Employee Retention Credit Taxation – IRS Adds Complexity, Cost, and Burden
The Cares Act (signed by President Trump on March 27, 2020) provided for a refundable Employee Retention Credit (ERC); however, PPP loan recipients were precluded from qualifying for the ERC. At that time, many businesses chose to apply for PPP loans in 2020 as opposed to ERCs. The President signed the Consolidated Appropriations Act (CAA) on December 27, 2020, allowing PPP loan recipients to qualify for the ERC retroactively to March 27, 2020, and did not allow the same wages to be used to calculate both PPP loan forgiveness and ERCs. Businesses with PPP loans began evaluating their qualifications for the ERC in early 2021, analyzing available payroll (i.e., wages not used to calculate PPP loan forgiveness, FFCRA paid leave, and other wage-based tax credits) for the 2020 ERC quarterly computations, and preparing amended 2020 payroll tax returns (Form 941X). Many businesses had not received PPP first draw loan forgiveness at the beginning of 2021, so they made certain assumptions about PPP loan forgiveness and excluded “PPP wages” from the retroactive 2020 quarterly ERC calculations.
Businesses face continued tax reporting and planning uncertainty due to a lack of clarity in the existing guidance regarding which tax year to disallow qualified 2020 ERC wages (an unfavorable tax adjustment) – on an amended 2020 income tax return to match the period the wages used to calculate the ERC were incurred, or on a 2021 income tax return during the time period the ERCs were calculated, amended payroll tax returns were filed, and ERC funding is expected to be received. Existing IRC rules (§ 1.280C-1 ) state that expense reduction occurs in the year a credit is earned, even if the employer is not able to use the credit. §1.280C-1 goes on to say the employer must reduce its deduction for wages by the amount allowable as a credit, effectively increasing federal taxable income. Not all states have rolling conformity to the IRC, adding another layer of complexity to amended returns on the determination of state taxable income. In the case in which wages and salaries are capitalized, the amount subject to depreciation must be reduced by an amount equal to the amount of the credit in determining the depreciation deduction. In the case of an employer who uses the full absorption method of inventory costing, the portion of the basis of the inventory attributable to the wage or salary expenses giving rise to the credit and paid or incurred in the year the credit is earned must be reduced by the amount of the credit allowable.
Because of the late timing (December 27, 2020) of the enactment of the CAA’s changes to ERC qualifications, many businesses filed their 2020 income tax returns before they could practically and thoroughly complete the complex analysis of whether or not the business qualified for 2020 Employee Retention Credits. Businesses with PPP loans spent time analyzing and quantifying wages available for the ERC since PPP loan forgiveness may not have been known at the end of 2020 or even into first quarter 2021. However, because the CAA was passed in December 2020, it was technically “possible” for the business to know it could qualify for the ERC prior to filing its 2020 income tax return.
Qualified Wage Deduction Disallowance
Fast forward to August 4, 2021, when Treasury and the IRS issued further guidance on the ERC. Notice 2021-49 provided guidance that the timing of the qualified wage deduction disallowance for the retroactively claimed 2020 ERC’s should be recognized on an amended federal income tax return (or administrative adjustment request (AAR), if applicable), for the taxable year in which the qualified wages were paid. Taxpayers who already filed a 2020 income tax return would thus be required to amend the 2020 business income tax return. Pass-through entities (S-corporations and partnerships) issuing amended 2020 K-1s would result in multiple shareholders and partners incurring the expense and administrative burden of filing amended 2020 personal income tax returns.
Businesses, shareholders, and partners of pass-through entities face significant compliance issues as a result of IRS Notice 2021-49. Individuals who own stock or units in multiple businesses could wind up receiving amended K-1’s from multiple unrelated businesses, for the next several years. Questions remain. Is an individual required to amend their personal income tax return every time a business in which they invest sends them an amended K-1 due to the timing of the ERC wage disallowance? Should the small business investor wait until the statute of limitations for amending 2020 business tax returns is nearly expired and collect amended K-1’s to file one amended return, and deal with potential IRS notices in the interim? Will the businesses and owners face penalties for underpayment of 2020 tax liabilities that were not known at the time (although technically could have been measured prior to filing tax returns in 2021)? Businesses and individuals now have the added expense of preparing amended 2020 income tax returns and possibly have a tax payment due for the ERC wage adjustment, when the proceeds of the ERC have not yet been received.
Small businesses may also have 2020 and 2021 financial reporting issues to consider if it was probable that the business would comply with any conditions attached to the tax credit and probable the tax credit would be received.
This is an unnecessary administrative and cost burden on small businesses who qualified for and claimed retroactive Employee Retention Credits that were designed to help small businesses keep people employed even as they experienced hardships caused by the Covid-19 pandemic. The owners of the businesses could not have planned for the additional tax liability during 2020 and made estimated tax payments and would be better served to have the option to recognize the ERC wage disallowance in the tax year in which the credit is realized. The additional burden on the accounting profession and IRS to process amended returns for every business in the country that qualified for the retroactive 2020 ERCs seems inefficient and expensive compared to the benefit of following § 1.280C-1.
Have questions on any of the above, need help applying for the Employee Retention Credit (ERC), or other questions or issues, contact us – we’re here to help!