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When is the Amount of the Employee Retention Credit Subject to Tax?

March 12, 2021, 9:00 AM

The CARES Act created a lot of new acronyms for taxpayers to memorize, including the CARES Act itself, which is also an acronym. Among these are PPP (paycheck protection program), EPTD (employer payroll tax deferral), and ERC (employee retention credit). This article focuses on the ERC, and, in particular, the taxation of the ERC.

What is the ERC?

The ERC is a fully refundable tax credit equal to 50% of wages paid to employees up to a maximum of $10,000 in wages per employee in 2020. Accordingly, the maximum ERC per employee in 2020 is $5,000 (50% of $10,000). Until December 2020, any taxpayer who obtained a PPP loan was not eligible to also claim the ERC, but this changed with the passage of the Consolidated Appropriations Act, 2021, or CAA (yet another acronym) on Dec. 27, 2020. Since the CAA, taxpayers who obtained a PPP loan can also qualify for the 2020 ERC retroactively by filing amended employment tax returns (on Forms 941-X) for the relevant calendar quarters in 2020.

Is the ERC Taxable?

Yes and no. The ERC is not includible in gross income, but it is subject to expense disallowance rules, which effectively make it taxable. See Notice 2020-21, Q&As 60-61; IRS FAQs 85 & 86. For example, if an employer received $200,000 in ERCs, then it would be required to reduce its deductible wage expenses, including qualified health plan expenses, by $200,000, thus subjecting it to tax on an extra $200,000 of income (or causing less of a loss if it was in a net loss position). The expense reduction rules apply to the wages, including qualified health plan expenses, paid or incurred in 2020 and that were reimbursed by the ERC. There is no reduction in the employer’s deduction for its share of Social Security and Medicare taxes by any portion of the ERC.

Further, while not mentioned by the IRS in the Notice or its published list of FAQs, the expense disallowance rules likely also require taxpayers to reduce depreciation or basis for any capitalized wages or wages included in inventory under the full absorption method of costing. See Treasury Regulations Sections 1.280C-1; 1.280C-3(b).

When is the ERC-Related Income Taken Into Account for Tax Purposes?

It would have been nice if the IRS addressed this timing issue in its Notice or its FAQs, but it did not. For taxpayers that claimed and received the ERC in 2020, the answer is clear that expense disallowance occurs in 2020. But what about taxpayers that claimed or will claim the 2020 ERC in 2021—when does expense disallowance occur for them?

For readers who have been following tax arcana the past few months, recall that a similar issue arose in connection with the PPP before the CAA reversed the IRS and allowed deductions relating to PPP loan forgiveness. The IRS had taken the position that PPP-related expense disallowance occurs in 2020 if the borrower had a reasonable expectation of loan forgiveness at the end of 2020. See Revenue Ruling 2020-27; Notice 2020-32. This position was based on preexisting expense reimbursement case law and tax code Section 265 (addressing expenses relating to tax-exempt income), both of which were discussed in the guidance. Expense disallowance relating to the ERC, however, is based on Section 280C (addressing expenses relating to certain tax credit reimbursements).

Should the rules addressing the timing of PPP expense disallowance apply to the ERC? Does it make a difference that PPP borrowers had use of the funds in 2020, but taxpayers claiming the 2020 ERC in 2021 did not receive the economic benefit of the credit until 2021? Unfortunately, no, economic fairness is not relevant here.

For cash-basis taxpayers that claim the 2020 ERC in 2021, expense disallowance likely occurs in 2020, regardless of when the ERC is claimed. This is because, at 2020 year end, the taxpayer satisfied all the requirements for the 2020 ERC, and the same reasoning that the IRS used in Rev. Rul. 2020-27 would apply. Further, section 280C provides in relevant part that no deduction is allowed for wages “paid or incurred for the taxable year” in which the credit is “determined for the taxable year.” This suggests that expense disallowance occurs in 2020, and is consistent with the IRS position regarding section 280C more generally. See, e.g., Treas. Reg. Section 1.280C-1 (expense reduction occurs in the year the credit is “earned”). Thus, regardless of whether a cash-basis taxpayer claims the 2020 ERC in 2020 or 2021, expense disallowance likely occurs in 2020.

For accrual-basis taxpayers that claim the 2020 ERC in 2021, the analysis is largely the same, but can also be predicated on the all-events test in tax code Sections 451 and 461.

In general, income and deductions are recognized by accrual-basis taxpayers in the year when—

  • all events have occurred that fix the right to income or determine the taxpayer’s liability for payment, and
  • the amount can be determined with reasonable accuracy.

In the case of a deduction, there is a further limitation. The all-events test is not considered met until economic performance occurs, which generally is when services are performed or as property is used or provided.

These rules do not apply neatly to expense disallowance, which is neither an item of income nor deduction. For taxpayers that obtained a PPP loan in 2020, and became entitled to the 2020 ERC after the passage of the CAA, they satisfied all requirements for the ERC in 2020. At the end of 2020, such taxpayers had already paid any ERC-eligible wages and the amount of the ERC could have been determined with reasonable accuracy, even if the actual calculation of the credit was not performed until later. Thus, regardless of whether the ERC is claimed in 2020 or 2021, expense disallowance likely occurs in 2020 and should be reflected on the 2020 federal income tax return. Nothing allows for the deferral of ERC-related income beyond 2020.

Taxpayers also should keep in mind that expense disallowance relating to the ERC may impact their wage limitation for purposes of the qualified business income (QBI) deduction under section 199A.

What about the 2021 ERC?

The 2021 ERC is more generous than the 2020 ERC. Here are some of its more expansive provisions:

increases maximum credit amount per employee (making it 70% of $10,000 of qualified wages per quarter); expands the category of employers entitled to the credit; lowers the threshold in the gross receipts test; and expands the definition of qualified wages and the definition of employers entitled to the larger wage base.
On the tax side, the analysis of the timing of expense disallowance relating to the 2020 ERC should apply with equal force to the 2021 ERC; however, since most taxpayers will claim the 2021 ERC on a real-time (quarterly) basis, the timing issue will not be as prevalent as it is for the 2020 ERC.

The recent IRS Notice on the ERC is helpful but incomplete. It leaves many unanswered questions and does not even attempt to address the 2021 ERC. I guess the best we can hope for is that the next round of guidance will be better than the last.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Daniel Mayo is a principal with Withum and has more than 20 years of professional tax experience as well as experience in federal, international and financial products taxation. He is a member of Withum’s National Tax Services Group and oversees the U.S. Federal income tax research, planning and review functions. He is experienced in mergers and acquisitions, capital markets and cross-border transactions.

Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at TaxInsights@bloombergindustry.com.

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