ERC Guidance on Eligibility, Claims, and Withdrawals

The Employee Retention Credit (ERC) was established as a refundable tax credit to help businesses and tax-exempt organizations keep employees on their payroll during the COVID-19 pandemic. Enacted under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, the credit applies to qualified wages paid between March 13, 2020, and September 30, 2021, though certain recovery startup businesses remained eligible through the end of 2021. The rules governing the credit changed multiple times, creating complexity for employers. In response to widespread questionable claims, the Internal Revenue Service (IRS) has increased its enforcement and compliance efforts.

Determining Employer Eligibility

An employer’s eligibility for the Employee Retention Credit can be established through one of two pathways. The first is the significant decline in gross receipts test, which is a quantitative analysis comparing an employer’s revenues in a calendar quarter to the same quarter in the pre-pandemic year of 2019.

For the 2020 tax year, an employer qualifies for the credit in the first calendar quarter they experience a greater than 50% reduction in gross receipts compared to the same quarter in 2019. Eligibility continues in subsequent quarters until the quarter after their gross receipts recover to exceed 80% of the 2019 level. The rules for 2021 required only a 20% decline in gross receipts for a calendar quarter compared to the corresponding 2019 quarter.

The IRS also provides an alternative quarter election rule for 2021. Under this provision, an employer can choose to measure the gross receipts decline by looking at the immediately preceding calendar quarter and comparing it to the same quarter in 2019. For instance, to determine eligibility for the first quarter of 2021, a business could compare its gross receipts from the fourth quarter of 2020 to the fourth quarter of 2019.

The second pathway to eligibility is the full or partial suspension of operations test. This test applies if a government order related to COVID-19 directly impacted the employer’s ability to operate. The order must have limited commerce, travel, or group meetings, and a partial suspension is sufficient to meet the criteria.

A partial suspension occurs when a government order restricts operations, resulting in more than a nominal portion of the business being affected. IRS guidance in Notice 2021-20 defines “more than a nominal portion” through two benchmarks. A business meets this standard if the gross receipts from the suspended part of the operation are at least 10% of the total gross receipts, or if the hours of service performed by employees in that part of the business are at least 10% of the total employee hours.

Calculating Qualified Wages and the Credit Amount

For wages paid in 2020, the credit is calculated at 50% of qualified wages. There is a cap on the amount of wages that can be considered for each employee, which is set at $10,000 for the entire year. This means the maximum credit an employer could claim for any single employee in 2020 is $5,000.

The rules for 2021 increased the potential credit amount. The credit rate was raised to 70% of qualified wages, applying a $10,000 cap per employee for each of the first three calendar quarters. This change meant an employer could claim a maximum credit of $7,000 per employee per quarter, totaling up to $21,000 for the year.

Qualified wages generally include gross wages subject to FICA taxes and certain allocable pre-tax health plan expenses. The definition of which wages qualify depends on the employer’s size, based on the average number of full-time employees during 2019. For 2020, a “large employer” was one with more than 100 full-time employees; for 2021, this threshold was raised to more than 500 full-time employees.

For small employers (those at or below the employee threshold), all wages paid to employees during the eligible period are considered qualified wages. For large employers, the definition is narrower; qualified wages are only those wages paid to employees for time they were not providing services.

An employer cannot use the same wages to support both Paycheck Protection Program (PPP) loan forgiveness and the ERC. Wages reported on a PPP loan forgiveness application could not be used for the ERC if they were part of the payroll costs that secured forgiveness, even if they exceeded the amount needed for full forgiveness.

Required Documentation and Substantiation

To substantiate eligibility under the gross receipts test, an employer must maintain clear financial records. This includes quarterly profit and loss statements and annual income statements for both 2019 and the claim periods in 2020 and 2021. If the alternative quarter election is used, the financial statements for the relevant preceding quarters must also be kept.

For employers qualifying under the suspension of operations test, it is necessary to retain copies of the specific government orders that limited the business’s operations. The employer must also keep records that demonstrate the operational impact, such as business records or operational data showing how the order caused a more than a nominal effect on the business.

Supporting the credit calculation requires a separate set of documents.

• Payroll records, such as payroll ledgers and reports for all relevant periods.
• Copies of the originally filed Forms 941, Employer’s QUARTERLY Federal Tax Return.
• Records of any allocable health plan expenses.
• The PPP loan forgiveness application and the forgiveness letter, if the business received a PPP loan.

Process for Withdrawing or Correcting a Claim

The procedural steps for an employer depend on whether they are withdrawing an unprocessed claim or correcting an improper claim for which a refund was already received. Each path has a distinct process outlined by the IRS.

For businesses that have filed a claim but now believe it was in error, the IRS has established a formal claim withdrawal process. This option is available only if the claim was filed on an adjusted return (like Form 941-X), the employer wants to withdraw the entire amount, and the IRS has not yet paid the claim or the refund check has not been cashed. To initiate a withdrawal, the employer makes a copy of the adjusted return, writes “Withdrawn” in the left margin, signs and dates it, and faxes it to the dedicated IRS fax line. If the claim is under audit, the withdrawal request should be sent directly to the assigned examiner.

If a business received and cashed an ERC refund it was not entitled to, it may be eligible for an IRS resolution program. The IRS has provided options, like the Voluntary Disclosure Program, to resolve erroneous claims. These programs generally allow an employer to repay the improperly received credit with relief from penalties and interest, provided they are not already under an employment tax audit or criminal investigation.