When is the amount of the employee retention credit taxable?

The CARES Act created many new acronyms for taxpayers to memorize, including the CARES Act itself, which is also an acronym. These include PPP (Paycheck Protection Program), EPTD (Employer Payroll Tax Deferral), and ERC (Employee Withholding Credit). This article focuses on the ERC and, in particular, the ERC taxation.

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. Consequently, 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 approval of the Consolidated Allocations Act of 2021 or CAA (yet another acronym) on December 27, 2020. Since Under the CAA, taxpayers who obtained a PPP loan may also qualify for ERC 2020 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 cannot be included in gross income, but is subject to expense write-off rules, which effectively make it taxable. Watch Notice 2020-21, Questions and answers 60-61; IRS FAQ 85 and 86. For example, if an employer received $ 200,000 in ERC, then it would be required to reduce its deductible salary expenses, including qualified health plan expenses, by $ 200,000, thus taxing it on an additional $ 200,000 of income (or causing fewer losses ). if it was in a net loss position). The expense reduction rules apply to salaries, including qualified health plan expenses, paid or incurred in 2020 and that were reimbursed by ERC. There is no reduction in the employer’s deduction for your share of Social Security and Medicare taxes anywhere in the ERC.

Additionally, while the IRS does not mention it in the Notice or in its published list of FAQs, the expense write-off rules also likely require taxpayers to reduce the depreciation or basis of any capitalized wages or wages included in inventory. under the total absorption cost calculation method. Watch Sections 1.280C-1 of the Treasury Regulations; 1,280C-3 (b).

When is 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 FAQ, but it didn’t. For taxpayers who claimed and received the ERC in 2020, the answer is clear that the write-off occurs in 2020. But what about taxpayers who claimed or will claim the ERC 2020 in 2021? When does the cancellation of expenses occur for them?

For readers who have been following the tax arcana in recent months, remember that a similar problem arose regarding the PPP before the CAA repealed the IRS and allowed deductions related to the forgiveness of PPP loans. The IRS had taken the position that the write-off of PPP-related expenses occurs in 2020 if the borrower had a reasonable expectation of loan forgiveness by the end of 2020. Watch Income Resolution 2020-27; Notice 2020-32. This position was based on pre-existing expense reimbursement jurisprudence and Tax Code Section 265 (which addresses expenses related to tax-exempt income), both of which were discussed in the guide. However, write-off of ERC-related expenses is based on Section 280C (which addresses expenses related to certain tax credit refunds).

Should the rules that address the timing of denial of APP expenditures apply to the ERC? Does it make a difference that the APP borrowers used the funds in 2020, but the taxpayers claiming the ERC 2020 in 2021 did not receive the financial benefit of the credit until 2021? Unfortunately, no, economic equity is not relevant here.

For cash-based taxpayers claiming the ERC 2020 in 2021, expense reversal is likely to occur in 2020, regardless of when the ERC is claimed. This is because, at the end of 2020, the taxpayer met all the requirements for the ERC 2020 and the same reasoning used by the IRS in Rev. Rul. It would apply 2020-27. In addition, section 280C establishes in the relevant part that no deduction is allowed for wages “paid or incurred during the taxable year” in which the credit is “determined for the taxable year.” This suggests that expense reversal occurs in 2020, and is consistent with the IRS position regarding section 280C more generally. See for example., Treas. Reg. Section 1.280C-1 (expense reduction occurs in the year the credit is “earned”). Therefore, regardless of whether a cash-based taxpayer claims the 2020 ERC in 2020 or 2021, expense reversal is likely to occur in 2020.

For accrual-based taxpayers claiming the ERC 2020 in 2021, the analysis is largely the same, but it can also be based on testing all events in Sections 451 and 461 of the tax code.

In general, income and deductions are recognized by taxpayers on an accrual basis in the year when:

  • all the events that establish the right to income or determine the taxpayer’s obligation to pay have occurred, and
  • the amount can be determined with reasonable precision.

In the case of a deduction, there is an additional limitation. The test of all events is not considered fulfilled until economic performance occurs, which is generally when the services are rendered or when the property is used or provided.

These rules do not clearly apply to write-off of expenses, which is not an item of income or deduction. For taxpayers who obtained a PPP loan in 2020, and were eligible for the ERC 2020 after CAA approval, they met all the requirements for the ERC in 2020. By the end of 2020, those taxpayers had already paid eligible wages for ERC. and the amount of the ERC could have been determined with reasonable precision, even if the actual credit calculation was not made until later. Therefore, regardless of whether ERC is claimed in 2020 or 2021, expense reversal will likely occur in 2020 and should be reflected on the 2020 federal income tax return. Nothing allows deferral of ERC-related income anymore beyond 2020.

Taxpayers should also be aware that offsetting ERC-related expenses may affect their salary cap for purposes of the Qualified Business Income (QBI) deduction under section 199A.

What about ERC 2021?

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

increases the maximum amount of credit per employee (making it 70% of $ 10,000 of qualified wages per quarter); broadens the category of employers entitled to credit; lowers the threshold on the gross income test; and broadens the definition of qualified wages and the definition of employers entitled to a broader wage base.
From a tax point of view, the analysis of when to cancel expenses related to the 2020 ERC should be applied with the same force as the 2021 ERC; However, since most taxpayers will claim ERC 2021 in real time (quarterly), the time issue will not be as prevalent as it is for ERC 2020.

The recent IRS notice about the ERC is helpful but incomplete. It leaves a lot of questions unanswered and doesn’t even attempt to tackle ERC 2021. I think 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 Office of National Affairs, Inc. or its owners.

Author information

Daniel Mayo is a director of Withum and has more than 20 years of professional tax experience, as well as experience in federal, international and financial product taxes. He is a member of Withum’s National Tax Services Group and oversees the investigation, planning, and review functions of the US federal income tax.He has experience in mergers and acquisitions, capital markets, and cross-border transactions.

Bloomberg Tax Insights articles are written by seasoned professionals, academics, and policy experts who discuss current developments and issues in tax matters. To contribute, contact us at [email protected].

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