and EIDL grants (8). For both years, you compare the qualifying quarter to the same quarter in 2019 (yes, even in 2021, it’s compared to 2019). There is a vast difference from 2020 to 2021 in how a following quarter, to the quarter with the required reduction in gross receipts, may qualify. In 2020, the quarter following the quarter in which the gross receipts were down more than 50% will automatically qualify, and the employer will continue to qualify through the quarter in which the gross receipts are more than 80% (9). Take note that if the employer qualifies in fourth quarter 2020 (under the 2020 rules), it does not automatically qualify the first quarter in 2021. For 2021, each quarter is a stand-alone comparison, with an alternative method available that if the correlating quarters gross receipts are not down more than 20%, but the immediately preceding quarters gross receipts are down more than 20%, then the employer will qualify for the quarter (10). However, if an employer qualifies in 2021 under the alternative method, it does not automatically qualify the next quarter.
Switching gears to the other qualifying event of a governmental order causing a partial or full shutdown, here comes the pepper on essential businesses because I may already know what you are thinking; essential businesses don’t qualify. While it is easy to see the pepper on that steak, the IRS goes out of their way to show the many ways essential businesses can still qualify (11). Two biggies are if the business had its operations sincerely affect by its suppliers or the business also included non-essential streams of income that exceed 10%.
Speaking of essential businesses, knocking out a big misconception, employees are never broken out into any category as all types and classifications are included in the ERTC calculation, including essential, non-essential, full-time, part-time, salaried exempt, salaried non-exempt, hourly, temporary, and even leased employees. The only time an employee’s compensation is possibly not included for the ERTC is when an employer has more than a 100-employee head count for 2020 and more than a 500-employee head count in 2021. For both years the head count is based on the average number of full-time employees in 2019 (full-time being at least 30 hours per week or 130 hours per month, not based on full-time equivalents). With these larger employer groups, only the compensation and employer paid health insurance for the employees that did not work, but were paid, are included. There are some additional caveats for these large employers such as paid time off compensation being excluded as well. However, if the employer is of the smaller size, all qualifying wages and employer paid health expenses are included.
Now that you smell what is cooking, you may be interested if the wages of owners and their families can be included in the ERTC (12). If an owner has 50% or less ownership, considering ownership attribution rules, the answer is yes, qualifying wages to owners, their spouse and family can be included (13). However, if the owner has more than 50% ownership, applying the same rules, then only if the owner has no living relatives, can they include their wages or their spouses (14). Take note that spouses are included when determining constructive ownership by family attribution but excluded when determining if (whole or half-blooded) living relatives exist (15). Basically, orphans without children would be the only ones able to benefit from being a majority owner and including their wages. Seems quite unfair to those with living relatives, but that is how the tax law cooks this up.
For owners with a full buffet of businesses, aggregation rules are mandatory and apply with the threshold of 50% of more common ownership (16). If an employer is required to aggregate, to determine if they qualify for ERTC, they must aggregate all aspects of the ERTC rules as it looks at the companies as one, regardless if they are different types of businesses (essential or not), in different states with different governmental orders, or even different legal or tax structures. However, if the collective businesses qualify for ERTC, each employer files for its respective ERTC based on its qualifying wages paid under each employer identification number (EIN).
After surfing through the tidal waves of the ERTC, we’ve got a mountain to climb to obtain the icing on the cake (the tax benefit) as the employer must file an amended payroll tax form (Form 941-X) to get the credit. Good news here is the due date of any Form 941-X is three years from the original due date of the applicable Form 941 (17). For example, if filing for second quarter 2020, the due date for Form 941-X would be July 31, 2023. NOTE: One caveat to the ERTC for first quarter 2020 is the IRS dictates that be reported on second quarter 2020 (18).
Okay, at this point you may wonder why this is becoming more of a headline in the tax world and how was this overlooked. Well, when we check our history homework, we remember that when the ERTC was first presented in the CARES Act related to the pandemic back in March of 2022, an employer could not get both the Paycheck Protection Program loan (PPP) and the ERTC. Most employers and their advisers found PPP more financially beneficial, and thus the ERTC was not elected, leading to most tax advisers not having to wrap their brains around how to calculate the ERTC or employers not having to report this on their originally filed Form 941. Later, when the Appropriations Act became law in the final days of 2020, it included a provision that allowed employers to obtain both PPP and the ERTC, including retroactively. Because the Appropriations Act also included a new round of PPP, once again most of the attention of advisers was geared toward that, not to mention tax season was in full swing with a historical Oklahoma winter storm smack dab in the middle of it. The other factor of the late attention to the ERTC is that most employers don’t prepare their own payroll forms, neither do their tax advisers, and historically payroll processing companies aren’t proactively offering these services either and thus, the lighthouse was casting its light behind everyone. Also, as of late there have been many “pop up shops” providing these services (some near scamsters in my opinion), cold calling employers (your clients), convincing them they qualify (sometimes in a far-fetched manner), creating a ”fire in the hole” client inquiry coupled with these new groups charging (sometimes outrageous) contingency fees that has brewed up a perfect storm scenario of the CPA being asked, if not needing, to jump into action to not only help but possibly protect their client. So now we find ourselves as CPAs playing catch up to offer the services related to ERTC, as seemingly we are the only ones left capable (at least how see it).
So now is the time to put on your cape, show those three letters you wear, and proactively communicate with your client that you need to be, at a minimum, involved with the process of determining if your client qualifies for the ERTC, and possibly assisting them in properly obtaining it. In your quest, refer to IRS Notices 2021-20, 2021-23, 2021-49 and 2021-65, as well as Rev. Proc. 2021-33.
IRS Notice 2021-49 (Pages 6-11) A “recovery start up business” may qualify for fourth quarter 2021
IRS Notice 2021-49 (Pages 24-25)
AICPA Code of Professional Conduct, Section 1.510
IRS Circular 203, Section 10.27
Ridgely v. Lew, 7/17/2014, U.S. District Court for the District of Columbia
AICPA Podcast: “Challenges with Contingency Fees and the ERC”
IRS Notice 2021-20, FAQ #22
IRS Rev. Proc. 2021-33
IRS Notice 2021-20, Section E
IRS Notice 2021-49, Section E
IRS Notice 2021-20, Sections C & D
IRS Notice 2021-49, Pages 25-31
IRC Section 51(i)(1)
IRC Section 267(c)
IRC Section 152(d)(2)(A)-(H)
IRC Sections 52(a) or (b), or 414(m) or (o)
Form 941-X Instructions (Rev. April 2022) Page 6
Form 941-X Instructions (Rev. April 2022) Page 24