Employee Retention Credit: What it is and How it Works
When the pandemic hit in 2020, the Employee Retention Credit (ERC) was put in place to temporarily provide coronavirus relief, helping small companies keep their employees on payroll. Since many affected businesses were still unable to recoup their losses, the ERC has been extended with the turn of the new administration.
This article will cover what ERC is, how it works, and what requirements are needed to qualify for one.
What is Employee Retention Credit?
The Employee Retention Credit is a refundable tax credit that small business owners can claim on qualified wages that are paid to employees.
The tax credit is 50 percent of the qualified wages that employers pay to employees after March 12, 2020 and before January 1, 2021. The ERC is under the Coronavirus Aid, Relief, and Economic Security Act (CARES) Act that aims to encourage employers to retain their employees even if they have been restricted from work due to lockdown measures or any consequences as a result of the coronavirus outbreak.
According to the Internal Revenue Service, eligible employers may instantly have “access to credit by reducing employment tax deposits they are otherwise required to make.” On top of that, employers may get advance payments from the IRS if the employer’s employment tax deposits would not suffice to cover the credit.
In Section III.A. of Notice 2021-23, the ERC has been extended for qualified wages paid by an eligible employer after December 31, 2020 and before July 1, 2021. This was further extended to wages paid after June 30, 2021 and before January 1, 2022, as indicated in the Internal Revenue Code section 3134. This means that eligible employers may also claim their ERC for qualified wages paid in the last two quarters of 2021.
With the extension, the maximum amount an eligible employer may receive in ERC for the first and second quarters of 2021 is up to 70% of qualified wages, and the amount of qualified wages taken into account with respect to any employee is $10,000 for any calendar quarter for a maximum credit of $7,000 per employee for all quarters in 2021.
However, a separate credit limit has been set for employers who are considered “recovery startup business.”
Who are Considered as Recovery Startup Businesses?
According to Section 3134(c)(5)(A) of the Internal Revenue Code, employers who fall under Recovery Startup Business Category are:
- Employers who began carrying on a trade or business after February 15, 2020
- Employers whose average annual gross receipts for the 3-taxable-year period ending with the taxable year that precedes the calendar quarter for which the credit is determined does not exceed $1,000,000, and
- Employers who are not an eligible employer due to a full or partial suspension of operations or a decline in gross receipts
The IRS stated that if the employer falls under this category, the amount of credit allowed for each of the third and fourth calendar quarters of 2021 cannot be more than $50,000.
Who is Eligible for Employee Retention Credit?
Employers who want to qualify for an ERC should be operating a trade or businesses during calendar 2020 or throughout the peak of the COVID-19 pandemic. They must also experience either of the following:
- Full or partial suspension of the operation of their trade or business during any quarter of the calendar year due to the government’s call to limit commerce, travel or group meetings, or
- Have had a significant drop in gross receipts during the pandemic
Take note that the significant decline in gross receipts should begin:
- On the first day calendar quarter of 2020
- If the employer’s gross receipts are below 50% of its gross receipts
- Should be for the same calendar year in 2019.
The significant decline in gross receipts should end:
- On the first day of the first calendar quarter following the calendar quarter
- If the employer’s gross receipts are more than 80% of its gross receipts
- Should be for the same calendar year in 2019.
Meanwhile, some businesses practically do not meet the criteria for ERC. Check out those who do not qualify:
- Businesses that are considered essential, unless they have supply of critical material or goods disrupted in a manner that affects their operations
- Businesses that were affected by the consequences of the pandemic but are able to continue their operations through telework
The Qualified Wages for Employee Retention Credit
When applying for ERC, the qualified wages of employers depend on the number of employees they have during the period.
- If an employer averaged more than 100 full-time employees during 2019, qualified wages are those wages, plus healthcare costs up to $10,000 per employee. This is paid to employees who are unable to provide services due to work suspensions or declines in gross receipts. Note that employers may only count wages up to the amount employees would have been paid for working an equivalent duration during the 30 days.
- If an employer averaged 100 or fewer full-time employees during 2019, qualified wages are those wages, plus healthcare costs up to $10,000 per employee. This is paid to employees during the time work has been suspended or when gross receipts have declined, whether or not employees are providing their services.
Does Getting a PPP Loan Affect My Application for ERC?
Definitely. Supposing that you qualified for and received a Small Business Interruption Loan under the Paycheck Protection Program (PPP), then you are no longer eligible for ERC.
Other credit provisions may also affect your application for an ERC:
- If the employer received a tax credit for paid sick and family leave under the Families First Coronavirus Response Act
- If the credit has been included in the credit for paid family and medical leave, under section 45S of the Internal Revenue Code
- If the employer is allowed a Work Opportunity Tax Credit under section 51 of the Internal Revenue Code for the employee
How to Claim Your Employee Retention Credit
Once you’ve qualified for the Employee Retention Credit, you may claim the funds by reporting your total qualified wages together with the health insurance costs for each quarter on your quarterly employment tax returns, starting with the second quarter. Credit may be taken against your share of Social Security tax but the excess is refundable. This means that the credit will serve as an overpayment, and may be refunded to the employer after subtracting your share of taxes.
Moreover, eligible employers will need to report any qualified sick leave and qualified family leave wages for which they are entitled to credit under FFCRA on Form 941. This form is used to report income and social security as well as Medicare taxes withheld by the employer from employee wages, and the employer’s social security.
Can you Claim Retroactively?
Employers who received a PPP loan can retroactively claim the employee retention tax credit. To claim the credit for the previous quarters, employers must file Form 941-X, Adjusted Employers’ Quarterly Federal Tax Return or Claim for Refund, for the quarters in which the qualified wages were paid.
While it may take some time before business owners will get the refund for the credit, just ensure that you are filing correctly to avoid delays by several months.
How is The Maximum Amount of ERC Determined?
For the purpose of discussion, let’s use the original maximum ERC as an example. Credit is equal to 50% of the qualified wages paid to employees between March 12, 2020 and before January 1, 2021, including health plan expenses, that an eligible employer pays in a calendar quarter. The maximum amount of qualified wages for all quarters is $10,000, so that the maximum credit for qualified wages paid to an employee is $5,000.
So, supposing that you paid $10,000 in qualified wages to an employee in the second quarter of 2020, the ERC available to you for the qualified wages paid to the employee is $5,000.
Do Employers Need to Show Proof That Their Decline in Gross Receipts is Due to COVID-19?
Not really. The CARES Act does not require employers to keep records of the reason behind the decline in their gross receipts. However, it’s best to keep records for the relevant calendar quarters in 2019 and 2020 for documentation purposes. The IRS will review these documents when needed.
The ERC has become a top-of-mind for many small business owners who struggled during the COVID-19 pandemic. If you think your business could use some financial aid to prevent layoffs and retain your workforce, it’s best to apply for an employee retention credit while it’s still here.
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