How to Calculate the Employee Retention Credit

The Employee Retention Credit (ERC) is a refundable tax credit established to encourage businesses to keep employees on their payrolls during the economic disruptions caused by the COVID-19 pandemic. It was introduced as part of the Coronavirus Aid, Relief, and Economic Security (CARES) Act in 2020 and expanded by later legislation. This credit aims to provide financial assistance to employers who maintained their workforce despite facing significant challenges. Calculating the ERC involves understanding eligibility requirements, identifying qualified wages, and applying distinct formulas for different periods.

Understanding Eligibility Criteria

Determining eligibility for the Employee Retention Credit is the first step. Businesses generally qualify if they experienced a significant decline in gross receipts or faced a full or partial suspension of operations due to a governmental order.

For 2020, a business qualifies if its gross receipts for a calendar quarter were less than 50% of its gross receipts for the same quarter in 2019. Eligibility continues until gross receipts for a subsequent quarter are more than 80% of the corresponding 2019 quarter. For 2021, a business qualifies if its gross receipts for a calendar quarter were less than 80% of its gross receipts for the same quarter in 2019.

Alternatively, a business can qualify if its operations were fully or partially suspended due to a governmental order limiting commerce, travel, or group meetings because of COVID-19. This includes orders restricting capacity, like limiting indoor dining, or caused supply chain disruptions that directly impacted its ability to operate. The suspension must be due to a governmental order, not guidance or a recommendation.

Businesses that received Paycheck Protection Program (PPP) loans can also qualify for the ERC. However, wages used for PPP loan forgiveness cannot also be used as qualified wages for the ERC. Employers must maintain clear documentation to demonstrate that there is no “double-dipping” of wages between these two programs. If a business is part of an aggregated group, all members are treated as a single employer when determining eligibility, impacting gross receipts and full-time employee counts.

Identifying Qualified Wages

Once eligibility is established, the next step is identifying qualified wages. These generally include gross wages subject to Federal Insurance Contributions Act (FICA) taxes and certain employer-provided health plan expenses. This determination is critical as the credit amount directly depends on these figures.

The definition of qualified wages depends on employer size, based on the average number of full-time employees in 2019. For 2020, a small employer had 100 or fewer full-time employees. For these small employers, all wages paid during an eligible period can be qualified wages, regardless of whether employees were actively providing services.

For large employers (more than 100 full-time employees in 2019 for 2020, or more than 500 for 2021), only wages paid to employees for not providing services can be qualified wages. Wages paid for work performed do not count towards the credit for large employers.

There are specific limits on qualified wages per employee. For 2020, the maximum is $10,000 per employee for the entire year. For 2021, this limit is $10,000 per employee per quarter. Wages used for other federal tax credits, such as paid sick and family leave credits or the Work Opportunity Tax Credit, cannot be included as qualified wages for the ERC.

Applying the Credit Calculation Formulas

With eligibility confirmed and qualified wages identified, the next step is applying the specific formulas to compute the credit amount. Calculation mechanics differ for 2020 and 2021.

For qualified wages paid between March 13, 2020, and December 31, 2020, the credit is 50% of qualified wages. The maximum qualified wages per employee for the year are capped at $10,000, resulting in a maximum credit of $5,000 per employee for 2020.

For qualified wages paid between January 1, 2021, and September 30, 2021, the credit is 70% of qualified wages. The maximum qualified wages per employee are capped at $10,000 per quarter. This means an eligible employer could receive a maximum credit of $7,000 per employee per quarter, potentially totaling $21,000 per employee for the first three quarters of 2021.

To calculate the credit:
Determine total qualified wages for each eligible employee within the relevant quarter or year.
Apply the per-employee wage cap ($10,000 per year for 2020; $10,000 per quarter for 2021).
Multiply these capped qualified wages by the applicable credit rate (50% for 2020 and 70% for 2021).
Sum the individual employee credits to arrive at the total credit for the business for that specific quarter.
For example, if an employee had $10,000 in qualified wages in Q1 2021, the credit for that employee would be $7,000 ($10,000 70%).

Maintaining Supporting Documentation

Accurate documentation is required for any business claiming the Employee Retention Credit. These records substantiate eligibility, qualified wages, and the final credit calculation, all subject to potential IRS review or audit.

Businesses should retain specific records to support eligibility. These include copies of governmental orders that led to a full or partial suspension of operations. Detailed calculations of gross receipts, comparing quarterly revenues to corresponding 2019 periods, must also be maintained. If a Paycheck Protection Program loan was received, documentation related to its forgiveness and a clear reconciliation showing wages were not double-counted for both programs is essential.

For substantiating qualified wages and credit calculation, detailed payroll records are necessary. This includes comprehensive payroll reports, general ledger entries reflecting wage payments, and employee lists detailing wages paid to each individual. Documentation supporting employer-provided health plan expenses, if included in qualified wages, should also be readily available.

The Internal Revenue Service requires employers to maintain all records pertinent to employment taxes for at least four years after the tax becomes due or is paid, whichever is later. This retention period applies to all ERC-related documentation. Organized records facilitate a smooth process during any IRS inquiry and demonstrate due diligence in adhering to tax regulations.