When is the employee retention credit amount subject to tax?


The CARES Act created many new acronyms for taxpayers to remember, including the CARES Act itself, which is also an acronym. These include the PPP (Paycheck Protection Program), EPTD (Employer Payroll Tax Deferral) and ERC (Employee Retention Credit). This article focuses on the ERC, and, in particular, the taxation of the ERC.

What is the ERC?

The ERC is a fully refundable tax credit equal to 50% of the salary paid to employees up to a maximum of $ 10,000 of salary per employee in 2020. Therefore, the maximum CER per employee in 2020 is 5,000. $ (50% of $ 10,000). Until December 2020, any taxpayer who obtained a PPP loan was not eligible to also claim the ERC, but that changed with the passage of the Consolidated Appropriations Act, 2021, or CAA (yet another acronym) on December 27, 2020. Since the CAA, taxpayers who have obtained a PPP loan can also benefit from the ERC 2020 retroactively by filing amended tax returns (on Forms 941-X) for the relevant calendar quarters in 2020.

Is ERC taxable?

Yes and no. ERC is not included in gross income, but it is subject to expense rejection rules, making it effectively taxable. See Notice 2020-21, Q&A 60-61; IRS FAQ 85 & 86. For example, if an employer received $ 200,000 in ERC, then it would be required to reduce its deductible salary expenses, including eligible health plan expenses, by $ 200,000, thereby subjecting it to tax on additional income of $ 200,000 (or causing less loss if in a net loss position). The expense reduction rules apply to salaries, including eligible health plan expenses, paid or incurred in 2020 and which have been reimbursed by the ERC. There is no reduction in the employer’s deduction for its share of social security and health insurance taxes by any part of the ERC.

Additionally, while not mentioned by the IRS in the notice or its published list of FAQs, the expense denial rules likely also require taxpayers to reduce depreciation or the base of any salary. capitalized or any salary included in inventory using the full cost absorption method. See Articles 1.280C-1 of the Treasury Regulations; 1.280C-3 (b).

When is ERC-related income taken into account for tax purposes?

It would have been nice if the IRS addressed this timing issue in its notice or FAQ, but it did not. For taxpayers who have requested and received the ERC in 2020, the answer is clear that the expense rejection occurs in 2020. But what about taxpayers who have requested or will claim the 2020 ERC in 2021 – when? does the rejection of expenses happen to them?

For readers who have followed the intricacies of taxation in recent months, remember that a similar problem arose with the PPP before the CAA canceled the IRS and allowed deductions relating to the remittance of the tax. PPP loan. The IRS had taken the position that the rejection of P3-related expenses occurs in 2020 if the borrower had a reasonable expectation of a loan forgiveness at the end of 2020. See Decision on revenues 2020-27; Notice 2020-32. This position was based on pre-existing case law on reimbursement of expenditure and on Article 265 of the Tax Code (expenditure relating to income exempt from tax), both of which were addressed in the guidelines. The rejection of expenses relating to the ERC, however, is based on section 280C (addressing expenses relating to certain refunds of tax credits).

Should the rules regarding when to reject PPP expenditures apply to the ERC? Does it make a difference that PPP borrowers used the funds in 2020, but taxpayers claiming the 2020 ERC in 2021 did not receive the economic benefit of credit until 2021? Unfortunately, no, economic equity is irrelevant here.

For on-hand taxpayers claiming the 2020 ERC in 2021, expense rejection is likely to occur in 2020, regardless of when the ERC is claimed. This is because at the end of 2020, the taxpayer met all the requirements of the ERC 2020 and the same reasoning as the IRS used in Rev. Rul. 2020-27 would apply. In addition, section 280C provides in the relevant part that no deduction is allowed for wages “paid or incurred for the taxation year” in which the credit is “determined for the year of taxation”. taxation ”. This suggests that the expense rejection takes place in 2020 and is consistent with the IRS’s position on Section 280C more generally. See, for example., Treas. Reg. Section 1.280C-1 (reduction in expenditure occurs in the year the credit is “earning”). So whether a cash taxpayer claims the 2020 ERC in 2020 or 2021, the expense denial will likely occur in 2020.

For accrual-based taxpayers who claim ERC 2020 in 2021, the analysis is largely the same, but can also be based on testing all events of Articles 451 and 461 of the Tax Code.

In general, income and deductions are recognized by taxpayers on an accrual basis in the year in which:

  • all events have occurred which establish the right to income or determine the taxpayer’s payment obligation, and
  • the amount can be determined with reasonable precision.

In the case of a deduction, there is another limitation. The test of all events is not considered completed until economic performance occurs, which is usually when the services are rendered or when the property is used or provided.

These rules do not clearly apply to the denial of expenses, which is neither an item of income nor a deduction. For taxpayers who obtained a PPP loan in 2020 and obtained the right to the ERC 2020 after the adoption of the CAA, they have fulfilled all the requirements of the ERC in 2020. By the end of 2020, these taxpayers had already paid any salary eligible for the ERC. and the amount of the ERC could have been determined with reasonable precision, even if the actual credit calculation had not been made until later. So, regardless of whether the ERC is claimed in 2020 or 2021, the expense denial will likely occur in 2020 and should be reflected on the 2020 federal income tax return. – beyond 2020.

Taxpayers should also be aware that the denial of ERC-related expenses may affect their limitation of wages for the purposes of the qualifying business income deduction (RQC) under section 199A.

And the ERC 2021?

ERC 2021 is more generous than ERC 2020. Here are some of its more extensive provisions:

increases the maximum credit amount per employee (making it 70% of $ 10,000 of eligible salary per quarter); broadens the category of employers entitled to credit; lowers the threshold for the gross revenue test; and broadens the definition of skilled wages and the definition of employers entitled to the broader wage base.
From a fiscal point of view, the analysis of the schedule for rejecting expenses relating to the ERC 2020 should apply with the same force to the ERC 2021; However, since most taxpayers will be claiming the real-time (quarterly) 2021 ERC, the timing issue will not be as widespread as for the 2020 ERC.

The recent IRS opinion on the ERC is helpful but incomplete. It leaves many questions unanswered and doesn’t even attempt to address ERC 2021. I guess the best we can hope for is that the next set of guidance will be better than the previous one.

This column does not necessarily reflect the opinion of the Bureau of National Affairs, Inc. or its owners.

Author Info

Daniel Mayo is a Director at Withum and has over 20 years of professional tax experience as well as federal, international and financial product tax experience. He is a member of Withum’s National Tax Services Group and oversees the US federal income tax research, planning and review functions. He is experienced in mergers and acquisitions, capital markets and cross-border transactions.

Bloomberg Tax Insights articles are written by seasoned practitioners, academics, and policy experts who discuss current tax developments and issues. To contribute, please contact us at [email protected].

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