8555 / What is the CARES Act employee retention tax credit that was available during 2020 and 2021?

Editor’s Note: In September 2023, the IRS stopped processing new ERC claims.  The IRS began processing ERC claims again on August 8, 2024.  The IRS also announced a voluntary disclosure and repayment program (see heading below for details).

The IRS has repeatedly issued warnings about false or overstated ERC claims.  The statute of limitations for IRS challenges to Forms 941 is three years.  However, the three-year period does not start to run until April 15 of the calendar year following the year in which the form is filed (i.e., the statute of limitations for 2020 Forms 941 started to run on April 15, 2021 and expired April 15, 2024).  However, there is a special limitations period for the third quarter of 2021. That statute of limitations does not expire until April 15, 2027.  Further, proposals would apply the special, longer statute of limitations to any period in which the ERC was available.  Taxpayers who received ERC refunds should also be aware that the IRS can challenge the payment in court within two years of the date the refund was paid (five years if the taxpayer obtained the refund based on fraud or misrepresentation).  The IRS has also released proposed regulations providing that the IRS plans to assess and collect overpayment interest paid to taxpayers on erroneous COVID-related tax credit refunds.

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Planning Point: The IRS has provided new details about a withdrawal process for taxpayers who filed employee retention tax credit (ERC) claims that they now believe to be erroneous.  Employers can use the withdrawal process if (1) they made the claim on an adjusted employment return (Forms 941-X, 943-X, 944-X, CT-1X), (2) they withdraw the entire amount of the claim, and (3) the IRS has not paid their claim or they have not cashed/deposited the IRS' refund check.  Taxpayers who are not eligible to withdraw a claim can still file an amended return to reduce or eliminate the ERC claim.  Taxpayers who filed their ERC claims themselves, have not received, cashed or deposited a refund check and have not been notified their claim is under audit can fax withdrawal requests to the IRS (a special fax line has been set up and details are available at IRS.gov/withdrawmyERC). Taxpayers who are under audit can send the withdrawal request to their examiner or in response to their audit notice.  Claims that are properly withdrawn will be treated as though they were never filed, and no interest or penalties will apply.  However, taxpayers who willfully filed fraudulent claims or assisted in fraudulent claims need to know that withdrawing the claim will not exempt them from criminal investigations.

Additionally, the agency is working on a program that will allow employers to repay improperly received ERC claims (it is unclear whether these repayments can be made without the threat of criminal investigation).

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Under IRS final regulations released in 2023, erroneous refunds of COVID-19-related credits are treated as underpayments of tax under IRC Sections 3111(a) or (b).  Both assessment and administrative collection procedures may apply.  The regulations also clarify that if third-party payers claimed tax credits on behalf of common law employer clients, employers against which erroneous refunds of credits can be assessed include anyone treated as an employer under IRC Sections 3401(d), 3405 and 3511.  The common law employer client of the third-party payor remains liable for the erroneous refunds of these tax credits.

Voluntary Repayment Program.

The IRS created a voluntary disclosure program that allowed employers with erroneous employee retention credit claims to avoid potential penalties, interest and civil litigation. The deadline for participation in a second-round VDP was November 22, 2024 (December 31, 2024, for certain third-party payers who filed ERC claims on behalf of clients).

The program first settled the ERC claim for purposes of the employer's employment tax obligations via eliminating their ERC eligibility while allowing the employer to retain 20% of the claimed ERC amount.  The disclosure also resolved the corresponding adjustment for income tax expense.  Individuals were entitled to participate in the program if (1) they were not under criminal investigation and had not been notified by the IRS of a forthcoming criminal investigation, (2) the IRS had not received information from a third party about the employer's noncompliance, (3) the individual was not under employment tax examination for any tax period for which the individual was applying for the program and (4) the individual had not already received a notice and demand for repayment for all or a part of the claimed ERC.  If the terms were satisfied, the employer was required to repay 80% of the amount claimed (including refundable and non-refundable portions) and was not be responsible for repaying overpayment interest received and was not charged underpayment interest.  The individual was not deemed to receive taxable income by way of repaying only 80% of the claimed amount.¹

Editor’s Note: The Infrastructure Investment and Jobs Act of 2021 retroactively ended the employee retention tax credit, so that wages paid after September 30, 2021, were not eligible for the credit. The law did exempt recovery startup businesses from the early termination. Originally, the credit was set to expire after 2021. 

The IRS released guidance on the early termination of the employee retention tax credit, which expired after the third quarter of 2021. Employers who received advance payment of the ERC for fourth quarter wages could avoid penalties for failure-to-pay if they repaid the amount by the due date of their employment tax returns. Employers who reduced employment tax deposits on or before December 20, 2021 for fourth-quarter wages in reliance on the ERC were not subject to penalties for failure-to-deposit if (1) the employer reduced deposits in anticipation of receiving the ERC under the rules in Notice 2021-24, (2) the employer deposited the amounts retained on or before the due date for wages paid on December 31, 2021 (regardless of whether the employer actually paid the wages on that date), and (3) the employer reported tax liability resulting from the end of the ERC on the employment tax return or schedule including the period from October 1, 2021 through December 31, 2021. Failure to deposit penalties were not waived if the employer reduced deposits after December 20, 2021. Employers who did not qualify for relief under these rules can reply to any notice of a penalty with an explanation, and the IRS will consider whether to grant reasonable cause relief. 

Early in 2022, the IRS provided penalty relief for taxpayers who owed additional income tax because their deduction for qualified wages was reduced by a retroactively-claimed ERTC if the taxpayer was unable to pay the additional tax because the ERTC refund had yet to be received. The IRS acknowledged that this often occurred because of its own backlog in processing Forms 941-X. Taxpayers in this situation were eligible for penalty relief for inability to pay their tax liability if they could show reasonable cause, rather than willful neglect, under Notice 2021-49 provisions.³

ERTC Rules for 2020 and 2021

IRS regulations allow the IRS to recapture any of the tax credits credited to an employer in excess of the amount that the employer was actually entitled to receive. That includes the ERTC, credits for qualified leave wages and credits for qualified health plan expenses under Sections 3131(d) and 3132(d). Those incorrect tax credits are treated as underpayments of taxes and may be administratively assessed and collected in the same manner as the taxes. The temporary regulations also provided that the calculation of any credits erroneously claimed must account for any amounts that were advanced to the employer under the processes established in 2020.

The Consolidated Appropriations Act of 2021 expanded the employee retention tax credit (ERTC), discussed below. Under the CAA, the applicable credit percentage increased from 50 percent to 70 percent of qualified wages. The limit on qualified wages per-employee increased from $10,000 per year to $10,000 per quarter. The “decline in gross receipts” threshold decreased from 50 percent to 20 percent, and a safe harbor rule allowed business owners to use the calendar quarter immediately preceding the current quarter to determine eligibility.

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Planning Point: IRS Revenue Procedure 2021-33 offered a safe harbor that allowed employers to exclude certain amounts from gross receipts for the sole purpose of determining eligibility for the ERTC.

Amounts that could be excluded include: (1) the amount of forgiveness for a PPP loan, (2) Shuttered Venue Operators Grants under the Economic Aid to Hard-Hit Small Businesses, Non-Profits, and Venues Act, and (3) Restaurant Revitalization Grants under the ARPA.

Employers elected to apply this safe harbor by excluding the amounts for purposes of determining whether it was an ERTC-eligible employer on an employment tax return. Employers were required to apply the safe harbor consistently in determining ERTC eligibility (meaning the employer had to exclude the amounts from gross receipts for each calendar quarter when gross receipts were relevant to determining ERTC eligibility). If the employer applied the safe harbor, it was also required to apply the safe harbor to all employers treated as a single employer under aggregation rules.

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The rules discussed below that applied to “large employers” only applied to employers with more than 500 employees under the CAA (as opposed to 100 under the CARES Act). Further, employers that were not in existence for all or part of 2019 became eligible to claim the credit. Businesses with 500 or fewer employees had the option of advancing the credit at any point during the quarter, and the amount of the credit was estimated based on 70 percent of the average quarterly wages the employer paid in 2019.

As long as the wages were not paid with forgiven PPP loan proceeds, PPP loan recipients were entitled to claim the ERTC retroactive to the date of the CARES Act.

Editor’s Note: The ARPA made further changes the ERTC, which remained fixed at 70 percent of qualified wages (up to a $10,000 per-quarter cap) for employers who had experienced a 20 percent year-over-year decline in per-quarter gross receipts (or a qualifying suspension of business). Starting June 30, 2021, certain small businesses that began operations after February 15, 2020 became eligible for a maximum $50,000 per-quarter credit.

Qualifying “recovery startup businesses” were required to have average annual gross receipts for the three-taxable-year period ending with the taxable year that precedes the quarter that did not exceed $1 million. These businesses could qualify to claim the expanded ERTC even if they did not otherwise meet the eligibility requirements for claiming the credit. Beginning in the third quarter of 2021, employers who had suffered a decline of 90 percent or more in gross receipts compared to the same quarter in 2019 could treat all wages paid as qualified wages (up to the $10,000 cap) regardless of the number of employees the business had and regardless of whether the employees provided services (in other words, even employers with more than 500 employees qualified if they were under severe financial distress). Employers could continue to claim the credit even if they had received a PPP loan, but could not claim the credit with respect to wages paid with forgiven PPP funds.

The ERTC was allowed against the Medicare tax only in the third and fourth quarters of 2021. While this procedural shift did not impact the available value of the ERTC, it was often important for business owners who had relied upon taking the credit in advance. Because the Medicare tax is only 1.45 percent, more clients were required to file Form 7200 to receive advance payment of the credit. ARPA also extended the statute of limitations on assessments under the law to five years from the date the return claiming the credit was filed.

CARES Act ERTC

The CARES Act created a refundable tax credit designed to help employers who retained employees during the COVID-19 health crisis. The credit was taken against employment taxes and was equal to 70 percent (originally 50 percent) of the first $10,000 of qualified wages paid to the employee. Wages paid between March 12, 2020 and September 30, 2021 counted in calculating the credit.⁴ Wages included both cash payments and employer health care payments (see below for allocation rules). Because the credit was refundable, employers were eligible for a refund if the credit amount exceeded the employment taxes due.

Employers were eligible regardless of size if they were in business during 2020.

The credit was available for calendar quarters where either:

(1)  operations were either fully or partially suspended because of a government-issued order relating to COVID-19 (see below), or

(2)  the business remained open, but gross receipts declined by more than 20 percent (originally 50 percent) when compared to the same calendar quarter in the previous year. Once gross receipts rebounded and exceeded 80 percent when compared to the same quarter in 2019, the employer no longer qualified in the subsequent quarter.

Eligible government issued orders included restrictions on travel, group gatherings or limitations on commerce (such as orders requiring certain businesses to close or limit operations).

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Planning Point: The IRS released a generic legal advice memorandum (GLAM) to clarify when and whether a business owner could have properly qualified for the employee retention tax credit (ERC) based on supply chain disruptions.  The GLAM contained five different scenarios where supply chain disruptions did not qualify the business for the ERC.  Under the guidance, some type of governmental order must have caused the supplier to suspend its operations during the pandemic.  That suspension, in turn, must have caused the business claiming the ERC to suspend its own business operations.  It is up to the business to provide documentation to prove that the governmental order applied, and to substantiate the link between that governmental order and the business owner’s own suspension of operations.  If the business cannot substantiate the governmental order, the business will also not be treated as having a partial suspension of operations.  Importantly, business owners should be aware that even dramatic price increases or inability to offer some (but not all) of the business’ goods and services does not equate to a partial suspension.  Business owners who justified ERC claims based on supply chain disruptions should maintain careful documentation in anticipation of a future IRS challenge.⁵

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Qualification was calculated every quarter.⁶ If the employer had no more than 500 (originally 100) employees, the amount of qualified wages included wages paid during a quarter where COVID-19 impacted the business, including when the employees continued to provide services for payment during the relevant period and when employees were paid, but not working.

If the employer had more than 500 full-time employees, the wages counted toward the credit included only those paid while the employee was not working for the employer because of a government order or decline in gross receipts. In counting the number of employees, the employer used average employees during 2019.

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Planning Point: For purposes of determining whether a credit-eligible employer is a large eligible employer or a small eligible employer, employers were not required to include full-time equivalents when determining the average number of full-time employees. However, for purposes of identifying qualified wages, an employee’s status as a full-time employee was irrelevant because wages paid to a part-time employee could be treated as qualified wages if all other requirements are satisfied.⁷

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Employers who paid wages with PPP loans that were forgiven could not claim the tax credit for the same wages. Further, the credit did not apply with respect to wages paid under the FFCRA paid sick leave laws (in other words, the employer could not “double dip”).

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Planning Point: Any cash tips treated as wages within the definition of IRC Section 3121(a) or compensation within the definition of IRC Section 3231(e)(3) were treated as qualified wages if all other requirements were satisfied. According to IRS reasoning, eligible employers were not prevented from receiving both the employee retention credit and the Section 45B credit (the FICA tip credit) for the same wages because the CARES Act and subsequent legislation did not reference Section 45B in areas where a “no double dipping” rule applied.⁸

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The amount of wages considered for purposes of the credit could not exceed the wages the employee would have received for working an equal amount of time in the 30-days preceding the applicable period when the credit was available.

Qualified wages also included the employer’s health plan expenses allocated to the wages taken into account for the credit. The health plan expenses must be amounts paid or incurred by the employer to provide and maintain a group health plan, but only if the amounts were excluded from employees’ income under IRC Section 106(a).⁹

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Planning Point: IRS Notice 2021-49 addressed the issue of whether wages paid to majority owners and spouses of majority owners could be treated as “qualified wages.” “Majority ownership,” for these purposes, means more than 50% of the value in a corporation. According to the IRS, if the majority owner of a corporation had no brother or sister (whether by whole or half-blood), ancestor, or lineal descendant as defined in IRC Section 267(c)(4), then neither the majority owner nor the spouse was a related individual within the meaning of Section 51(i)(1) and the wages paid to the majority owner and the spouse were qualified wages for ERTC purposes, assuming the other requirements for qualified wages were satisfied. The notice contains multiple examples that provide guidance on various scenarios and various types of relationships.

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Unless otherwise provided, allocating health expenses pro rata among employees and pro rata based on the periods of coverage (i.e., lining the payments up with the periods to which the wages relate) was sufficient.