How Is the Employee Retention Credit Calculated?
Understand the detailed methodology for calculating the Employee Retention Credit, from initial assessment to final adjustments.
The Employee Retention Credit (ERC) was a refundable tax credit established under the Coronavirus Aid, Relief, and Economic Security (CARES) Act in March 2020. This credit aimed to encourage businesses to retain employees on their payroll during periods of economic disruption caused by the COVID-19 pandemic. It provided financial relief to eligible employers by offsetting a portion of their payroll taxes.
Determining Eligibility for the Credit
Eligibility for the ERC hinged on meeting one of two primary criteria, assessed on a quarter-by-quarter basis. The first pathway to eligibility involved a significant decline in gross receipts. For 2020, a business qualified if its gross receipts in any calendar quarter were less than 50% of its gross receipts for the same calendar quarter in 2019. This eligibility continued until gross receipts in a subsequent quarter exceeded 80% of the corresponding 2019 quarter.
For 2021, the gross receipts test was adjusted; a business qualified if its gross receipts in a calendar quarter were less than 80% of its gross receipts for the same quarter in 2019. Businesses could also elect to compare the immediately preceding calendar quarter’s gross receipts to the corresponding quarter in 2019 to determine eligibility for 2021. The second eligibility criterion involved a full or partial suspension of operations due to governmental orders limiting commerce, travel, or group meetings because of COVID-19. This suspension had to be due to an order from a federal, state, or local government authority.
A partial suspension could occur if a “more than nominal” portion of operations was suspended by a government order, or if the order resulted in a significant impact on the business’s ability to operate. Examples of qualifying orders included mandated closures of non-essential businesses or capacity restrictions. However, voluntary closures or a decline in customer demand not directly caused by a government order did not qualify.
Identifying Qualified Wages
Once eligibility for a specific quarter was established, the next step involved identifying which wages qualified for the credit. Qualified wages generally included not only cash wages but also certain health plan expenses paid by the employer. The definition of qualified wages varied depending on the average number of full-time employees a business had in 2019.
For businesses with more than 100 full-time employees in 2019 (for 2020 ERC) or more than 500 full-time employees in 2019 (for 2021 ERC), qualified wages were generally limited to those paid to employees who were not providing services due to the qualifying event. For businesses with 100 or fewer full-time employees in 2019 (for 2020 ERC) or 500 or fewer full-time employees in 2019 (for 2021 ERC), all wages paid to employees during the eligible period generally qualified, regardless of whether the employees were providing services.
There was a maximum amount of qualified wages per employee that could be used for the calculation. For 2020, the maximum was $10,000 in qualified wages per employee for the entire year. For 2021, this limit increased to $10,000 in qualified wages per employee per eligible calendar quarter.
Calculating the Credit Amount
The actual credit amount was determined by applying a specific percentage to the identified qualified wages. For 2020, the Employee Retention Credit was equal to 50% of qualified wages. Considering the maximum qualified wages of $10,000 per employee for the year, the maximum credit an employer could claim per employee for 2020 was $5,000.
For 2021, the credit percentage increased significantly to 70% of qualified wages. With the maximum qualified wages set at $10,000 per employee per eligible quarter, this resulted in a potential maximum credit of $7,000 per employee per quarter. When calculating the credit, aggregation rules applied to related entities, such as controlled groups or businesses under common control. These rules required that all members of an aggregated group be treated as a single employer for purposes of determining eligibility, employee counts, and the maximum credit amount.
Understanding Adjustments and Interactions
After the initial calculation, several adjustments and interactions with other relief programs could modify the final ERC amount. A significant interaction was with Paycheck Protection Program (PPP) loans. Initially, businesses could not claim both a PPP loan and the ERC. However, the Consolidated Appropriations Act, 2021 (CAA), retroactively allowed employers to claim both, provided the same wages were not used for both PPP loan forgiveness and ERC calculation.
Similarly, wages used to claim other federal tax credits could not also be used for the ERC. This included, for instance, wages claimed for the Work Opportunity Tax Credit (WOTC) or certain research and development (R&D) tax credits.
An important post-calculation adjustment involved the wage deduction for income tax purposes. The amount of the ERC received reduced the amount of wage expenses a business could deduct on its federal income tax return. This rule prevented a “double-dipping” of tax benefits for the same wages. If an employer claimed the ERC, they would need to reduce their deductible wage expense for the tax year in which the qualified wages were paid or incurred.