Employee Retention Tax Credit: Reevaluating Small Employer Status To Increase Cash Payments

A question has arisen amongst advisors on how to appropriately count employees when determining whether an employer is considered a large or small employer for the Employee Retention Credit (ERC). The ability for businesses to be considered a small employer for the ERC calculation can significantly increase the amount of the ERC credit, and drive much needed cash into businesses. Employers with significant part-time workers, including restaurants, retailers, nursing homes, manufacturers, and delivery services, may need to reevaluate their employee head count.

An employer must pass one of two tests to be deemed an eligible employer for purposes of the 2020 and 2021 ERC. The first test requires that the employer has a significant decline in gross receipts during a qualifying 2020 or 2021 calendar quarter, when compared to the same 2019 quarter. The second test is passed if the employer has a full or partial suspension due to a governmental order during a calendar quarter between March 12, 2020 and June 30, 2021. There is no limitation on number of employees in order to qualify for the ERC. However, the amount of wages that an eligible employer can evaluate when calculating the ERC is drastically different if they are considered a small employer. 

For the 2020 tax year, a small employer is defined as an employer who averaged a 100 or less full-time employees in 2019. For the 2021 tax year, the definition of a small employer for the ERC became much broader and includes an employer if they averaged 500 or less full-time employees in tax year 2019. Both assessments of whether a business employs 100 or 500 full time employees is based on the number of employees the business had in 2019. The debate amongst advisors is whether the determination of full-time employees should include part-time employees as full-time equivalents.

A small employer’s qualified wages include the wages paid to any employee during the period in which the business had a suspension or the quarter in which the business experienced a significant decline in gross receipts. However, if an employer is considered a large employer, the only wages an eligible employer can evaluate for the ERC are wages paid to any employee for the time that the employee is not providing services in which the business had a suspension or the quarter in which the business experienced a significant decline in gross receipts. What does that mean? On the surface, this can be a bit confusing. Let’s take a simple example. ABC Company is a trucking company and considered a large employer when calculating the 2020 ERC, as the business had more than 100 full-time employees in 2019. The trucking company has 40 drivers that deliver to restaurants and another 65 drivers that deliver to grocery stores. During the 2^nd quarter of 2020, the company had a significant decline in gross receipts.  During the 2^nd quarter, the restaurant delivery drivers were told to stay at home, while the grocery store delivery drivers continued to work. Each driver was paid at least $10,000 for the quarter. When evaluating the wages paid during the 2^nd quarter for purposes of the ERC, since ABC is considered a large employer, it is only allowed to include the wages paid to employees who are not providing services. In this example, assuming the restaurant delivery drivers were paid to stay home, only the $40,000 of wages (40 x $10,000) paid to those drivers would be considered qualified wages for the ERC.   This would lead to an ERC of $20,000 for 2020. The wages of $65,000 (65 x 10,000) paid to the grocery store drivers would have to be excluded from the ERC qualified wages, as those drivers continued to provide a service to the employer.

However, if ABC Company was considered a small employer, they would be allowed to include any wages paid to any employee during the quarter they experienced a significant decline in gross receipts, regardless of whether the employees provided services or not. A small employer classification would allow ABC Company to include wages paid to both restaurant and grocery store delivery drivers, for a total of $105,000, to be included as qualified wages for purposes of the ERC. This would increase the 2020 ERC to $52,500 (105,000 x 50%) for the 2020 taxable year. Lesson learned?  If possible, employers want to be considered small employers. But how?

The CARES Act Section 2301 determines qualified wages for an eligible employer based on the average number of full-time employees, within the meaning of Internal Revenue Code Section 4980H. Note that the CARES Act only references full-time employees, and not full-time equivalents. The definition of a full-time employee under Section 4980H(c)(4), with respect to any month, is an employee who is employed on average of at least 30 hours of service per week. 

Taking it one step further, the IRS does not indicate the need to include full-time equivalents when referencing their frequently asked questions (FAQ) surrounding the ERC. Specifically, ERC FAQ #49 states:

The term “full-time employee” means an employee who, with respect to any calendar month in 2019, had an average of at least 30 hours of service per week or 130 hours of service in the month (130 hours of service in a month is treated as the monthly equivalent of at least 30 hours of service per week), as determined in accordance with section 4980H of the Internal Revenue Code.

While the IRS FAQs cannot be relied upon as legal authority, they can provide insight on how the IRS may interpret the law.

So, what’s the problem? Isn’t it clear? Maybe not. There is concern that Congress intended to include full-time equivalents. Some advisors point to another subsection in Section 4980H, which states that an employer should include employees, who are not full time employees, in their full-time employee count by dividing the total number of hours of service of employees for the month by 120. However, the language that precedes Section 4980H(c)(2)(E) specifically states: “Solely for purposes of determining whether an employer is an applicable large employer under this paragraph…”. The fact that the language of Section 4980H(c)(2)(E) states solely for purposes of this paragraph and the CARES Act does not directly reference 4980H(c)(2)(E), leaves many to believe that part-time employees should not be included when determining whether a business is a large or small employer for purposes of the ERC.

A better argument of why full-time equivalents should be included in the ERC employee count is tied to the CARES Act Joint Committee on Taxation report. Committee reports discuss and explain the purpose of a bill and provide reasons for the committee’s recommendations on the bill. On page 40 of the report, it states that the definition of qualified wages depends on the average number of full-time and full-time-equivalent employees that the eligible employer had during 2019. It then references a footnote, which refers directlyto Section 4980H(c)(2)(E), which would require a company to total the hours per month worked by part-time employees and divide by 120 for purposes of the employee headcount calculation.

Whether intentional or by mistake, the final CARES Act did not include the reference of full-time-equivalent employees and the IRS FAQ does not either. Therefore, a position exists that when calculating the number of 2019 employees to determine whether an employer is large or small, and therefore the amount of wages that will qualify for the ERC, part-time employees can be excluded. Such a position may allow a significant number of businesses to fall under the ERC small employer definition when considering whether their business had a suspension or a quarter in which the business experienced a significant decline in gross receipts. Those businesses would then be able to evaluate all the wages paid to employees between March 12, 2020 and June 30, 2021 when the employer is eligible. The inclusion of all wages paid during qualifying time periods will significantly increase the ERC. It might be time for businesses to sharpen their pencils again and count their 2019 employees under this new lens. In the meantime, Congressional or IRS guidance should be monitored closely.