Tom Talks Taxes - August 13, 2021
Explaining recent guidance on the employee retention credit
In the last week, the IRS released two documents related to the employee retention credit (ERC): Revenue Procedure 2021-33 and Notice 2021-49. Both are critical to being able to properly advise clients on the ERC and how to maximize a client’s ERC.
Revenue Procedure 2021-33
Revenue Procedure 2021-33 is straightforward: Paycheck Protection Program (PPP) loan forgiveness, shuttered venue operator grants, and restaurant revitalization grants are included in gross receipts for ERC qualification purposes; however, the IRS provided a safe harbor that, if elected, allows the taxpayer to exclude these amounts from gross receipts for ERC qualification purposes only. A taxpayer elects to use the safe harbor by simply excluding these amounts from the ERC gross receipts determination (either on an original or amended return) consistently over all quarters.
Notice 2021-49: Majority Shareholders
Notice 2021-49 has created a firestorm in the tax community due to its position that §267(c) attribution, in tandem with §51(i), disqualifies the wages of majority shareholders from the ERC in most circumstances. The notice exactly adopts the analysis I outlined previously in the April 30, 2021 edition of this newsletter. It is important to note that a majority shareholder can still generally claim the ERC on his or her wages if the “no living relatives” exception is met — there are no living brothers and sisters (whether by the whole or half blood), ancestors, and lineal descendants to which constructive ownership applies under §267(c). Note that constructive ownership applies regardless of whether or not the relative is an employee of the corporation or not. Due to the complexity in this provision, I recommend an individual analysis for each C or S corporation client to determine if the shareholder wages are eligible for ERC.
My opinion: the IRS analysis is the correct interpretation of the Internal Revenue Code as written. Congress would have to enact an exception into the law, which it may do, as it did with the deductibility of expenses used to generate PPP loan forgiveness.
Notice 2021-49: Recovery Startup Businesses
The other major topic in Notice 2021-49 relates to a recovery startup business (RSB). For the 3rd and 4th quarters of 2021 only, Congress allowed a RSB an ERC up to $50,000 per quarter.
New §3134(c)(5) defines a RSB as any employer:
Which began carrying on any trade or business after February 15, 2020,
For which the average annual gross receipts of such employer over the prior three years does not exceed $1,000,000, and
Which, with respect to such calendar quarter, does not meet either the gross receipts test or the suspended operations test, which are the normal tests to qualify for the COVID-19 employee retention credit.
Here are the key considerations in determining the ERC for a potential RSB:
§162 Trade or Business Standard. The IRS said that general §162 principles apply when determining if an employer began carrying on a trade or business. There are two questions that must be asked:
Is the new activity a separate trade or business from an existing one?
When did the trade or business begin?
For the first question, we can look to guidance related to §446 (related accounting methods) and §199A (qualified business income deduction):
No trade or business is separate and distinct unless a complete and separable set of books and records is kept for such business. See Treas. Reg. §1.446-1(d)(2).
Landscape, LLC sells landscaping equipment and also provides consulting services on landscape design for large office parks. Landscape, LLC separately invoices for its landscape design services and does not sell the trees, shrubs, or flowers it recommends for use in the landscape design. Landscape, LLC maintains one set of books and records and treats the equipment sales and design services as a single business. Landscape, LLC operates one trade or business. See Treas. Reg. §1.199A-5(c)(1)(iii)(A).
Animal Care, LLC provides veterinarian services and also develops and sells its own line of organic dog food at its veterinarian clinic and online. Animal Care, LLC separately invoices for its veterinarian services and the sale of its organic dog food and maintains separate books and records for its veterinarian clinic and its development and sale of its dog food. Animal Care, LLC also has separate employees who are unaffiliated with the veterinary clinic and who only work on the formulation, marketing, sales, and distribution of the organic dog food products. Animal Care, LLC operates two trades or businesses. See Treas. Reg. §1.199A-5(c)(1)(iii)(B).
Based on the above, separate books and records, separate invoicing, and separate employees are important factors weighing in favor of the activity being a separate trade or business.
For the second question, we can look to guidance related to §195 (start-up expenditures) and the allowance of trade or business deductions and credits:
“In general, for purposes of §62, a taxpayer has not begun carrying on a trade or business ‘until such time as the business has begun to function as a going concern and performed those activities for which it was organized.’” See Notice 2021-49, quoting Richmond Television Corp. v. U.S., 345 F.2d 901, 907 (4th Cir. 1965).
“The authorities cited can be summarized by stating that... the enterprise incurring them must be beyond the point of mere preparation and actually be engaged in the primary activities intended. Applying this rule to the question of when an entity already engaged in a trade or business begins a new trade or business, it is appropriate to look for a change in the nature of the activities engaged in by the entity.” See Private Letter Ruling 9331001.
In McManus v. Comm., T.C. Memo 1987-457, the Tax Court determined that carrying on a trade or business generally requires (1) the intention of making a profit, (2) being regularly and actively involved in the activity, and (3) having commenced business operations.
Based on the above, the most important factor in determining whether a trade or business has begun is whether or not the business has actually commenced the activity for which it was created.
Attribution Rules Apply. Certain corporations or trades or businesses subject to §52(a), §52(b), §414(m), or §414(o) are aggregated for ERC purposes and treated as a single employer for purposes of:
Suspended operations test,
Gross receipts test,
Recovery startup business,
Number of full-time employees, and
Maximum credit per employee.
If an employer to which the aggregation rules apply has a RSB, then the $50,000 overall ERC limit applies to the aggregated employer, not just the specific RSB. This is just one example of how the aggregation rules impact the RSB.
All Wages Factor Into Credit Amount. The IRS stated that all wages paid to all eligible employees are qualified wages for a RSB. The employer is still subject to both the $10,000 per employee per quarter limit and the $50,000 credit per quarter limit.
Notice 2021-49: Miscellaneous Items
Here are two other important clarifications from Notice 2021-49 that apply to all ERC quarters:
A taxpayer must reduce the deductible wage expense by the ERC amount in the tax year the taxpayer earned the ERC and not the year in which the ERC was received by the taxpayer. For example, for a calendar year employer, if the employer amended 2020 payroll returns to claim the ERC, then the taxpayer must reduce the deductible wage expense on its 2020 tax return, even if it is already filed.
The number of “full-time employees” an employer had in 2019 determines which wages paid qualify for the ERC. The IRS determined that a full-time employee is someone who worked 30 hours per week or 130 hours per month, and full-time equivalents are not used. It is important to note that an employee’s wages can be qualified wages (if they otherwise qualify) regardless of the number of hours worked per week or per month by the employee.
The bipartisan infrastructure bill, which passed the Senate this week, eliminates the ERC for Q4 of 2021 except for a recovery startup business. It also eliminates the requirement that a RSB fail both the gross receipts test and the suspended operations test.
Want More Information?
If you’d like comprehensive continuing education on the ERC, I recently recorded ERC Update: Notice 2021-49 (2 CE) and Rev. Proc. 2021-33: PPP and ERC (brief, free webinar) through Compass Tax Educators.