Understanding the Employee Retention Tax Credit and Preparing Against the Risk of IRS Audit and Tax Litigation

By Juan F. Vasquez, Jr., Victor J. Viser and Tania Albuja

Tax Topics | July-August 2023 Today's CPA

In response to the economic consequences of the COVID-19 pandemic, Congress introduced a series of relief measures, including the Employee Retention Tax Credit (ERC). The ERC is aimed at providing financial relief to employers affected by the pandemic and encourage them to retain their employees.

As tax and legal professionals navigate the complexities of this credit, it is crucial to understand its application, eligibility criteria, tax treatment and the implication of Circular 230, among other issues. With the recent infusion of $80 billion to the IRS as part of the Inflation Reduction Act, the IRS has apparently trained approximately 400 agents for the review and audit process of the ERC.

Millions of ERC claims for refund have already been filed with the IRS and paid out, many of which are correct and legitimate ERC claims, but a number of such claims are quite questionable at best. The IRS audits are already underway, and the audit process and corresponding ERC litigation will take years to resolve.

The ERC is a refundable credit against payroll taxes for certain employers whose operations were fully or partially suspended due to COVID-19-related governmental orders (the Governmental Order Test) or who experienced substantial declines in gross receipts (the Gross Receipts Test).

The ERC was first introduced in the Coronavirus Aid, Relief, and Economic Security Act (CARES Act); later updated and expanded by the Taxpayer Certainty and Disaster Tax Relief Act of 2020; expanded, extended and codified by the American Rescue Plan Act of 2021; and finally terminated as of September 30, 2021, for most employers by the Infrastructure Investment and Jobs Act.

For CPAs and other practitioners, understanding the ERC is essential to ensure that employers are eligible for the credit, claim the correct amount of credit, and are prepared for an IRS audit and potential litigation. Understanding the nuances of this relief can help businesses take full advantage of available tax credits, while also ensuring they are compliant with applicable tax law.

This article will provide an overview of the ERC and discuss key considerations for CPAs and other practitioners in advising employers on this credit.

The Differing Application of the ERC in 2020 and 2021

Certain eligibility rules and calculation rules differ between 2020 and 2021. Therefore, it is important to understand how these differences affect employers' ability to claim the ERC. It is also important to note that when the CARES Act initially proposed both the Paycheck Protection Program (PPP) and the ERC, employers were initially eligible only to claim the PPP or the ERC. Subsequent legislation removed that restriction, making the ERC available to the millions of businesses that had previously received the PPP.

2020 ERC

In the 2020 calendar quarters, employers can claim the ERC for qualified wages starting March 13, 2020, if they experienced:

a full or partial suspension of one or more business operations due to COVID-19-related governmental orders; or
a 50% decline in gross receipts in a calendar quarter (2Q-4Q 2020) compared to the same 2019 calendar quarter.

The 2020 ERC is equal to 50% of up to $10,000 in qualified wages paid per employee throughout 2020. Because the $10,000 maximum is allocated across all 2020 quarters, the employer may only receive an ERC of up to $5,000 per employee in total for 2020.

2021 ERC: 1Q and 2Q

For the first and second quarters of 2021, employers can claim the ERC if they experienced:

a full or partial suspension of one or more business operations due to COVID-19-related governmental orders; or
a 20% decline in gross receipts in a calendar quarter compared to the same 2019 calendar quarter.

Notably, the 2021 ERC makes the Gross Receipts Test easier to satisfy by reducing the required decline from 50% to 20%. Additionally, the 2021 ERC expands significantly the potential credit amount. The 2021 ERC is equal to 70% of up to $10,000 in qualified wages paid per employee, per quarter. The resulting potential credit amount is up to $7,000 per quarter.

2021 ERC: 3Q and 4Q

We distinguish the third and fourth quarters of 2021 from the previous quarters because the third and fourth quarters are separately governed by IRC Sec. 3134.

For the third quarter of 2021, the ERC eligibility requirements are the same as those for the first and second quarters of 2021, except that an additional category is included: recovery startup businesses. A recovery startup business is an employer that:

does not satisfy the Governmental Order Test and the Gross Receipts Test;
began carrying on a trade or business after February 15, 2020; and
averaged annual gross receipts for the three tax years preceding the quarter in which it claims the credit of no more than $1 million.

The requirement that annual gross receipts be averaged over three tax years does not appear to consider that recovery startup businesses will not have three tax years of data given the February 15, 2020 cutoff. The applicable test for recovery startup businesses is then found in IRC Sec. 448(c)(3), which requires the annual gross receipts to be evaluated over the period during which the entity was in existence.

Because 2020 and/or 2021 will be short taxable years, the annual gross receipts are calculated by multiplying the respective 2020 and/or 2021 gross receipts figures by 12 months and then dividing the result by the number of months in each short taxable year. 2020 will be a short taxable year because the employer must have started operations after February 15, 2020. 2021 will be a short taxable year because the period ends June 30, 2021 (for 3Q 2021 ERC) and September 30, 2021 (for 4Q 2021 ERC).

For the fourth quarter of 2021, only recovery startup businesses are eligible for the ERC. Originally, employers that satisfied the Governmental Order Test or the Gross Receipts Test were also eligible, but they were retroactively made ineligible by Congress. Accordingly, particular attention should be paid to an employer that has claimed or intends to claim the 4Q 2021 ERC to ensure that they are indeed eligible as a recovery startup business.

The maximum credit amount available for each employee is the same as the first and secondquarters of 2021, 70% of up to $10,000 in qualified wages per employee (in the third quarter only), except that recovery startup businesses are eligible for up to $50,000 in total per quarter.

Eligibility Criteria

To be eligible for the ERC, employers generally must satisfy the Governmental Order Test or the Gross Receipts Test. While a number of employers may qualify under both tests, it is only necessary to qualify for one of the tests to determine eligibility.

Governmental Order Test

To satisfy the Governmental Order Test, an employer must have experienced a full or partial suspension of their business operations due to a governmental order related to COVID-19 in 2020 (starting March 13, 2020) and/or in 2021 (ending September 30, 2021). To constitute a suspension, the business operation must comprise a more than nominal portion of its total business operations. This occurs if either:

the gross receipts from that portion of the business operations is not less than 10 percent of the total gross receipts (determined using gross receipts from the corresponding 2019 quarter); or
the hours of service performed by employees in that portion of the business is not less than 10 percent of the total number of hours of service performed by all employees in the employer’s business (determined using hours of service from the corresponding 2019 quarter).

Even if the employer was not directly subject to a governmental order, they may still satisfy the Governmental Order Test if the employer suspended operations because a supplier of critical goods or materials was unable to make deliveries. The supplier's delay must be caused by a COVID-19-related governmental order; delays related to supply chain issues alone are insufficient.

If an employer is eligible under the Governmental Order Test, particular attention should be paid to the calculation of qualified wages. While the employer is considered an eligible employer for the entire calendar quarter in which they satisfy the Governmental Order Test, only wages paid during the period that the governmental orders are in effect may be treated as qualified wages. Another important factor to keep in mind regarding wages is that if the employer also received a PPP loan that was forgiven, the ERC calculations mandate that certain PPP amounts be offset against the ERC amount. Generally speaking, we have found that for lower wage workers, the PPP offset against the ERC can be substantial.

Gross Receipts Test

Gross receipts have the same meaning as when used under IRC Sec. 448(c). Gross receipts of the taxable year include total sales (net of returns and allowances) and all amounts received for services. Any income from investments, and incidental or outside sources (interest, dividends, rents, royalties, and annuities) are included. Gross receipts are generally reduced by the adjusted basis in capital assets sold. For an aggregated group, all entities are considered a single employer for purposes of determining whether the employer had a significant decline in gross receipts.

For 2020, the quarterly gross receipts decline must have been greater than 50%. To determine this, employers must compare their 2020 quarterly gross receipts on a per quarter basis and compare it to the exact same quarter for 2019.

For 2021, the quarterly gross receipts decline must have been greater than 20%. Employers must compare their 2021 quarterly gross receipts to the same quarter for 2019. A special rule for 2021, known as the alternative quarter election or the lookback test, allows an employer to determine eligibility by using the gross receipts decline in the immediately preceding quarter. The alternative quarter election may be applied in any quarter in 2021, including 1Q 2021 (by using 4Q 2020/2019 gross receipts), 2Q 2021 (by using 1Q 2021/2019 gross receipts) and 3Q 2021 (by using 2Q 2021/2019 gross receipts).

Tax Treatment

The ERC can have a significant impact on an employer’s tax liability, reducing the amount of taxes owed or potentially resulting in a refund. Nevertheless, employers must understand both federal and state tax consequences of claiming the ERC to accurately report their taxes and avoid the imposition of penalties.

Federal Treatment

Legislation and statutes do not expressly state whether the ERC is includable in the employer's income. The IRS clarified in Notice 2021-20 that the ERC is not includable in gross income, providing "[a]n employer receiving a tax credit for qualified wages, including allocable qualified health plan expenses, does not include the credit in gross income for federal income tax purposes. Neither the portion of the credit that reduces the employer's applicable employment taxes nor the refundable portion of the credit is included in the employer's gross income."

While the ERC is not includable in gross income, it is subject to expense disallowance rules. An employer is generally required to reduce its deductible wage expenses by the amount of the ERC. The expense reduction rules apply to the wages (including qualified health plan expenses paid or incurred in 2020 or 2021) that were reimbursed by the ERC. There is no reduction in the employer’s deduction for its share of Social Security and Medicare taxes based on the amount of the ERC.

When an employer files a Form 941-X to claim the ERC for prior quarters but has already filed a federal income tax return for the year in which the ERC is claimed, the employer should subsequently file an amended federal income tax return or administrative adjustment request (AAR), if applicable, for the tax year in which the qualified wages were paid or incurred to correct overstated deductions. Section 2301(e) of the CARES Act provides that rules similar to the rules of IRC Sec. 280C(a) apply. IRC Sec. 280C(a) requires tracing to the specific wages generating the applicable credit. Accordingly, if the ERC refund claim corresponds to a quarter in 2020, the adjustment to taxable income equal to the ERC must be reflected on the 2020 federal income tax return, regardless of when the refund is filed.

IRS guidance to date has not clarified “when” the taxpayer is required to amend their federal income tax return. The “when” question raises an important cash-flow issue. For a frame of reference, ordinarily, under the ERC, employers simultaneously reduce their employment taxes on their employment tax returns by the amount of the credit and correspondingly reduce the deduction on their federal income tax return for the wages used to compute the credits. (The due date for filing the federal income tax return for the ERC periods is ordinarily after the employment tax returns on which the ERC is claimed.) This provides the employer with a cash-flow benefit, as the credit is greater than the lost deduction. This cash-flow benefit was among Congress’ goals when enacting the ERC.

Leading up to the enactment of the ERC, members of Congress emphasized the cash-crunch problem that businesses faced due to the COVID-19 pandemic and included the ERC as part of a legislative package to ameliorate the problem and as one of the tools to provide stability to businesses.

Certain taxpayers have requested relief from penalties arising when additional income tax is owed because the retroactive ERC claim reduces for deduction for qualified wages, but the employer is unable to pay the additional income tax because the refund payment had not yet been received. The IRS has acknowledged this issue may be due in part to its backlog in processing Forms 941-X. The applicable IRS guidance states that taxpayers in this situation may be eligible for relief from failure-to-pay penalties if they can show reasonable cause and not willful neglect for the failure to pay and/or may qualify for administrative relief under the IRS's First Time Penalty Abatement program.

State Treatment

The state income tax implications of the ERC primarily depend on how the applicable state conforms to the federal income tax base. States that conform to the Internal Revenue Code as of a fixed date (fixed conformity) must enact legislation that updates their conformity date or incorporates by reference Section 2301(e) of the CARES Act.

States that automatically conform to federal tax law (rolling conformity) will not have to enact legislation to reflect the federal treatment of the ERC. Nevertheless, because fixed conformity states or rolling conformity states may subsequently modify the federal treatment of the ERC, special consideration should be taken regarding the specific state-level tax treatment at the time the ERC is claimed and/or subsequently received.

Professional Responsibility

Practitioners who provide advice on the ERC or sign returns that claim the ERC must comply with Circular 230. Circular 230 is the set of rules issued by the IRS that governs the practice of tax professionals. Specifically, in addition to providing guidance related to professional responsibilities and ethical requirements for professionals who practice before the IRS, it requires practitioners to exercise due diligence when preparing their clients' returns. This includes obtaining and providing relevant and accurate information, as well as properly applying relevant law.

The IRS Office of Professional Responsibility recently confirmed that it will be looking closely at practitioners who help clients abuse the ERC and practitioners who provide ERC advice are governed by Circular 230. The IRS has also included a warning about inappropriate ERC claims and corresponding ERC promotions as part of its list of the 2023 “Dirty Dozen” transactions.

Against this heightened and appropriate governmental scrutiny, recall that Circular 230 applies due diligence and disclosure requirements for practitioners who prepare returns that reflect the ERC or who advise clients on whether to claim the ERC. These include obtaining enough information to reasonably conclude that the taxpayer is eligible for the credit and determining whether the claimed amount is proper.

Finally, professionals should also document the credit calculations and/or applicable governmental orders, properly disclose information on returns, and provide sufficient explanations for claims for the ERC to comply with Circular 230 standards. Failure to do so may run afoul of obligations under Circular 230 and may also lead to difficult IRS audits and litigation for taxpayers.

Understanding the ERC

The ERC is an important and popular COVID-19 relief measure. Due to the credit's complexity, practitioners must ensure they understand all aspects of the ERC, including its application, eligibility criteria and tax treatment, as well as each practitioner’s responsibilities under Circular 230. With proper understanding, practitioners can help ensure that their clients receive the full benefit of this helpful tax provision and be prepared against a potential IRS audit and tax litigation.

About the Authors:

Juan F. Vasquez, Jr. is a Shareholder in the Houston and San Antonio offices of Chamberlain Hrdlicka and serves as the Chair of the firm’s nationwide Tax Controversy Section. He concentrates his practice on federal and SALT controversy matters. He also serves as an Adjunct Professor at the University of Houston Law Center, where he teaches Tax Controversy & Litigation and Tax Procedure & Practice.

Victor J. Viser is a tax associate with Chamberlain Hrdlicka in San Antonio. His practice focuses on federal, state and international tax planning and controversy matters. He is a graduate of New York University School of Law with an LL.M. in Taxation and holds a J.D. from the University of Virginia School of Law.

Tania Albuja is an associate in the Tax Controversy Section of Chamberlain Hrdlicka in Houston. She received her J.D. from the University of Houston Law Center and her LL.M in Taxation from the Georgetown University Law Center. She assists with a wide range of federal tax controversy and litigation matters at all stages before the IRS and federal courts.