IRS updates, formalizes ERC guidance

On March 1, 2021, the IRS released Notice 2021-20, providing long-awaited guidance on the retroactive changes made to the employee retention credit (ERC) by the Consolidated Appropriations Act, 2021 (CAA). The notice is mainly in the form of 71 frequently asked questions (FAQ), most of which are similar to the ERC FAQ the IRS previously published on its website. Specifically, the notice outlines how Paycheck Protection Program (PPP) loan borrowers who have already applied for forgiveness can claim the ERC. Broadly, the ERC can be retroactively claimed for qualified wages reported on a forgiveness application that exceed the total reported payroll and nonpayroll costs needed to support the forgiven amount of the loan.

Further, the notice adopts the definition of “full-time employee,” initially provided by the IRS FAQ for use in determining an employer’s headcount to assess whether it is a large or small employer, without requiring either seasonal workers or part-time employees be included in the computation. It also defines key terms used in determining whether an employer is eligible under the suspension test.

This tax alert is a preliminary overview of critical points covered by the notice. Baker Tilly will provide additional information in the coming weeks and months as we analyze the guidance in detail.

Key takeaways

• The notice retains the FAQ format of the preexisting IRS guidance: updating it for retroactive changes made to the ERC by the CAA and making additional clarifications. The notice does not cover CAA updates to the credit that apply exclusively to 2021. While the guidance relies on the FAQ format, by being incorporated in a notice and formally published in the Internal Revenue Bulletin, it allows taxpayers to rely on the contents for penalty protection.
• Determining PPP loan recipient’s qualified wages: A PPP loan recipient is deemed to have made an election under the Coronavirus Aid, Relief, and Economic Security (CARES) Act to exclude qualified wages from its ERC determination for all wages that are reported on an application for forgiveness — up to the amount of total payroll and nonpayroll costs reported on the application needed to support the forgiven amount. The ERC can be claimed on qualified wages in excess of this figure, but not on any amounts for which the election is deemed made (unless forgiveness is ultimately denied). As stated in the notice, the IRS’ position is effectively that an employer “cannot reduce the deemed election by the amount of the other eligible expenses that it could have reported on its PPP Loan Forgiveness Application” (emphasis added); a potentially damaging blow to borrowers that have already filed a forgiveness application.

The borrower is not considered to have made the election for any qualified wages paid that are not included in payroll costs reported on the forgiveness application.

Example 1: Employer X received a PPP loan of $200,000 and is an eligible employer for ERC purposes who paid $250,000 in qualified wages during the second and third quarter of 2020 (which overlapped with X’s covered period). X reported $250,000 of payroll costs on its loan forgiveness application, which was ultimately approved by the Small Business Administration (SBA) in full. X is deemed to have made an election to exclude $200,000 of qualified wages from its ERC determination (the maximum reported payroll costs needed to support the $200,000 forgiven amount), and can claim the ERC for the remaining $50,000 of qualified wages in 2020’s second and third quarters.

Example 2: Same facts as Example 1, except X additionally incurred and reported $80,000 of eligible nonpayroll costs on its forgiveness application. In this instance, X is deemed to have made an election to exclude $120,000 of qualified wages ($200,000 PPP loan principal * 60% minimum payroll cost requirement), the minimum amount of payroll costs together with the reported nonpayroll costs needed to support the $200,000 of forgiveness. X can therefore claim the ERC on $130,000 of qualified wages ($250,000 total, less $120,000 in reported payroll costs needed to support forgiven amount) in the second and third quarters of 2020.

Example 3: Same facts as Example 2, except X did not report the $80,000 of eligible nonpayroll costs on its forgiveness application, despite incurring them during its covered period. As such, X is deemed to have elected to exclude $200,000 of qualified wages from its ERC determination (the maximum reported payroll costs needed to support the $200,000 forgiven amount) and can claim the ERC for the remaining $50,000 of qualified wages in 2020’s second and third quarters.

• FAQ definition of “full-time employee”: For purposes of the 2020 credit, an employer is considered a large employer if it had more than 100 average full-time employees in 2019 (for purposes of the 2021 credit, the 100 threshold is increased to 500). The notice retains the same definition of full-time employee provided by the original IRS FAQ for this purpose, which appears to limit the employees that need to be included in the calculation to those who performed an average of at least 30 hours of service per week or 130 hours of service in the month. References to part-time employees and seasonal workers remain absent from the definition.
• “More than nominal portion” of employer’s operations defined: An essential business can be an eligible employer under the suspension test if based on the facts and circumstances that “more than a nominal portion” of its operations have been suspended by a government order. Per Q&A No. 11, a portion of an employer’s operations will be considered more than nominal for the quarter in which the employer is testing eligibility if either:

1. The gross receipts from that portion of the business make up at least 10% of the employer’s total gross receipts (both determined using the gross receipts from the same calendar quarter in 2019), or
2. The hours of service performed by employees in that portion of the business make up at least 10% of the employer’s total employee service hours (both determined using the service hours performed by employees in the same calendar quarter in 2019).

• “More than nominal effect” on employer’s operations defined: An employer can qualify under the suspension test if its operations are not shut down, but rather subject to a government-mandated modification that has “more than a nominal effect” on the operations under the facts and circumstances. Per Q&A No. 18, a modification will have more than a nominal effect if it results in a 10% or more reduction in an employer’s ability to provide goods or services in its normal course of business. The notice however does not appear to provide any parameters by which this reduction can be measured.
• Factors for defining “comparable operations” via telework provided: An employer subject to a government-ordered closure will not be eligible under the suspension test if it can maintain “comparable operations” via telework. Q&A No. 16 provides the following four factors for consideration in determining whether comparable operations have been maintained and allows for additional factors to be considered if relevant:

1. Telework capabilities – Determine whether an employer has adequate support (IT and otherwise) such that operations can continue from another location. 
2. Portability of employees’ work – Determine the amount of work that is portable or otherwise adaptable to be performed from a remote location.
3. Need for presence in employee’s physical workspace – If an employer’s physical workspace is so critical to its trade or business operations that central tasks cannot be performed remotely, this factor alone indicates the employer is unable to continue comparable operations. Examples of critical physical workspaces include laboratories or manufacturing involving special equipment or materials that cannot be accessed or operated remotely.
4. Transitioning to telework operations – A period of adjustment to telework is expected, and an employer will not be considered to have a suspension of operations while it experiences inefficiencies attributable to the transition. However, if an employer incurs a significant delay (for example, two weeks) in moving operations to comparable telework on account of a need to, for example, implement teleworking policies or provide employees with necessary equipment, the employer’s operations may be deemed subject to a partial suspension during such a transition period.

• Some areas remain unclear: While much is covered by the notice’s 102 pages, questions and areas of uncertainty remain, most notably, whether foreign affiliates must be included for aggregation purposes.

Please reach out to your Baker Tilly tax advisor to discuss how the above may affect your tax situation.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.