Tom Talks Taxes - March 4, 2022
Step-by-step tax return adjustments for the employee retention credit
You likely have businesses that claimed the COVID-19 employee retention credit (ERC) for tax year 2021. Claiming the credit on Form 941 is only the first part of the ERC process; the second is reporting that credit correctly on both the books and the income tax return of the business.
Below is an example of all the downstream effects of claiming ERC for a S corporation.
Simple, Inc. is a cash-basis S corporation that claimed and received $50,000 in COVID-19 ERC as a recovery startup business in Q3 and Q4 of 2021. $25,000 was received in 2021 (for Q3) and $25,000 was received in 2022 (for Q4). It started operations on January 15, 2021 and has two unrelated 50% shareholders. The shareholders collectively took $20,000 in distributions.
Simple, Inc. must reduce its wage expense in tax year 2021 by $50,000 since that is the tax year the wages were paid that generated the ERC. See §280C, Treas. Reg. §1.280C-1, and Notice 2021-49. It does not matter when the taxpayer received the credit proceeds.
The journal entry for the 2021 ERC received would be:
The year-end adjusting journal entry for the 2022 ERC to be received would be:
Assume Simple, Inc. had pre-ERC book net income of $30,000; after adjusting for the ERC, book net income increases to $80,000. If there are no other book-to-tax adjustments on Schedule M-1, then the net business income for tax purposes is also $80,000.
The nondeductible wage expense has two other effects on the tax return:
It decreases the accumulated adjustments account (AAA) per Treas. Reg. §1.1368-2(a)(3)(C), and
It passes through to the S corporation shareholders as a nondeductible expense, thus reducing shareholder basis in the S corporation stock.
The 2021 Schedule M-2 for Simple, Inc. would be:
With respect to the shareholder basis adjustment, the IRS Practice Unit on Adjustments to Stock Basis for S Corporations discusses this on page 9:
Claiming the ERC will also have two effects on the §199A deduction:
QBI increases due to the nondeductible wage expense, and
The nondeductible wages are not included in the wage limitation for taxpayers above the §199A taxable income threshold.
With regard to the wage limitation, Treas. Reg. §1.199A-2(b)(4) states wages are allocable to the QBI of a trade or business if the associated wage expenses are taken into account in computing QBI under Treas. Reg. §1.199A-3. Treas. Reg. §1.99A-3(b)(2)(i) states items of income, gain, deduction, and loss must be included or allowed in determining taxable income to flow into QBI. Rev. Proc. 2019-11, which outlines the three methods to calculate the §199A wage limitation, says in Sec. 3.01:
In calculating W-2 wages for a taxable year under the methods described in this revenue procedure, include only wages properly reported on Forms W-2 that meet the applicable rules of §1.199A-2(b).
In closing, when you discover (many people still are not taking advantage of this!) or claim ERC opportunities for taxpayers:
Estimate the downstream tax effects when quantifying the ERC value, and
Ensure your entity tax return pricing reflects the complexities described above.
Share Your Thoughts!
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