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!
If you are a paid subscriber, use the comments section below to discuss and ask questions about reporting the COVID-19 ERC on income tax returns.
Upcoming Education Events
Compass Tax Educators - Virtual
Sales are open for our 2022 webinar season all-access pass! Get over 30 CE/CPE of live webinar education at a bundled rate plus access to my recorded Tax Season Support Sessions. Click here for additional information and to purchase.
Individual registration for each of the following webinars I am teaching will be open soon:
S Corps - Formation and Return Preparation - May 5, 2022
S Corps - Basis, Disposition, and Planning - May 19, 2022
Roth IRA Fundamentals - June 2, 2022
Tax Credits - August 4, 2022
Filing Status: Rules and Planning - August 18, 2022
Reasonable Compensation Issues & Planning - October 20, 2022
Representation Panel Discussion - November 3, 2022
2022 Individual Tax Update - December 8, 2022
2022 Business Tax Update - December 15, 2022
NATP - Florida Chapter - May 15-17, 2022 - Daytona Beach, FL - Live
Mastering Tax Research & Creating a Winning Tax Argument (3 CE); Disclosing Tax Return Positions (1 CE); Form 1099 Reporting, Compliance, and Reconciliation (2 CE); Circular 230 Ethics: Pricing Tax Engagements (2 CE); Entity Classification: Rules and Elections (2 CE); Tax Implications of Major Life Events (2 CE); Cryptocurrency Taxation (2 CE); Penalty Abatement Strategies (2 CE)
Oregon Society of Tax Consultants - May 20, 2022 - Newport, OR - Live
7 CE - To be announced
AICTP Tax Planning Academy - May 23-25, 2022 - San Diego, CA - Live
Virginia Society of Enrolled Agents - June 8, 2022 - Fredericksburg, VA - Live
Tax Planning - Individuals (2 CE); Tax Planning - Businesses (2 CE); Gambling Tax Issues (2 CE)
Florida Society of Enrolled Agents - June 17, 2022 - Orlando, FL - Live
Tax Planning - Individuals (2 CE); Mastering the Tax Research Process (2 CE); Rental Property Taxation (2 CE)
National Association of Enrolled Agents 2022 Tax Summit - July 26, 2022 - Las Vegas, NV - Live
Examination Issues for Pass-Through Entities (2 CE); Panel Discussion on Working with the IRS in 2022
Minnesota Society of Enrolled Agents - November 16, 2022 - Live
Business Tax Topics TBD (8 CE)
Hi Tom
Can you please see below and provide your thoughts on a differing position:
§3134(e) states that rules similar to §280C(a) will apply. §280C discusses how expenses relating to tax credits received are not deductible. This part I agree with.
The part that I disagree with is whether this affects the AAA account and basis. The credits discussed under §280C are income tax credits. ERC is a payroll tax credit. The method that ERC makes the wages non-deductible is from the book reduction of wages. AAA and retained earnings should be very close to each other, other than differences in book vs tax basis for things such as depreciation and reserve accounts.
Here are two examples of the thought process.
• The R&D tax credit has a similar addback provision under §280C(c). Let’s assume that $100,000 were expended, resulting in a $20,000 credit. I agree here that the $20,000 credit should be a reduction to AAA. The net affect to AAA is a reduction of $100,000. If looking at AJEs for a C corporation, the $20,000 credit would look like this:
Cash $20,000
Tax Expense ($20,000)
Since this is a pass-through, there is no tax expense. The S Corporation would not receive the cash; instead, its shareholders would receive an offset to their tax liabilities.
• For 50% meals, the non-deductible portion has still been expended by the taxpayer. So, $1,000 of meals expended results in a $500 deduction but a $1,000 reduction of AAA.
Where the ERC is different is that the credit is for payroll tax, and the S Corporation receives the cash. Let’s assume that wages are $100,000, and the ERC is $20,000. Once the ERC is received, the journal entry would look similar to this:
Cash $20,000
Wages ($20,000)
The end result would be a net expense for wages of $80,000.
In the above R&D example, books show an expense of $100,000, and the tax return shows a deduction of $80,000. The $20,000 difference is non-deductible.
For the ERC example, both books and the tax return show the same amount of expense for $80,000. There is no difference between the book expense and the tax return deduction, and this is why I believe there is no reduction to AAA.
Appreciate your response.