The Employee Retention Tax Credit (ERTC) was created as part of the massive $2 trillion Coronavirus Aid, Relief, and Economic Security (CARES) Act to provide much-needed financial support for businesses affected by the economic fallout of COVID-19. Under the ERTC, businesses can claim a tax credit of up to $26,000 per employee to cover the cost of retaining employees during this time.
Is The Employee Retention Tax Credit Taxable
While the goal of the ERTC is undoubtedly to help businesses sustain operations and avoid massive job losses, questions remain on whether the tax credits themselves are considered taxable income. There have been some clarifications provided by the IRS, however, the nuances of the ERTC rules may still leave businesses unsure of their obligations, especially when it comes to the tax treatment of the credits received.
Several factors determine a business’s eligibility and ability to benefit from the ERTC. The credit is available for businesses, non-profits, and certain governmental entities that faced either full or partial suspension of operations under a government order related to COVID-19 or a decline in gross receipts of more than 50% when compared to the same quarter in 2019. The credit equals 50% of up to $5,000 in qualified wages paid by an eligible employer per employee.
To claim the credit, businesses need to determine if their operations were suspended or gross receipts declined by the required amounts, calculate the maximum credit amount based on employee wages, and ensure proper documentation is in place. While the goal of the CARES Act was undoubtedly to provide immediate cash flow relief, the conditions attached to benefits like the ERTC require careful review to maximize advantages and minimize risks of penalties.
As businesses navigate the complex rules of the ERTC, determining whether the tax credit amounts themselves are considered taxable income or not continues to be an open question with valid arguments on both sides. The IRS guidance suggests the credits are not taxable, but nuances in how businesses operate may lead to different interpretations. Careful record-keeping and consulting tax professionals are advised to ensure businesses claim their fair share of benefits from the ERTC legally and without unnecessary tax complications.
ERTC eligibility and calculation
The Employee Retention Tax Credit (ERTC) provides eligible businesses with a tax credit of up to $26,000 per retained employee to help cover the costs of payroll and other expenses during the COVID-19 pandemic. To claim the ERTC, businesses must first establish that they meet the criteria for an eligible employer. According to the IRS, eligible employers include:
•Businesses, non-profits, and certain governmental entities that faced full or partial suspension of operations under a government order related to COVID-19. This includes orders requiring closures of premises, social distancing, or travel restrictions.
•Businesses that saw a significant decline in gross receipts. Eligible employers must have experienced a more than 50% decline in quarterly gross receipts in 2020 compared to the same 2019 quarter.
•Businesses that were not eligible for, did not receive, or repaid any Small Business Administration (SBA) Paycheck Protection Program (PPP) loan funds. The ERTC cannot be claimed for wages covered under a qualifying PPP loan.
Once eligibility is established, the amount of the ERTC depends on wages paid to retained employees. The credit equals 50% of up to $5,000 in qualified wages paid by an eligible employer for each retained employee. Qualified wages include those paid to employees whose services have been interrupted due to COVID-19, including those with reduced hours or furloughed employees. These wages must be paid for periods when operations were suspended or gross receipts declined.
The total ERTC amount is capped at $26,000 per employee. There are also limitations that begin to phase out the credit at higher compensation levels. The credit is claimed on Form 7200 and can potentially be received as an advance payment. To substantiate claims, businesses need detailed records on employment, wages, business operations, and financial performance.
Fraudulent or inflated claims can lead to penalties and even criminal prosecution. For this reason, determining eligibility and properly calculating credit amounts based on actual impacts and costs is critical. While the goal of the ERTC is to provide much-needed cash flow support, the conditions attached to claiming the benefits necessitate close review to maximize advantages legally and minimize risks. Careful planning and consulting tax professionals are advisable, especially for complex business structures.
Is the ERTC taxable income?
Determining whether the Employee Retention Tax Credit (ERTC) amounts themselves constitute taxable income remains an open question for businesses. On the one hand, the ERTC was created as a tax credit to offset business costs, suggesting the amounts received should not be taxable. However, some argue the credits could be considered taxable income since they result in a dollar-for-dollar reduction in tax liability.
The IRS guidance on this issue provides some clarification but not a definitive rule. According to the IRS FAQs on the ERTC, “This tax credit is not included in the gross income of the employer.” This suggests the credit amounts are not taxable income. However, the FAQ also notes that the determination is made at the business level based on individual circumstances. There is validity to arguments on both sides, especially considering the nuanced rules around claiming the ERTC.
Some key points that support considering the ERTC non-taxable income include:
•The credit is designed to offset business costs (like wages) and prevent double taxation. Taxing the credits themselves would negate this intent.
•Business expenses (wages) that the credits offset are typically deductible. Taxing the credits could cancel out this deduction and reduce the overall tax benefit.
•Credits received as advance payments under Form 7200 Advancing are meant as pre-payment of tax liability, suggesting they should not be taxable income in themselves.
Factors arguing that ERTC amounts could potentially be taxable income include:
•Though meant as an offset, the credits directly reduce tax bills dollar-for-dollar. This could be viewed as a taxable benefit or financial gain.
•The tax code treats most financial benefits or reductions in tax liability as taxable income unless explicitly excluded. The ERTC is not explicitly excluded, so an argument could be made that it results in taxable income.
• Though not meant as direct wages, the credits free up funds that could essentially operate like wages. Some may argue this indirect wage benefit should be taxable.
Considering the nuances on both sides, the conservative approach is to consider ERTC credit amounts as non-taxable income given the IRS guidance. However, businesses should keep records substantiating their position in case of any questions or audits. And for complex structures, consulting tax professionals is advisable to ensure compliance and minimize risks.
Recordkeeping requirements
To claim the Employee Retention Tax Credit (ERTC), businesses must keep adequate records to establish their eligibility and support the credit amounts claimed. According to the IRS guidelines, the following types of records should be maintained:
•Payroll records including federal income tax withholding, Medicare tax withholding, and wages paid for each retained employee. These will be used to calculate the maximum credit amount of $5,000 per employee.
•Records of those employees for whom qualified wages were paid under the ERTC including employment contracts, dates of hire, services performed, hours worked, and wages paid. These substantiate that employees were providing services prior to the COVID-19-related suspension of operations or significant decline in gross receipts.
•Documentation of the business operations’ suspension or receipt decline including copies of directives from an eligible governmental entity requiring closure or records showing a more than 50% drop in quarterly gross receipts in 2020 compared to 2019. This substantiates the eligibility criterion met to claim the ERTC.
•Records of any Small Business Administration PPP loan, grant or other CARES Act program funding received to ensure no duplication of benefits. The ERTC cannot be claimed for wages covered by these other programs.
•Documentation of any limitations applied such as no credit claimed for employees above $100,000 in wages or calculation of the phase-out of the credit. This demonstrates compliance with the rules put in place to target the benefits.
•Financial records including income statements, balance sheets, cash flow statements or applicable tax returns for 2019 and 2020. These may be needed in case of any questions regarding eligibility, credit calculation or the effect of COVID-19 on the business.
The recordkeeping requirements ultimately aim to ensure credits are only claimed for actual costs incurred and substantiate the amounts claimed could have legitimately resulted from the impact of COVID-19 business suspensions or financial declines. Lacking or improperly maintained records could lead the IRS to deny or reduce claimed ERTC amounts, or in serious cases even pursue criminal prosecution for fraud.
Application process
To receive the benefits from the Employee Retention Tax Credit (ERTC), businesses must apply for the credit through the proper application process. According to the IRS guidelines, there are two main steps to applying for the ERTC:
- Businesses must first determine their eligibility for the ERTC and calculate the maximum credit amount based on qualified wages paid to retained employees. This requires reviewing IRS documentation on eligibility criteria, credit calculation methodology, and any limitations or phase-outs applicable based on business characteristics. Stringent record-keeping and documentation are required to substantiate all figures used.
- Eligible businesses can then apply for the ERTC in two ways:
•Request for Advance Payment of Earned Income Tax Credit under Form 7200 – This allows businesses to potentially receive the credit amounts as advance payment. Payments are made as pre-payments of their tax liability. Businesses need to apply and provide requested records and IRS will review applications to determine the maximum advance that can be paid out.
•Claim the ERTC on their quarterly employment tax return such as Form 941 or Form 944 – Businesses can also choose to claim the full amount of their calculated ERTC when filing their quarterly employment taxes. This will reduce their employment tax liabilities for 2020 by the amount of allowed credit. Backup records are still required in case of any reviews or audits.
There are pros and cons to each application method to consider:
Advance Payment (Form 7200):
Pros: Access funds immediately to support operations.
Cons: The application process involves additional time and documentation. Payments are made regardless of the final tax liability calculation. Potential for overpayment requiring repayment.
Claiming on Tax Return:
Pros: No additional application is required. Final tax credit amount nets against the final tax liability for 2020.
Cons: Do not receive funds or reduced tax liability until filing the return, which can be months after advancing via Form 7200.
To ensure maximum benefits and compliance, businesses should evaluate both options based on their short-term cash needs and long-term tax liability calculations. Consulting with tax professionals is advisable, especially for complex structures. While the goal of the credit is undoubtedly needed financial support, application procedures require navigating additional rules and nuances. With limited time to consider implications, professional guidance can help avoid pitfalls and claim the ERTC in a manner that is legally sound and optimizes financial advantages.
Careful planning, records, and consideration of risks along with potentially consulting expert advisors are recommended given the complexities of eligibility requirements, credit calculations, limitations, application methods, and overall treatment of the benefits for tax filing purposes. Maximizing benefits legally and minimizing complications should be the primary aim.
Limitations and phase-out
To prevent abuse and target benefits to those most in need, the Employee Retention Tax Credit (ERTC) includes certain limitations and phase-outs. Businesses should be aware of these rules before determining their maximum potential credit amount and applying for advance payments or claiming the full credit on tax returns.
There are two main types of limitations and phase-outs applicable to the ERTC:
- Limitations on highly compensated employees: The ERTC is limited to $10,000 per employee for higher-income individuals (those making over $100,000 in wages). This means businesses can only claim a $10,000 credit for each employee with wages over $100,000 in 2019. This limitation aims to prevent excessive benefits for high earners.
- Phase-out based on gross receipts: The amount of ERTC per employee phases out for businesses with gross receipts over certain thresholds in 2019. The phase-out begins at $1 million in gross receipts, with a 50% phase-out rate so that businesses with $6 million or more in gross receipts in 2019 cannot claim any ERTC. The goal of this phase-out is to target benefits to those businesses most significantly impacted financially by COVID-19.
Some key points and examples regarding these ERTC limitations and phase-outs include:
•The $100,000 wage limitation results in a maximum $10,000 credit per high-earning employee, not $26,000. Only $10,000 of $50,000 in qualified wages for an employee making $125,000 would be eligible for the 50% credit.
•For employees with wages between $75,000 to $100,000, the limitation is prorated. For example, an employee making $87,500 would be limited to a $15,000 credit (50% of $30,000 in eligible wages).
•The gross receipts phase-out reduces the overall maximum $26,000 per employee benefit amount. A business with $2.5 million in gross receipts in 2019 could claim $13,000 per employee (50% of $26,000 maximum), while one with $4 million in receipts could only claim $6,000 per employee.
• Phase-outs begin at $1 million in receipts despite eligibility not being impacted until $3 million-6 million range for many business types under NAICS codes. The phase-out aims to prevent excessively large tax credits rather than impact entrance into the credit.
•businesses with annual gross receipts from $3 million to $6 million may see significantly reduced ERTC due to swift phase-out, while slightly larger businesses could be phased out entirely from benefitting. The rules aim to target small and mid-sized businesses but phase-outs occur over a wide range.
To determine your business’s maximum potential ERTC, the impact of these limitations and phase-outs on your specific employee compensation and gross receipts figures should be carefully calculated. Limited benefits or phase-outs may still provide some financial support, so applying for advance payments or claiming on tax returns based on calculated maximum amounts is advisable if eligible. Consulting tax professionals can also help navigate the complex rules and ensure compliance to achieve intended benefits legally.
Conclusion
While the aim of the ERTC is undoubtedly to help sustain business operations and avoid job losses, many questions remain regarding the complicated rules attached to claiming the benefits. Key considerations include determining if the credit amounts themselves are taxable as income, strict documentation requirements to substantiate claims, options for advancing payments or claiming on tax returns, limitations that cap benefits for high-income individuals or phase them out based on business size, and complex eligibility criteria regarding operations suspensions, financial declines or receipt of other aid.
There are reasonable arguments on both sides of whether the ERTC constitutes taxable income, so the conservative approach is to consider it non-taxable given IRS guidance. However, businesses must keep meticulous records to prove eligibility and calculations in case of any reviews or audits. Both requesting advance payments through Form 7200 and claiming the full benefit on employment tax returns are options, with pros and cons to evaluate based on business needs and long-term tax liability.
Limitations aim to prevent abuse but may substantially reduce benefits for some businesses based on characteristics like average employee pay, revenue levels, or location within certain industries. Even with limits, the ERTC could provide critical financial support, so determining maximum potential and applying as advisable is recommended if eligible.
Consulting tax professionals is also advisable, especially for complex companies, to navigate requirements, ensure compliance, maximize allowable benefits, and avoid penalties. While the goal of the ERTC is undoubtedly providing much-needed aid, the conditions attached necessitate close review by those with expertise. Careful planning and consideration of impacts and risks at every step are recommended to claim the ERTC legally and optimize advantages amid the challenges of COVID-19.
