As part of the CARES Act last year, Congress created a new tax credit to incentivize employers to keep workers on the payroll during the pandemic. The employee retention credit is an offset to certain payroll taxes; it is not an income tax credit (although there is a similar income tax credit explained later). The credit, which began on March 12, 2020, was originally set to expire at the end of 2020. The Consolidated Appropriations Act, 2021, extended it through the first half of 2021 and then the American Rescue Plan extended it through the end of 2021. Because of modifications by the different laws, the rules are very confusing. Here’s what you need to know about the employee retention credit. Note that the credit applies to employers large and small, but the following discussion only includes rules applicable to small employers (100 or fewer in 2020; 500 or fewer in 2021).
Employment tax offset
Other than the income tax-related credit explained later, the employee retention credit is an offset to the employer’s share of the Old Age, Survivors, and Disability Insurance (the Social Security tax within FICA) and, after June 30, 2021, the Medicare tax as well. As such, it is claimed on the employer’s quarterly return, Form 941.
However, if the amount of the credit exceeds the employer’s Social Security tax, an employer may reduce the deposit of federal employment taxes, including withheld taxes, that would otherwise be required and request an advance of the anticipated credit by filing Form 7200.
Rules for 2020
The rules for the credit for qualified wages paid by an eligible employer after March 12, 2020, and before January 1, 2021, are:
- Eligibility. You must have experienced a full, or partial suspension of operations or a significant decline in gross receipts. A suspension of operations is something that results from a government order limiting commerce, travel, or group meetings. A significant decline means that gross receipts for the calendar quarter or less than 50% of the gross receipts for the same calendar quarter in the prior year. The period during which there is a significant decline in gross receipts ends with the earlier of January 1, 2021 or the calendar quarter following the first calendar quarter in which an employer’s 2020 quarterly gross receipts are greater than 80% of its gross receipts for the same calendar quarter in 2019.
- Credit amount. The credit is 50% of qualified wages (including qualified health care expenses), up to $10,000 per employee. The maximum credit is $5,000 per employee, with no limitation on the number of employees for whom the credit may be claimed. The credit applies whether or not the employee performed services. Qualified wages don’t include amounts paid to more-than-50% owners and certain related parties (e.g., children).
- Coordination with other tax benefits. If you obtained a PPP loan that has not been forgiven, you can claim the employee retention credit for qualified wages. COVID-19-related employment tax credits for paid sick leave, paid family leave, and the employee retention credit are figured on Worksheet 1 in the instructions to Form 941. If an employer opted to defer the employee’s share of Social Security taxes from September 1, 2020, through December 31, 2020, this has no impact on the employer’s employee retention credit, although it may impact a request for an advance of the credit. The same wages used for the employee retention credit can’t be used for the work opportunity credit and the family and medical leave credit (income tax credits).
The IRS has more guidance on the credit in 2020.
Rules for the Q1 and Q2 of 2021
The rules for the credit for qualified wages paid by an eligible employer from January 1, 2021, through June 30, 2021, are:
- Eligibility. The eligibility requirement has been modified so that an employer may elect to use an alternative quarter to calculate gross receipts (e.g., for Q1 2021, an employer may compare gross receipts in Q4 2020 with Q4 2019). Also, a determination of whether there has been a significant reduction in gross receipts is made separately for each calendar quarter and is based on an 80% threshold.
- Credit amount. The credit is 70% of qualified wages (including qualified health care expenses), up to $10,000 per employee for each calendar quarter. The maximum credit is $7,000 per employee per quarter (meaning $14,000 for Q1 and Q2). Again, there’s no limitation on the number of employees for whom the credit may be claimed.
- Coordination with other credits. See “coordination” above. Also, the same wages can’t be used for the R&D credit, the Indian employment credit, and the empowerment zone credit.
The IRS has more guidance on the credit for Q1 and Q2 2021. It cautions employers to maintain documentation to support a determination of a decline in gross receipts.
Rules for Q3 and Q4 of 2021
The rules for the credit for qualified wages paid by an eligible employer from July 1, 2021, through December 31, 2021, are:
- Eligibility. The eligibility rules for the second half of 2021 generally are the same as the first half of 2021, except that an employer that started business February 15, 2020, or later may be eligible for the credit. What’s more, there is a new category of “severely financially stressed employers” (those with gross receipts down 90% in Q3 or Q4 2021 compared with 2019.
- Credit amount. The credit amount for the second half of 2021 generally is the same as the first half of 2021, except for businesses that commenced on or after February 15, 2020, the credit is capped at $50,000 per quarter.
- Coordination with other credits. See “coordination” above. In addition to what’s immediately above, the same wages can’t be used for the Shuttered Venue Operator grants and Restaurant Revitalization grants.
The IRS has yet to issue guidance for the credit in Q3 and Q4 2021. Stay tuned!
Employee retention credit for disaster situations
If your business experienced a federally-declared disaster (other than COVID-19), you may be eligible for an income tax credit for keeping workers on your payroll (whether or not they perform services). Key points for this credit:
- Eligibility. You must have conducted an active business in a qualified disaster area and became inoperable due to the incident. A qualified disaster area is any location declared as such under the Robert T. Stafford Disaster Relief and Emergency Assistance Act beginning January 1, 2020, through February 26, 2021. Eligible disasters through 2020 are listed in the instructions (the link is below).
- Credit amount. The credit is 40% of qualified wages up to $6,000, for a maximum credit of $2,400 per employee. There’s no limit on the number of employees for whom you can claim this employee retention credit. The deduction for compensation is reduced by the amount of the credit and like other income tax credits, this credit is subject to the general business limitation. If the limitation applies, it means an amount is carried back one year and forward for up to 20 years.
- Coordination with other tax credits. You cannot use the same wages for more than one credit. So, if you claim the work opportunity credit for hiring an employee from a targeted group, you cannot also claim the employee retention credit for that employee. What’s more, you can’t count any wages used for the COVID-19-related employee retention credit.
For more information, see instructions to Form 5884-A.
The employee retention credit presents a significant tax-saving opportunity for eligible employers. Be sure to discuss this with your CPA or other tax adviser.