What Employers Need To Know About Employee Retention Credits: Rules for the Second Half of 2021 and General Clarifications

Employee Retention Credits (“ERC” or “credits”) are available to eligible employers that paid qualified wages after March 12, 2020, and before January 1, 2022. Multiple pieces of legislation and Internal Revenue Service (“IRS”) guidance expanded and modified the ERC rules and determination of eligibility for ERC, and computation of the credits may vary based on each individual calendar quarter in 2020 and 2021. We have previously provided a summary of the IRS guidance for 2020 and a summary of the rules applicable to the first two quarters of 2021. This alert discusses the most recent IRS guidance from August of 2021 and summarizes ERC rules applicable to the third and fourth quarters of 2021 and general clarification provided by the IRS.

ERC Claimed in Calendar Quarters 3 and 4 OF 2021

On August 4, 2021, the IRS released Notice 2021-49 (“Notice”), which amplifies prior IRS guidance and sets forth ERC rules for the third and fourth calendar quarters of 2021, which are further discussed below:

• Applicable Employment Taxes for Claiming ERC. For tax year 2020 and the first two calendar quarters of 2021, eligible employers could claim credit against the employer’s share of Social Security tax, as adjusted for credits claimed under Sections 311(e) and (f) of the Internal Revenue Code (“Code”) and FFCRA (or the equivalent portion of Tier 1 tax under the RRTA). However, for the third and fourth quarters of 2021, eligible employers are entitled to claim the credit against the employer’s share of Medicare tax (or the equivalent portion of Tier 1 tax under the RRTA), as adjusted for credits claimed under Sections 3131 and 3132 of the Code. Any excess credits are refunded to the employer.
• Maximum Amount of ERC. For tax year 2020, the maximum amount of ERC that could be claimed per employee for all four quarters was 50% of the maximum amount of qualified wages or $10,000, resulting in a maximum available credit of $5,000 per employee for all calendar quarters. For the first two quarters of 2021, the ERC equals 70% of qualified wages per calendar quarter, resulting in a maximum of $7,000 credit per employee per calendar quarter. The same limits continue to apply to the third and fourth quarters of 2021. Thus, the maximum available credit in 2021 per employee for all calendar quarters is equal to $28,000. A separate credit limit applies to “recovery startup businesses” as discussed below.

Note that the Bipartisan Infrastructure Bill (“Bill”), passed by the Senate, proposes to end the ERC program as of September 30, 2021. Thus, regardless of the IRS guidance, the future of the ERC program is not clear and would depend on the final version of the Bill passed by Congress. Since the House of Representatives is on recess until September 20, 2021, we will continue to monitor the ERC developments in the autumn.

• Recovery Startup Business. For the third and fourth calendar quarters of 2021, a “recovery startup business” will be able to claim the ERC as an eligible employer, limited to a maximum of $50,000. For these purposes, a “recovery startup business” is defined as an employer, including a tax-exempt organization, that began carrying on any trade or business after February 15, 2020, that is not otherwise an eligible employer due to the gross receipts test or suspension of operations test, and which had average annual gross receipts (determined under rules similar to the rules under Code Section 448(c)(3)) for the three taxable-year period ending with the taxable year preceding the calendar quarter in which the ERC is claimed does not exceed $1 million, as determined under the aggregation rules. Note, however, that an employer may change its qualification for the ERC in different calendar quarters from a recovery startup business to an eligible employer pursuant to the gross receipts test or the suspension of operations test, and vice versa. In such case, the $50,000 limitation would apply only to the calendar quarter for which the employer qualifies as a recovery startup business.
• Qualified Wages. For tax year 2020, the ERC was determined based on qualified wages (with a maximum of $10,000 per employee) paid after March 12, 2020, through December 31, 2020. In the case of a small employer that averaged 100 or fewer full-time employees in 2019 (“small employer”), the ERC was determined based on qualified wages paid to all employees. In the case of a large employer that averaged more than 100 full-time employees (“large employer”), the ERC was determined based on wages with respect to employees who were not providing services.

Similar rules apply to the first two quarters of 2021, except that the threshold for the determination of a small employer versus a large employer was raised to 500 full-time employees, resulting in more ERC available for employers with fewer than 500 employees. The same rules continue to apply to the third and fourth quarters of 2021 with a few exceptions:

• In the case of an employer that was not in existence in 2019, the average number of full-time employees may be determined based on tax year 2020 and not 2019.
• A large employer that is a severely financially distressed employer in the third, fourth, or both calendar quarters of 2021 may claim the ERC with respect to all qualified wages paid in the third and/or fourth quarters. For these purposes, a “severely financially distressed employer” is defined as an eligible employer with a 90% reduction in gross receipts as compared to the same calendar quarter in 2019 (or 2020 if the employer was not in existence).

General ERC Clarifications

In the Notice, the IRS also provided general clarifications of the ERC rules applicable to all periods, as follows:

• Full-Time Employees of a Large Employer Do Not Include Full-Time Equivalent Employees. For purposes of determining eligible employer’s status as a large employer or a small employer, employers are not required to include full-time equivalent employees in calculating the average number of full-time employees. For these purposes, a full-time employee is an employee that worked an average of 30 hours per week or 130 hours per month, as determined in accordance with Code Section 4980H. A full-time equivalent employee is a combination of employees, each of whom individually is not a full-time employee, but who, in combination, are equivalent to a full-time employee, based on the total number of hours worked in a month divided by 120. Note that for purposes of determining qualified wages, an employee’s status as a full-time employee is irrelevant.
• Cash Tips of $20 or More Are Qualified Wages. Only if cash tips received by an employee in a calendar month amount to $20 or more, then all of the cash tips will be treated as qualified wages assuming all other ERC requirements are met. Otherwise, none of the cash tips will be considered qualified wages for purposes of the ERC. Eligible employers will not be prevented from claiming Code Section 45B tip credit, in addition to the ERC, for the same wages paid to employees.
• File Amended Return to Reduce Deduction for Qualified Wages. As a general rule, to the extent an employer claims the ERC, such employer’s deduction for qualified wages, including qualified health plan expenses, must be reduced by the amount of ERC. The Notice provided more guidance about the timing of the deduction, especially in the case of adjusted employment returns claiming ERC for prior quarters and tax periods. The Notice states that if an employee claims ERC pursuant to a retroactive amendment of Section 2301 of the CARES Act or otherwise files an adjusted employment tax return to claim the ERC, the taxpayer should file an amended federal income tax return, or an administrative adjustment request in the case of partnerships subject to centralized partnership audit rules, for the taxable year in which the qualified wages were paid or incurred to correct the overstated deduction taken on the original tax return.
• Wages Paid to Majority Owners and Their Spouses. Whether wages paid to an employee who owns more than 50% of the value of a corporation (“majority owner”) and their spouse may be treated as qualified wages for purposes of the ERC will depend on the majority owner’s status as a “related individual” within the meaning of Sections 152(d)(2)(A)-(H) and 267(c) of the Code. If the majority owner has a family member owner who is a brother or sister (whether by whole or half-blood), ancestor, or lineal descendant, then the majority owner will be considered a related individual and those respective wages will not be considered qualified wages for ERC purposes. However, if the majority owner has no such family member owners, then neither the majority owner nor their spouse will be considered a related individual and the wages paid to the majority owner or the spouse will be qualified wages for ERC purposes.

This very “taxpayer unfriendly” rule undermines the legislative intent of the ERC in that the credits were originally intended to help small businesses, which in most cases consist of family-owned S corporations and businesses with majority owner employees. Pursuant to this Notice, any majority owner of a business that has family members as owners, other than their spouse, will not be able to claim ERC with respect to that owner’s wages. 

• Alternative Quarter Election Is Not Required for All Quarters. For purposes of determining if an employer experienced a significant decline in gross receipts (the “gross receipts test”), the employer’s gross receipts in a calendar quarter of 2020 had to be less than 50% of the gross receipts in the same calendar quarter of 2019. For calendar quarters in 2021, the gross receipts test is applied based on an 80% threshold (more taxpayer-friendly). In addition, an employer may use an alternative quarter method for calendar quarters in 2021 under which an employer would compare the gross receipts for the immediately preceding calendar quarter with those for the corresponding calendar quarter in 2019. The Notice further clarified that employers are not required to use the alternative quarter election consistently with respect to all quarters in 2021 and instead can make the election on a quarter-by-quarter basis.
• Gross Receipts Safe Harbor. If an employer acquired a business in 2020, for purposes of the gross receipts test, the employer was allowed to include the 2019 gross receipts of the acquired business regardless of the fact that the employer did not own the business in 2019 (the “gross receipts safe harbor”). The Notice clarified that employers that acquire a business in 2021 may also use the gross receipts safe harbor. In addition, employers that came into existence in the middle of a calendar quarter in 2020 should use the same rules as provided by Notice 2021-20 to calculate gross receipts.

Gross Receipts Safe Harbor Under Rev. Proc. 2021-33

On August 10, 2021, the IRS also issued Revenue Procedure 2021-33, which provides a safe harbor permitting employers to exclude certain amounts from gross receipts for purposes of determining eligibility for the ERC. As provided by the prior guidance, for purposes of the ERC, “gross receipts” of an employer, other than a tax-exempt entity, are determined with reference to Code Section 448(c) and applicable regulations. In the case of a tax-exempt employer, “gross receipts” are determined with a reference to Code Section 6033. Generally speaking, in both cases “gross receipts” include gross amounts received from all sources. Revenue Procedure 2021-33 provides a safe harbor that permits a taxpayer to exclude the following items from “gross receipts” for purposes of determining eligibility for the ERC:

• the amount of the forgiveness of a Paycheck Protection Program loan;
• a grant under Section 324 of the Economic Aid to Hard-Hit Small Businesses, Nonprofits, and Venues Act; and
• a restaurant revitalization grant under the American Rescue Plan of 2021.

As with all other ERC requirements, employers should retain good records to support the use of the safe harbor and the amount of ERC claimed on its returns.

Set forth below is a comparison chart that highlights the differences in the ERC rules as applicable to calendar quarters in 2020 and 2021.

ERC Comparison Chart

Requirements	2020 All Quarters	2021 Quarter 1&2	2021 Quarter 3&4
Eligible Employer	Must meet gross receipts test or have suspended operations	Must meet gross receipts test or have suspended operations	Must meet gross receipts test or have suspended operations, but also see recovery startup business and severely financially distressed employer
Amount of Maximum Qualified Wages per Employee	$10,000	$10,000	$10,000
Maximum credit per Employee	50% of qualified wages or $5,000 for all calendar quarters	70% of qualified wages or $14,000 for both calendar quarters	70% of qualified wages or $14,000 for both calendar quarters
Applicable Employer’s Taxes	Employer’s portion of Social Security Tax or equivalent portion of Tier 1 tax under RRTA	Employer’s portion of Social Security Tax or equivalent portion of Tier 1 tax under RRTA	Medicare Tax or equivalent portion of Tier 1 tax under RRTA
Gross Receipts Test	Gross receipts in calendar quarter of 2020 must be less than 50% of same calendar quarter in 2019	Gross receipts in calendar quarter of 2021 must be less than 70% of same calendar quarter in 2019 or alternative quarter election	Gross receipts in calendar quarter of 2021 must be less than 70% of same calendar quarter in 2019 or alternative quarter election
Threshold for Small Employer vs Large Employer	100 full-time employees	500 full-time employees	500 full-time employees
Interaction with PPP Loan	Can claim ERC, but cannot use the same wages that were used for PPP loan forgiveness	Can claim ERC, but cannot use the same wages that were used for PPP loan forgiveness	Can claim ERC, but cannot use the same wages that were used for PPP loan forgiveness
Statute of Limitations for Audit by IRS	5 years	5 years	5 years

For more information, please contact Michael Cumming (248-203-0740 or mcumming@dykema.com), Asel Lindsey (210-554-5298 or alindsey@dykema.com) or Victoria Remus (248-203-0553 or vremus@dykema.com), or your Dykema relationship attorney.