Clarifications Made Under Notice 2021-20
The CARES Act provided similar rules to section 51(i)(1) of the Internal Revenue Code, that apply to the Employee Retention Credit (ERC). Wages paid to “related individuals” may not be taken into account for determining the credit. Treatment for this credit is similar to the work opportunity credit.
Notice 2021-11 permits employers to postpone the withholding and payment of the employee’s share of social security tax on wages paid to an employee during the period beginning September 1, 2020 and ending on December 31, 2020. Under the newly issued Notice 2021-20, if an employer defers the employee’s share of social security tax it does not impact an employer’s eligibility to take the Employee Retention Credit. However, it may affect the amount that an employer may request as an advance of this credit on Form 7200.
Self-employed individuals without employees and Household employers are not eligible for the credit. Self-employed individuals are allowed to take the credit if they have employees that they pay.
There were no changes made to the eligibility requirements for the credit but examples and a reiteration of the two qualifying eligibility requirements were given in the notice. Questions 10 through 22 of the notice specifically relate to qualifying under being fully or partially shut down by governmental order. Questions 23 through 28 focus on the significant decline in gross receipts including some guidance on businesses that started during 2019 or acquired a business in 2020.
The interplay with Paycheck Protection Program loans is discussed in more detail in the guidance. You can find additional information and examples of the interaction between PPP and ERC here.
How to Claim the Employer Retention Credit
The credit must be claimed on a 941 or applicable payroll tax return. All of the quarterly or annual payroll tax returns for 2020 have already come due so amended returns will need to be completed in order to claim the credit and request a refund. For employers that received a PPP loan and did not claim the employee retention credit may file a Form 941-X (or applicable form) for the relevant calendar quarters (or applicable time period) in which the employer paid qualified wages, but only for qualified wages for which no deemed election was made. See interactions with PPP loans article for more information on the election.
There is a special fourth quarter rule that is available for any qualified wages paid in the second or third quarters of 2020 that were reported as payroll costs on a PPP loan forgiveness application if the loan amount was not forgiven by reason of a decision of the SBA.
If you use a third-party payroll provider such as ADP or Paychex you will want to check in with them on how to go about requesting amended payroll tax returns to claim the credit.
Example 1: Employer D is an eligible employer and paid qualified wages during the second quarter of 2020 but did not claim an employee retention credit on its second quarter 2020 Form 941. Employer D did not receive a PPP loan. If Employer D subsequently decides to claim the credit to which it is entitled for the second quarter of 2020, Employer D should file a Form 941-X for the previously filed second quarter 2020 Form 941 within the appropriate timeframe to make an interest-free adjustment or claim a refund. Employer D should not use a subsequent Form 941 to claim an employee retention credit for qualified wages paid in the second quarter of 2020.
Example 2: Employer E received a PPP loan of $200,000. Employer E is an eligible employer and paid $250,000 of qualified wages that would qualify for the employee retention credit during the second quarter of 2020. Employer E submitted a PPP Loan Forgiveness Application and reported the $250,000 of qualified wages as payroll costs in support of forgiveness of the entire PPP loan. Employer E received a decision under section 7A(g) of the Small Business Act in the first quarter of 2021 for forgiveness of the entire PPP loan amount of $200,000.
Employer E is not deemed to have made an election with respect to the excess $50,000 of qualified wages that are included in the payroll costs reported on the PPP Loan Forgiveness Application. Accordingly, Employer E may take into account the $50,000 of qualified wages for purposes of the employee retention credit. If Employer E decides to take the $50,000 into account to claim the credit to which it is entitled for 2020, Employer E should file a Form 941-X for the previously filed second quarter 2020 Form 941 within the appropriate timeframe to make an interest-free adjustment or claim a refund for the second quarter, as appropriate. Under these facts, Employer E should not use a subsequent Form 941 to claim an employee retention credit for qualified wages paid in the second quarter of 2020.
Example 3: Same facts as Example 2, except that Employer E’s PPP loan is not forgiven by reason of a decision under section 7A(g) of the Small Business Act. If Employer E decides to claim the credit to which it is entitled for 2020 with regard to the $250,000 of qualified wages, Employer E may file a Form 941-X for the previously filed second quarter Form 941 within the appropriate timeframe to make an interest-free adjustment or claim a refund for the second quarter in 2020. Alternatively, Employer E may use the special fourth quarter rule with respect to the $200,000 of qualified wages included in the payroll costs reported on the PPP Loan Forgiveness Application since the PPP loan was not forgiven, but not with respect to the excess $50,000 of qualified wages even though those amounts were included in the payroll costs reported on the PPP Loan Forgiveness Application.
How Does ERC Affect My Tax Return?
A deduction is disallowed for the portion of wages or salaries paid or incurred equal to the sum of certain credits determined for the taxable year. An employer will need to reduce the deduction for qualified wages, including qualified health plan expenses by the amount of the ERC reported for the entire year. The employer, however, should not reduce its deduction for the employer’s share of social security and Medicare taxes by any portion of the credit. No amount of the credit should be included in income.
Substantiation Requirements
An employer will need to create and maintain records that adequately substantiate eligibility for the credit. All records should be kept for at least 4 years after the date the tax becomes due or is paid. This information needed in the record includes the following:
- Documentation to show how the employer determined it was an eligible employer that paid qualified wages, including:
- Any governmental order to suspend the employer’s business operations;
- Any records the employer relied upon to determine whether more than a nominal portion of its operations were suspended due to a governmental order or whether a governmental order had more than a nominal effect on its business operations;
- Any records the employer used to determine it had experienced a significant decline in gross receipts;
- Any records of which employees received qualified wages and in what amounts; and
- In the case of a large eligible employer, work records and documentation showing that wages were paid for time an employee was not providing services.
- Documentation to show how the employer determined the amount of allocable qualified health plan expenses.
- Documentation related to the determination of whether the employer is a member of an aggregated group treated as a single employer for purposes of the employee retention credit and, if so, how the aggregation affects the determination and allocation of the credit.
- Copies of any completed Forms 7200 that the employer submitted to the IRS.
- Copies of the completed federal employment tax returns that the employer submitted to the IRS (or, for employers that use third-party payers to meet their employment tax obligations, records of information provided to the third-party payer regarding the employer’s entitlement to the credit claimed on the federal employment tax return).
Notice 2021-20 can be found here.