The COVID-19 pandemic impacted both small and large businesses worldwide, including many in the United States. To help domestic companies cope with the financial impact of pandemic restrictions and continue to compete in a global economy, the U.S. government launched multiple initiatives to keep businesses and their employees afloat.
Among the most powerful of these programs is the Employee Retention Credit (ERC), which was introduced in March 2020 as part of the Coronavirus Aid, Relief and Economic Security (CARES) Act. This act incentivized companies to retain employees during the COVID-19 pandemic by offering them a refundable tax credit claimed on their quarterly payroll tax reports. The ERC was expanded and extended in December 2020 and then again in March 2021, showing the U.S. Government’s commitment to the program.
Initially, this tax credit was worth 50 percent of qualified employee wages in 2020, but qualified wages per employee was limited to $10,000 for the calendar year. Employers who met the program’s initial requirements were entitled to tax credits of up to $5,000 per employee for wages paid from March 13, 2020, to December 31, 2020 (up to a limit of $10,000 in wages times 50 percent). Subsequent expansions of the ERC extended the program into 2021 and increased the potential credit to 70 percent of qualified wages for payroll periods in 2021. This also raised the qualified wage limit per employee from $10,000 per year to $10,000 for each calendar quarter in 2021.
The Employee Retention Credit is similar to the Payroll Protection Program (PPP) in that both are government assistance programs. The PPP, though, was a loan administered by the Small Business Administration (SBA), and the ERC is a tax incentive offered through the Internal Revenue Service (IRS). The ERC is a tax credit claimed on federal employment tax forms by eligible employers who paid qualified wages to their employees during the pandemic, including some health insurance costs.
Although the ERC is available to eligible companies of all sizes and structures, specific rules apply depending on how many full-time employees on average per month a company had in 2019 – before the COVID-19 pandemic. Wages that would normally qualify for the ERC in 2020 may be limited for employers with more than 100 full-time employees (FTEs) on average per month in 2019. The same restrictions apply in 2021 for businesses with more than 500 FTEs on average per month in 2019.
Since the credit was first introduced, it has gone through several changes. With these frequent changes and some continued ambiguity in the law, claiming the credit can be confusing, even for tax experts. Employers who were impacted by the COVID-19 pandemic and continued to pay employees should certainly explore the financial benefit the ERC offers and take advantage of the tax credit while they still can.
Eligibility for the Employee Retention Credit
As of 2020, a company may be considered eligible for the ERC if it is a private-sector employer or tax-exempt organization that was operational in the calendar year 2020. To qualify, businesses should generally have either:
- Been partially or fully suspended during any calendar quarter as a result of any government order that resulted in limited commerce, travel, or group meetings because of the pandemic; OR
- Experienced a significant decline in gross receipts during a calendar quarter compared to the same quarter in 2019.
Partial or full suspension means a business’s normal operations were directly or indirectly limited due to any federal, state, or local government order or proclamation. This generally means that a business modified its operations to comply with governmental COVID-19 orders, and the operational modifications more than nominally reduced its ability to provide goods or services to customers. It is important to document the government order, as well as the specific impact to your business.
Qualification guidelines under the significant decline in gross receipts rule were updated in 2021, creating different sets of rules for periods in 2020 compared to 2021. According to updated ERC guidelines defining significant declines in gross receipts, a company filing an ERC claim for a period in 2020 would qualify as having a significant decline in gross receipts when gross receipts for a period are less than 50 percent of gross receipts for the same period in 2019. Once an employer qualifies for 2020 ERC in this manner, it can continue to qualify for subsequent quarters until it recovers to a point where it has at least 80 percent of gross receipts as for the same quarter in 2019.
The Relief Act of 2021 expanded the definition of a significant decline in gross receipts for periods in 2021. For calendar quarters in 2021, an employer can first qualify under the significant decline rules when gross receipts fall below 80 percent of gross receipts in the same quarter in 2019.
Calculation of the Employee Retention Credit
If they meet the appropriate criteria, businesses are eligible to claim the ERC for both 2020 and 2021. In 2020, the credit limit per employee was 50 percent of qualified wages paid to that employee after March 12, 2020 and before January 1, 2021. For this period, businesses were eligible for a maximum credit of $5,000 per employee.
For 2021, the retention credit is capped at 70 percent of qualified wages paid from January 1, 2021 to December 31, 2021. However, the maximum credit per employee increased to $7,000 per quarter in 2021 rather than the $5,000 annual limit for 2020.
An employee who was paid at least $10,000 in 2020 and at least $10,000 in each of the first three quarters in 2021 can therefore generate a total ERC of up to $26,000 ($5,000 for 2020 plus $7,000 for each of three quarters in 2021). In most cases, however, the Employee Retention Credit is less than $26,000 per employee when properly calculated.
To calculate the potential Employee Retention Credit, it is important to be familiar with the following documents:
- IRS Notices 2021-20 and 2021-49. This helpful guidance on the ERC comes directly from the IRS and discusses the eligibility criteria for the credit.
- 2019, 2020 and 2021 profit & loss (income statement) per calendar quarter. This is important for determining whether you qualify for the credit due to a significant decline in gross receipts between 2019 and 2020 or 2019 and 2021.
- Applications for any PPP loans and associated loan forgiveness. You cannot use wages for ERC if they were paid by PPP funds.
- IRS Form 941 quarterly payroll tax reports filed for 2019 through 2021. The 2019 payroll reports will help determine the number of your employees to determine eligibility for the ERC. For quarterly payroll tax filers, this Form 941 is where you ultimately claim the ERC, and it is important to see what has already been filed if anything.
- For employers with more than 50 full-time employees on average per month, IRS form 1094-C will be useful to identify your average full-time and total employee headcount among all potentially related businesses.
Once you have all these documents, follow these steps to calculate your potential payroll tax credit:
- Determine how many members of the workforce you employed in 2020 and 2021. This number should include part- and full-time staff who continued to receive a paycheck from the company each of the two calendar years. If the business had zero employees, it doesn’t qualify for the ERC.
- Identify whether or not your business qualifies for the ERC. This may be through full or partial suspension due to a governmental order, by a significant decrease in gross receipts or as otherwise covered by ERC guidelines.
- Calculate the qualified employee wages or other payroll costs per quarter. Apply the correct limitation on qualified wages based on the quarter you are calculating and remove any nonqualified employees.
- Remove any wages or otherwise qualifying payroll costs that were paid by forgiven PPP loans.
- Apply the correct percentage of qualified wages per quarter to determine your potential tax credit.
An example of proper ERC calculation:
Your company has fewer than 500 employees, and its gross receipts for the first quarter of 2021 were $80,000. In the same quarter in 2019, the business had $140,000 in gross receipts. Based on these numbers, your business made roughly 60 percent of its revenue in 2021, making it qualified for this ERC government assistance using the significant decline in gross receipts.
For each qualified employee with wages in the first quarter of 2021, apply a maximum of $10,000 in qualified wages for the quarter. Multiply each employee’s wages (up to $10,000) by 70 percent to determine the potential credit per employee.
Using the same facts as example #1, you have one qualified non-owner employee who received $9,000 in compensation in the first quarter of 2021. Because of the ERC, your business may claim a refundable tax credit of $6,300 for that employee (70 percent of $9,000 in qualified wages) for the first quarter of 2021.
The ERC and Financial Statements
The ERC can impact to your financial statements, including your balance sheet and income statement. The Financial Accounting Standards Board (FASB) has extensive instructions on this topic for appropriate accounting. It’s recommended that you consult your accounting professional for guidance specific to your business and industry.
Depending on your company’s circumstances, there are three standards you can implement to follow generally accepted accounting principles (GAAP) for the ERC. They consist of:
- International Accounting Standards (IAS) 20, Accounting for Government grants
- Accounting Standard Codification (ASC) 958-605, Not-for-profit entities – Revenue recognition
- ASC 450, Contingencies
IAS 20 permits the recording and presentation of either the gross amount as other income or netting the credit against related payroll expense. Each quarter when a company is reasonably assured it meets the recognition criteria, it records a receivable and either other income or net expense.
Under ASC 958, a not-for-profit entity must treat the Employee Retention Tax Credit as a conditional contribution. This means you can recognize it on your income statement only after you’ve met the conditions to earn it. As the requirements are met, the revenue and related accounts receivable are recorded.
Through ASC 450, a for-profit business treats the ERC as a gain contingency. This requires recognizing the tax credit as other revenue on an income statement only – once you’ve resolved all uncertainties regarding receipt of the credit and the income becomes realizable.
Again, dealing with the accounting and reporting of the ERC can be challenging, especially for those not extremely knowledgeable about these specialized tax issues. Fortunately, there are tax professionals that can assist you in receiving your maximum available credit.
Many companies have the opportunity to take advantage of the Employee Retention Tax Credit until 2025, but it’s crucial that they procure and submit the necessary documentation to avoid possible issues and delays in receiving it.
What Type of Journal Entry is Required for the Employee Retention Credit?
Depending on your method of accounting, a retroactive claim for the ERC is recorded as either a debit to a cash account or a receivable account. The corresponding credit may be to an income account or as a reduction to a payroll expense account. If a business receives the ERC as a cash advance, cash is debited upon receipt, and a refundable prepayment is credited to a liability account.
Is the Employee Retention Credit Better than a Deductible Expense?
Yes. The Employee Retention Credit is a refundable payroll tax credit. A deductible expense reduces the amount of income you have to pay tax on. A tax credit like the ERC generates a dollar-for-dollar reduction to your tax liability. If your credit exceeds your liability, your business will be entitled to a refund. The ERC reduces your company’s deductible payroll tax expense, so it is like trading deductions for even more favorable tax credits.
Are Gross Receipts for the ERC Calculated on Cash or Accrual Basis?
Your gross receipts are determined by the same accounting method you use for federal tax purposes. If you use the cash basis method to file their tax returns, your gross receipts do not include sales that you invoiced but have not collected yet. Similarly, your cash basis gross receipts for determining ERC eligibility should not include any sales you have not collected on yet.