Using Payroll Costs to Calculate the Employee Retention Credit: A Step-by-Step Guide

Calculating the Employee Retention Credit (ERC) is a critical process for businesses looking to maximize their tax benefits. The ERC, a provision introduced in response to the COVID-19 pandemic, offers a refundable tax credit to eligible employers for wages paid to retained employees during a time when operations were affected by the health crisis. Understanding the specific payroll costs that qualify for the ERC is essential, as they form the basis of the credit calculation and can significantly impact the final credit amount.

Determining the eligibility and accurately computing the credit can be complex, with factors such as the period during which the wages were paid and the cap on qualified wages per employee per quarter coming into play. For instance, in 2021, the credit was equal to 70% of qualified wages paid to employees. Businesses must also consider the maximum allowable credit per employee to optimize their claim while adhering to Internal Revenue Service guidelines.

Navigating the specifics of the ERC involves a clear understanding of the nuanced requirements outlined by the IRS, including the amendments made under the Relief Act. As the financial landscape evolves and further legislative changes are implemented, employers must stay informed to ensure compliance and to harness the full potential of the Employee Retention Credit.

Understanding Employee Retention Credit

The Employee Retention Credit (ERC) is a measure established to incentivize businesses to retain their employees during disruptions caused by COVID-19. Here, businesses can grasp the intricacies of eligibility, wage calculations, and the application process.

Eligibility Criteria

Eligible employers are those who operated a business during the calendar year 2020 or 2021 and experienced either a full or partial suspension of operations due to government orders linked to COVID-19 or a significant decline in gross receipts. Specifically, gross receipts for a 2020 quarter must be less than 50% of those for the same quarter in 2019. Subsequent 2021 eligibility hinges on a decline to less than 80% compared to the same quarter of 2019.

Qualifying Wages and Health Expenses

For the ERC, qualifying wages are those paid to an employee during a time of business suspension due to government orders or a significant reduction in business operations. In addition, an eligible employer can also include the cost of health care benefits when calculating the credit. Wages and health expenses count up to a certain cap, established by the relevant legislation.

  • For 2020: 50% of up to $10,000 in wages per employee for the year
  • For 2021: 70% of up to $10,000 in wages per employee per quarter

Calculating Qualified Wages

Calculating qualified wages involves determining the average number of full-time employees in 2019, as legislation draws a distinction between small and large employers for the credit. Small employers, typically those with 100 or fewer full-time employees, can credit wages paid to working or furloughed employees. In contrast, larger employers can only include wages for the time employees are not providing services.

The maximum credit claimable varies over the periods covered by the Coronavirus Aid, Relief, and Economic Security Act and subsequent amendments under laws such as the Families First Coronavirus Response Act. The Internal Revenue Service (IRS) provides further guidance on specific refundable tax credit calculations for employers.

Changes in Legislation and Dates

The Employee Retention Credit (ERC) has seen several changes introduced by different laws since its inception, significantly altering the timeline and scope of eligible payroll costs for businesses.

Initial Legislation under the CARES Act

The Coronavirus Aid, Relief, and Economic Security (CARES) Act, enacted on March 27, 2020, established the Employee Retention Credit as a support measure for employers to retain employees on their payroll during the COVID-19 pandemic. Initially, eligible employers could claim a refundable tax credit for 50% of qualified wages paid to employees up to a maximum of $10,000 per employee for wages paid between March 12, 2020, and January 1, 2021.

Updates from the Consolidated Appropriations Act

The scope of the ERC was expanded by the Consolidated Appropriations Act, of 2021, signed into law on December 27, 2020. This act included the Taxpayer Certainty and Disaster Tax Relief Act of 2020, which extended the ERC’s availability through June 30, 2021, and increased the credit rate from 50% to 70% of qualified wages per quarter, while raising the limit on per-employee wages to $10,000 per quarter.

Amendments by the American Rescue Plan Act

The American Rescue Plan Act (ARPA), enacted on March 11, 2021, further amended the Employee Retention Credit. It extended the credit through December 31, 2021, but was later amended by the Infrastructure Investment and Jobs Act, which sunset the ERC for most businesses as of September 30, 2021. This act also allowed certain startup businesses to claim the credit for wages paid through the end of the fourth quarter of 2021. The ARPA made the ERC available even to employers who took out Paycheck Protection Program (PPP) loans, provided they didn’t use the same wages for both benefits.

Calculating and Claiming the Credit

To accurately calculate and claim the Employee Retention Credit (ERC), businesses must follow a series of specific steps related to their payroll costs and tax filings. Understanding the calculation of gross receipts, navigating Form 941 and any necessary adjustments, and managing advance payments are all crucial elements of this process.

Determining Gross Receipts

Gross receipts are a measure of a business’s total revenue and are used in determining eligibility for the ERC. A business’s gross receipts for a calendar quarter are compared to the same quarter in 2019 to determine if the requisite significant decline has occurred. This comparison decides if the business qualifies for the ERC for that quarter.

To Calculate Gross Receipts:

  • Sum all revenue in the form of sales, services, and any other income.
  • Do not deduct any costs or expenses.

Form 941 and Adjusted Returns

The primary method to claim the ERC is through Form 941, the Employer’s Quarterly Federal Tax Return.

Key Steps for Utilizing Form 941:

  • Document the total qualified wages and associated health insurance costs.
  • Calculate the credit amount for each quarter.

If a business identifies ERC eligibility after initially filing Form 941, it must file an adjusted employment tax return using Form 941-X to claim the credit for the specific quarter.

Advance Payments with Form 7200

Businesses expecting a refundable credit exceeding their total employment tax liabilities can request an advance of the ERC by filing Form 7200, Advance Payment of Employer Credits Due to COVID-19.

When Using Form 7200, Remember:

  • It should only be utilized if the credit exceeds the employer’s total social security and Medicare taxes.
  • File Form 7200 before filing the corresponding Form 941 to receive the advance payment.

Interaction with PPP and Other Relief Measures

Navigating the complexities of pandemic-related financial aid, businesses must understand the precise ways in which the Paycheck Protection Program (PPP) loans interact with other relief measures, notably the Employee Retention Credit (ERC). Accurate calculation and application of these programs are crucial to maximize benefits.

Paycheck Protection Program Loans

The Paycheck Protection Program (PPP) was established to provide loans as a direct incentive for small businesses to keep their workers on the payroll. However, the intricacy lies in the fact that while PPP loan forgiveness primarily covers payroll costs, it also affects the amount of wages eligible for the Employee Retention Credit. A key requirement for businesses is to prevent double-dipping; no wages used for PPP forgiveness can be claimed for the ERC. If a business received a PPP loan, it must carefully calculate its ERC to exclude any payroll costs accounted for in its PPP loan forgiveness application.

Grants and Tax Credits

Other than PPP loans, the government provided several other forms of grants and tax credits designed to alleviate financial burdens on businesses. These include various stimulus bills that extend tax credits and provide grants that can be utilized alongside PPP. Companies must consider the interaction between grants and the Employee Retention Credit, as certain grants might render businesses ineligible for the ERC, or limit the amount that can be claimed. Payroll expenses covered by grants should not overlap with the wages claimed for the ERC or PPP loan forgiveness, to ensure compliance with the program rules and maximize the relief received.

Businesses need to stay informed on legislative updates and seek guidance to accurately navigate these relief measures.

Special Considerations for Different Business Types

When calculating the Employee Retention Credit (ERC), different business types face unique considerations. What applies to one may not be relevant for another, impacting how the ERC claim is approached.

Recovery Startup Businesses

Recovery startup businesses, which began operation after February 15, 2020, are subject to distinct guidelines when it comes to the ERC. They can claim the credit on wages up to a certain threshold, and the calculation may differ from businesses established before that date. These startups need to carefully assess their eligibility, keeping in mind that special rules can affect their maximum credit amounts.

Small versus Larger Employers

Distinct methods apply for small employers versus larger employers when determining qualified wages for the ERC. Small employers, with an average number of full-time employees in 2019 that was 100 or fewer, can account for all wages paid to employees. On the other hand, larger employers must only consider wages paid to employees for the time the employee was not providing services. Criteria for what counts as qualified wages can be complex, and the size of the business can significantly influence these computations. Employers must ascertain their status since it directly affects the magnitude of the credit they can rightfully claim.

Maximizing the Employee Retention Credit

To effectively maximize the Employee Retention Credit (ERC), companies should familiarize themselves with the specific criteria that will enable them to claim the maximum benefits. Strategies differ based on company size and leverage various elements of the tax credit, which include qualified wages, qualified health plan expenses, and factors indicating economic hardship.

Strategies for Larger Companies

Larger businesses should perform a meticulous review of all payroll costs to determine what constitutes qualified wages. This includes assessing which periods of economic hardship allow for maximum credit application. For 2021, eligible employers can claim a tax credit of 70% of the first $10,000 in qualified wages paid to an employee per quarter. In addition, the inclusion of qualified health plan expenses can substantially raise the total credit, as these expenses are considered part of the qualified wages for ERC purposes. Larger companies typically have the resources to conduct detailed analyses or hire consultants to ensure that all claims align with the IRS’s evolving guidance.

Optimization for Small Businesses

Small businesses aim to optimize their ERC by focusing on their unique eligibility factors, like a more significant decline in business revenue. Such businesses can calculate the credit by applying the 70% rate to qualified wages, which may even include the wages paid when businesses were shut down due to the pandemic. Moreover, reviewing the full extent of qualified health plan expenses is critical as they can contribute substantially to the credit, especially given that small businesses also qualify for the ERC on wages paid to employees whether they are providing services or not. Expert assistance from tax professionals can be particularly beneficial for small businesses to navigate these specific scenarios efficiently.

In both cases, proper documentation and comprehensive reviews are critical in maximizing the Employee Retention Credit without contravening IRS rules.

Common Misconceptions and Compliance

Navigating the Employee Retention Credit (ERC) can be challenging, with businesses often misinterpreting the complex requirements. This section directly addresses two critical areas: claims, audits, and common errors related to eligible wages.

ERC Claims and Audits

Businesses must be aware that ERC claims are subject to review by the IRS. Compliance demands a thorough understanding of the requirements as outlined in IRS guidance, such as Notice 2021-20. Failing to adhere can lead to an audit, where eligible employers must substantiate their ERC claim with appropriate documentation. This includes proving that the business was directly affected by government orders or experienced a significant decline in gross receipts.

Eligible Wages Misunderstanding

The definition of eligible wages is frequently misunderstood, confusing what can be claimed for the credit. According to the IRS FAQs, eligible wages are those paid to full-time employees during periods of business suspension due to government orders or during quarters of significant revenue decline. However, employers should note that not every wage qualifies, and the cap on wages that can be considered for the credit differs between 2020 and 2021.

  • For 2020: The credit is limited to 50% of qualified wages per employee, up to a total of $10,000 for the year.
  • For 2021: This credit increases to 70% of qualified wages each calendar quarter but is capped at $10,000 per quarter, potentially totaling $28,000 for the year per employee through June 30, 2021.

Businesses must exercise due diligence and ensure compliance when calculating and claiming the ERC to avoid future issues with the IRS. Misinterpretations or errors can lead to adjustments during an audit and potentially result in penalties.

Frequently Asked Questions

This section addresses specific queries regarding the Employee Retention Credit, particularly how it is calculated, the role of payroll costs, and interactions with other federal programs.

How do you determine qualified wages for the Employee Retention Credit?

Qualified wages are those paid to employees during a period in which business operations were either fully or partially suspended by government order due to COVID-19, or during a quarter in which the business experienced a significant decline in gross receipts compared to the same quarter in the previous year. The definition of qualified wages depends on the employer’s number of full-time employees and varies as per IRS guidelines.

What are the steps to calculate the Employee Retention Credit using payroll expenses?

To calculate the Employee Retention Credit using payroll expenses, employers should identify all eligible wages paid during the qualified period. Then, they should calculate a percentage of those wages, up to the cap specified by the law, and include qualified health expenses. The total amount is the Employee Retention Credit they may claim against certain employment taxes.

What are the eligible payroll expenses for calculating the Employee Retention Credit?

Eligible payroll expenses for the Employee Retention Credit include salaries, wages, commissions, and certain employer-paid health insurance costs. These payroll costs must have been paid after March 12, 2020, and before January 1, 2021, for the initial ERC, with subsequent updates expanding eligibility dates.

How does the Paycheck Protection Program (PPP) loan interact with the Employee Retention Credit calculations?

Initially, wages that were paid with a forgiven PPP loan were not eligible for the Employee Retention Credit. However, with new legislation, businesses can now claim the ERC even if they received a PPP loan, as long as the same wages are not used for both benefits.

Can wages used for the Employee Retention Credit also be claimed as a deduction on taxes?

Yes, wages used for the Employee Retention Credit can be claimed as a deduction on taxes. However, the amount of the Employee Retention Credit would reduce the wage deduction dollar-for-dollar, to prevent a double tax benefit.

Is there a limit on the amount of wages that can be considered for the Employee Retention Tax Credit (ERTC)?

There is a limit on the wages that can be considered for the ERTC. For 2020, the credit is capped at 50% of up to $10,000 in qualified wages per employee annually. For 2021, this cap was increased to 70% of up to $10,000 per employee per quarter for the first two quarters. Employers should refer to the latest IRS updates for the most current cap limits.

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