July 10, 2020
Employee Retention Credits present challenges
The Employee Retention Credits (ERCs), awarded as part of the Coronavirus Aid, Relief and Economic Stabilization Act (P.L. 116-136 (CARES Act)), carry with them a series of technical considerations and challenges as employers begin accruing the benefit for them in their quarterly financial statements, including how to determine qualifying wages. Companies may have numerous business sectors within the same employer group; some considered essential, some not and may have numerous classes of employees with differing levels of impact of the COVID-19 shut-down efforts. Added to the business complexities are the facts that (1) Treasury has not yet issued official guidance, in the form of regulations or otherwise, on which wages truly qualify versus those that won't, and (2) there are numerous accounting principles to consider on the interplay of the credits with Federal and State income tax calculations.
As employers navigate the complexities of the new law, many are finding it challenging to determine wages that qualify for the credit due to the lack of available authorities in what are already challenging times. This Alert is intended to highlight some of the considerations from both a tax and financial accounting perspective when assessing the current effects of the benefit of ERCs.
Section1 2301 of the CARES Act provides a fully refundable tax credit against the employer share of the 6.2% Old-Age, Survivors, and Disability Insurance tax (OASDI or, more commonly, the Social Security tax) under Section 3111(a) of the Internal Revenue Code of 1986, as amended (the IRC), and the portion of taxes imposed on railroad employers under Section 3221(a) of the Railroad Retirement Tax Act (RRTA) that corresponds to the Social Security taxes under IRC Section 3111(a). The credit is commonly referred to as the Employee Retention Credit (ERC). The ERC is based on wages (under IRC Section 3121(a)) and compensation (under IRC Section 3231(e)) paid by an eligible employer after March 12, 2020 and before January 1, 2021. "Qualified wages" eligible for the ERC also include qualified health plan expenses, which include the portion of the cost paid by the employer and the portion of the cost paid by the employee with pre-tax salary reduction contributions.
Salary and wage deduction and deduction for payroll taxes
Section 2301(e) of the CARES Act states that "rules similar to the rules of sections 51(i)(1) and 280C(a) of the Internal Revenue Code of 1986 shall apply." The reference to IRC Section 280C(a) is significant in determining the tax results of the ERC. Specifically, IRC Section 280C(a) provides that "no deduction shall be allowed for that portion of the wages or salaries paid or incurred for the taxable year which is equal to the sum of the credits determined for the taxable year under [IRC] sections 45A(a) [Indian employment credit], 45P(a) [employer wage credit for employees who are active military service members], 45S(a) [employee credit for paid family and medical leave], 51(a) [Work Opportunity Tax Credit], and 1396(a) [Empowerment zone employment credit]." In contrast to the ERC, which is creditable against the employer share of Social Security tax but also wholly refundable, each of these tax credits specifically referenced in IRC Section 280C(a) is accumulated as part of the general business credit under IRC Section 382 and, thus, a credit against federal income tax liability, not employment tax liability.3
To assist employers with understanding the wide variety of issues raised by the enactment of the ERC, on April 30, 2020, the IRS issued a series of questions and answers under the title "FAQs: Employee Retention Credit under the CARES Act" (IRS ERC FAQs).4 In IRS ERC FAQ 85, which specifically addresses whether deductions for "qualified wages" used to compute the ERC would be disallowed in computing an employer's federal taxable income under IRC Section 280C(a), the IRS stated its view that " … a similar deduction disallowance (i.e., the disallowance of deductions under IRC Section 280C(a)) would apply under the [ERC], such that an employer's aggregate deductions would be reduced by the amount of the credit as result of this disallowance rule." Thus, the IRS believes that any employer receiving an ERC must reduce its deduction for salaries and wages by the amount of the ERC.
Unlike the IRS FAQs for paid leave credits under Sections 7001 and 7003 of the Families First Coronavirus Response Act (P.L. 116-127) (FFCRA), which state that such credits do not reduce the amount of employment taxes that may be deducted by the employer,5 the IRS ERC FAQs do not address whether the ERC reduces the amount of employment taxes that may be deducted by the employer for federal income tax purposes.
On April 23, 2020, the staff of the Joint Committee on Taxation (JCT) published its description of the tax provisions of the CARES Act (JCT CARES Act Report).6 The description of the ERC in the JCT CARES Act Report indicates the JCT staff's view that the ERC itself is also taken into account for purposes of determining any amount allowable as a payroll tax deduction for federal income tax purposes.
For example, assume an employer pays $2,500 of qualified wages for the quarter and claims an employee retention credit of $1,250 for qualified wages paid during the quarter. The employer's resulting OASDI [Old Age Survivors Disability Insurance or "Social Security"] tax liability (under [IRC S]ection 3111(a)) for the quarter is $155. Under the provision [CARES Act Section 2301(e)], the employer reduces its payroll tax expense by $155 and may deduct only $1,405 of qualified wages148 (assuming such wages are not subject to capitalization).
[FN]148 $2,500 — ($1,250 - $155) = $1,4057
Based on our analysis of the statute and considering the information in the IRS ERC FAQs and JCT CARES Act Report, we believe that an employer must reduce its total deduction by the amount of the ERC in accordance with IRC Section 280C(a). An employer is not required to reduce its deduction for qualified wages in excess of the credit.
Employment tax deferral
Section 2302 of the CARES Act provides for the deferral of taxes under IRC Section 3111(a) and the portion of taxes imposed under IRC Sections 3211(a) and 3221(a) (with respect to the taxes imposed under the RRTA that correspond to the Social Security taxes under IRC Section 3111(a)). Taxes that may be deferred are those due on or after March 27, 2020 and before January 1, 2021 (CARES deferred payroll taxes). Fifty percent of the deferred taxes must be paid by December 31, 2021 and the remaining portion by December 31, 2022.
IRC Section 461(h) and Treas. Reg. Section 1.461-1(a)(2)(i) provides that an expense is deductible for a tax year if three tests are met:
Revenue Procedure 2008-25 treats a taxpayer as satisfying the requirement in Treas. Reg. Section 1.461-5(b)(1)(i) for its payroll tax liability >in the same tax year in which all events have occurred that establish the fact of the related compensation liability and the amount of the related compensation liability can be determined with reasonable accuracy.
Treas. Reg. Section 1.461-4(g)(6) provides generally that, if a taxpayer is liable to pay a tax, economic performance occurs as the tax is paid to the governmental authority that imposed it.
Treas. Reg. Section 1.461-5(b)(1) provides a recurring item exception to the general rule of economic performance. Under the recurring item exception, a liability is treated as incurred for a tax year if: (i) at the end of the tax year, all events have occurred that establish the fact of the liability and the amount can be determined with reasonable accuracy; (ii) economic performance occurs on or before the earlier of (a) the date that the taxpayer files a return (including extensions) for the tax year, or (b) the 15th day of the 9th calendar month after the close of the tax year; (iii) the liability is recurring in nature; and (iv) either the amount of the liability is not material or accrual of the liability in the tax year results in better matching of the liability against the income to which it relates than would result from accrual of the liability in the tax year in which economic performance occurs. In the case of a liability for taxes, Treas. Reg. Section 1.461-5(b)(5)(ii) deems the matching requirement of the recurring item exception satisfied.
In the instant case, the fact of the payroll tax liability is established and the amount of such liability is determinable with reasonable accuracy in the same tax year in which all events have occurred that establish the fact of the related compensation liability and the amount of the related compensation liability can be determined with reasonable accuracy. Employment taxes ordinarily due between March 27, 2020 and January 1, 2021, but deferred and not paid until December 31, 2021 and December 31, 2022, respectively, would not be deductible until the tax year in which paid.
To accelerate the deduction for CARES deferred payroll taxes under the recurring item exception, a taxpayer must make the payment by the earlier of (a) the date that the taxpayer files a return (including extensions) for the 2020 tax year, or (b) the 15th day of the 9th calendar month after the close of the 2020 tax year.
Impact of the ERC on the employer's determination of taxable income — Federal and State
In IRS ERC FAQ 86, the IRS states that neither the portion of the ERC that reduces the employer's applicable employment taxes, nor the refundable portion of the ERC, is included in the employer's gross income.8 This gross income exclusion, as well as the IRC Section 280C(a) deduction disallowance previously described, impacts the employer's determination of federal taxable income and thus can impact the determination of state taxable income.
Many states utilize the federal income tax base as the starting point to determine state taxable income (e.g., they start the state income tax calculation by using either federal gross income or federal taxable income as the starting point). States vary, however, as to how they conform to the federal income tax base, and there is little uniformity. At a high level, those states that conform to the IRC as of a fixed date, commonly referred to as "fixed conformity" states (e.g., Virginia, which currently conforms to the IRC as of December 31, 2019), may not yet incorporate the CARES Act provisions into their tax laws. Other states, commonly referred to as "rolling conformity" states (e.g., Illinois), automatically conform to federal tax law changes as they are adopted.
The state income tax implications of the ERC are varied and complicated, largely as a result of state tax law conformity to the IRC described previously. For example, in order to conform to the IRC Section 280C(a) treatment of the ERC, fixed conformity states generally must enact legislation that either updates their IRC conformity date or specifically incorporates CARES Act Section 2301(e) by reference. After considering how or whether CARES Act modifications to the IRC are incorporated into the federal starting point for determining state taxable income, a state may subsequently modify the federal treatment of the ERC. Thus, an otherwise conforming state might reverse the impact of IRC Section 280C(a) to allow a deduction for creditable expenses, similar to federal expenses for research credits and foreign tax credits.
Because of the federal income tax "off-code" treatment of both IRC Section 280C(a) (which is not modified by but is only referenced in the CARES Act) and the exclusion of the ERC from gross income (which is covered merely in an IRS ERC FAQ as noted), employers should also be wary of the potential for unfavorable state income tax impacts of the ERC. For example, although unlikely, a state might treat the ERC as gross income but also conform to the IRC Section 280C(a) deduction disallowance.
Financial reporting considerations
The ERC is designed to encourage employers to keep employees on their payroll despite experiencing economic hardship due to the COVID-19 pandemic. An entity is eligible for the ERC if it has not received a Paycheck Protection Program loan and (1) its operations have been fully or partially suspended because of COVID-19 or (2) its gross receipts in a calendar quarter in 2020 declined by more than 50% from the same period in 2019.
As with other forms of government assistance provided under the CARES Act, entities will need to consider the accounting and financial reporting implications of their participation in this program. Because the ERC is not an income-based tax credit, it is not in the scope of Accounting Standards Codification (ASC) 740, Income Taxes.
There is no US GAAP guidance for for-profit business entities that receive government assistance that is not in the form of a loan, an income tax credit or revenue from a contract with a customer. As such, business entities will need to determine the appropriate accounting treatment by analogy to other guidance. When the assistance received is in the form of a government grant and is not an income tax credit, we generally believe that business entities should account for it by analogy to International Accounting Standards (IAS) 20, Accounting for Government Grants and Disclosure of Government Assistance, of International Financial Reporting Standards (IFRS). However, analogies to other guidance, such as ASC 958-605 for contributions received by not-for-profits or ASC 450, Contingencies, also may be appropriate. A not-for-profit entity that receives a government grant should apply ASC 958-605, Not-for-Profit Entities — Revenue Recognition.
Before selecting an accounting policy, a business entity should consider whether it has a preexisting policy for similar grants. If not, it should consider the facts and circumstances associated with the grant and which accounting model would best reflect the nature and substance of the grant. Regardless of the accounting model it applies, a business entity should adequately disclose its accounting policy for such grants and their impact on the financial statements.
Under an IAS 20 analogy, a business entity would recognize the credit on a systematic basis over the periods in which the entity recognizes the payroll expenses for which the grant (i.e., tax credit) is intended to compensate when there is reasonable assurance (i.e., it is probable) that the entity will comply with any conditions attached to the grant and the grant (i.e., tax credit) will be received. As also discussed previously, IAS 20 permits presentation as a credit in the income statement (either separately or under a general heading, such as "other income") or as a reduction of the related expense. Entities will need to evaluate their facts and circumstances to determine which presentation is most transparent to users of the financial statements.
A company applying IAS 20, ASC 450 or ASC 958-605 will need to carefully evaluate its facts and circumstances to determine when the recognition criteria under these standards have been met. For example, because final regulations have not yet been issued by Treasury, companies may find it challenging to determine under an IAS 20 analogy if it is "probable" that wages qualify for the ERC and that the entity has complied with all the conditions to realize the grant due to the lack of clear guidance on qualification. If the company has not met the recognition criteria in IAS 20, ASC 450 or ASC 958-605, the financial statement benefit from the ERC should be deferred until the recognition criteria is satisfied. For example, a company analogizing to IAS 20 should not recognize the benefit of the ERC in its income statement until it is probable that the entity will comply with all the conditions to receive the credit. Each standard has its own recognition criteria, and might require a higher threshold than "probable."
While the ERCs themselves are not income-based credits and thus accounted for as above (i.e., outside of ASC 740), the ancillary effects mentioned herein may have ASC 740 income tax accounting consequences. For instance, the timing of the deduction of payroll taxes discussed in the Employment Tax Deferral section may result in deferred tax considerations. Likewise, as discussed previously, States not conforming with the IRC Section 280C addback and/or the exclusion of the ERCs from income may have differing taxable income bases from that for Federal purposes, thereby creating an effective tax rate impact for the quarter and/or year.
1 "Section" references the relevant section or sections of the IRC, the CARES Act or the Families First Coronavirus Response Act (P.L. 116-127) (FFCRA), as set forth in this publication.
2 IRC Section 38(a) ("There shall be allowed as a credit against the tax imposed by this chapter [IRC Sections 1-1400Z] for the taxable year an amount equal to the sum of … ").
3 IRC Section 45A(a) ("For purposes of [IRC S]ection 38, the amount of the Indian employment credit determined under this section with respect to any employer for any taxable year … "); IRC Section 45P(a)("For purposes of [IRC S]ection 38, the differential wage payment credit for any taxable year is an amount equal to … "); IRC Section 45S(a) ("For purposes of [IRC S]ection 38, in the case of an eligible employer, the paid family and medical leave credit is an amount equal to … "); IRC Section 51(a) ("For purposes of [IRC S]ection 38, the amount of the work opportunity credit determined under this section for the taxable year shall be equal to … "); and IRC Section 1396(a) ("For purposes of [IRC S]ection 38, the amount of the empowerment zone employment credit determined under this section … ").
4 IRS, FAQs: Employee Retention Credit under the CARES Act (April 30, 2020) (available on the internet at https://www.irs.gov/newsroom/faqs-employee-retention-credit-under-the-cares-act (last accessed May 2, 2020)).
5 See IRS, COVID-19-Related Tax Credits for Required Paid Leave Provided by Small and Midsize Businesses FAQs (last updated April 28, 2020) (IRS Paid Family Leave FAQs), FAQ 51, ("Do the tax credits under sections 7001 and 7003 of the FFCRA reduce the amount deductible as federal employment taxes on an Eligible Employer's income tax return? Generally, an employer's payment of certain federal employment taxes is deductible by the employer as an ordinary and necessary business expense in the taxable year that these taxes are paid or incurred, and the amount deductible is generally reduced by credits allowed. Although the tax credits under sections 7001 and 7003 of the FFCRA are allowed against the Eligible Employer's portion of the social security tax, the credits are treated as government payments to the employer that must be included in the Eligible Employer's gross income. If the employer is otherwise eligible to deduct its portion of the social security tax on all wages, the proper amount deductible by the employer is the amount of federal employment taxes before reduction by the tax credits.") (available on the internet at https://www.irs.gov/newsroom/covid-19-related-tax-credits-for-required-paid-leave-provided-by-small-and-midsize-businesses-faqs (last accessed May 2, 2020)).
6 Joint Committee on Taxation, Description of the Tax Provisions of Public Law 116-136, the Coronavirus Aid, Relief, and Economic Security Act ("CARES") Act, JCX-12R-20 (Apr. 23, 2020) (JCT CARES Act Report) (available on the internet for download at https://www.jct.gov/publications.html?func=startdown&id=5256 (last accessed May 2, 2020)).
7 JCT CARES Act Report, pg. 42.
8 IRS ERC FAQs, FAQ 86 ("Does an Eligible Employer receiving an Employee Retention Credit for qualified wages need to include any portion of the credit in income? No. An employer receiving a tax credit for qualified wages, including allocable qualified health plan expenses, does not include the credit in gross income for federal income tax purposes. Neither the portion of the credit that reduces the employer's applicable employment taxes, nor the refundable portion of the credit, is included in the employer's gross income.") This treatment differs significantly from the treatment of the paid leave credits under Sections 7001 and 7003 of the FFCRA. IRC FFCRA FAQ 49 indicates the amounts should be included in the employer's gross income. ("What amount does an Eligible Employer receiving tax credits for qualified leave wages (and allocable qualified health plan expenses and the Eligible Employer's share of Medicare tax on the qualified leave wages) need to include in income? An Eligible Employer must include the full amount of the credits for qualified leave wages (and any allocable qualified health plan expenses and the Eligible Employer's share of the Medicare tax on the qualified leave wages) in gross income.")