What Is the Employee Retention Credit?

The Employee Retention Credit (ERC) is a refundable tax credit created to help businesses retain employees during the COVID-19 pandemic. The credit applies to qualified wages paid between March 13, 2020, and December 31, 2021, though eligibility in the fourth quarter of 2021 was limited.

The deadline to file a retroactive claim for 2020 has passed, but the deadline for the 2021 tax periods is April 15, 2025. Eligible employers can still claim the credit by amending past payroll tax filings. The rules for eligibility and calculation changed between 2020 and 2021, requiring a review of the requirements for each period.

Determining Employer Eligibility

An employer’s eligibility for the ERC is determined quarterly by meeting one of two primary tests: a significant decline in gross receipts or a full or partial suspension of operations due to a government order. A business only needs to meet one of these tests to qualify for a specific quarter. The rules and thresholds for these tests differ between 2020 and 2021.

The first eligibility pathway is a decline in gross receipts. For 2020, a business qualifies for a quarter if its gross receipts were less than 50% of the gross receipts for the same quarter in 2019. The employer then remains eligible for subsequent quarters in 2020 until its gross receipts recover to more than 80% of the amount from the corresponding 2019 quarter.

For 2021, the gross receipts test was less stringent, requiring only a 20% decline. An employer qualifies if its gross receipts for a quarter were less than 80% of the gross receipts from the same quarter in 2019. The 2021 rules also introduced an alternative election, allowing employers to use the gross receipts from the immediately preceding quarter to determine eligibility.

The second pathway is the suspension of business operations. An employer qualifies if its operations were fully or partially suspended during a quarter due to a COVID-19-related government order that limited commerce, travel, or group meetings. Qualification is based on the direct impact of the mandate, not a decline in revenue.

A government order can come from federal, state, or local authorities. To qualify as a full or partial suspension, the order must have had more than a nominal effect on business operations. For instance, a restaurant forced to close indoor dining but still able to offer takeout would be considered partially suspended. The operational limitation must be a direct result of the government order.

Special rules apply to “recovery startup businesses,” which began after February 15, 2020. These employers could qualify for the third and fourth quarters of 2021 if their average annual gross receipts were $1 million or less, without meeting the other tests. The credit for a recovery startup was capped at $50,000 per quarter, and they were the only businesses eligible for the ERC in the fourth quarter of 2021.

Employers must maintain documentation to substantiate a claim. For a claim based on the gross receipts test, this includes financial statements showing quarterly revenue for 2019, 2020, and 2021. For a claim based on a suspension of operations, the employer must keep copies of the government orders and records demonstrating how the order impacted their operations.

Calculating the Credit Amount

After confirming eligibility for a quarter, an employer must calculate the credit amount. The calculation method, credit rate, and definition of qualified wages differ for 2020 and 2021. The rules for qualified wages also depend on whether the company is a small or large employer.

For 2020, the credit is 50% of qualified wages. The amount of qualified wages was capped at $10,000 per employee for the entire year, resulting in a maximum credit of $5,000 per employee.

The definition of qualified wages for 2020 depends on the employer’s size, based on the average number of full-time employees in 2019. For small employers (100 or fewer employees), qualified wages include all wages paid to any employee. For large employers (more than 100 employees), qualified wages are only those paid to employees for time they were not providing services.

The rules for 2021 were more generous. The credit rate increased to 70% of qualified wages, and the wage limit was applied quarterly. An employer could count up to $10,000 in qualified wages per employee for each eligible quarter, for a maximum credit of $7,000 per employee, per quarter.

The employer size threshold also changed for 2021. A small employer was redefined as one with 500 or fewer full-time employees in 2019, and their qualified wages included all wages paid to any employee. For large employers (more than 500 employees), qualified wages remained only those paid to employees for not providing services.

Qualified wages can include salary, hourly pay, and the employer’s cost for certain group health plan expenses. The same wages cannot be used to calculate the ERC if they were also used for Paycheck Protection Program (PPP) loan forgiveness. Employers must carefully allocate wages between these two programs to avoid this common error. The final credit is claimed against the employer’s share of Social Security taxes.

The Claim Process for the Credit

Employers claim the ERC retroactively using Form 941-X, Adjusted Employer’s QUARTERLY Federal Tax Return or Claim for Refund. This form is used to amend a previously filed Form 941, the Employer’s QUARTERLY Federal Tax Return.

An employer must file a separate Form 941-X for each quarter they are claiming the credit. The form requires reporting the corrections to the original Form 941, including the calculated ERC amount.

The completed Form 941-X must be mailed to the correct IRS service center. The appropriate mailing address depends on the state where the business is located and can be found on the IRS website.

After submission, employers should expect a lengthy wait. The IRS has significant backlogs in processing amended payroll tax returns claiming the ERC, and processing can take many months.

Navigating the IRS Moratorium and Improper Claims

A high volume of improper claims led the IRS to take significant countermeasures. In September 2023, the agency announced a moratorium on processing new ERC claims to add more scrutiny and combat aggressive marketing campaigns. The IRS continues to process claims submitted before the moratorium, but with extended delays.

The moratorium was a response to “ERC mills,” which are promoters that market their services with unsolicited calls, texts, and emails. Red flags of these operations include promising guaranteed refunds, charging large upfront or contingency fees, and pressuring businesses to apply by misrepresenting eligibility rules.

Filing an improper claim carries substantial risks. If the IRS determines a claim is invalid, the employer must repay the credit with interest and penalties. An incorrect claim can also trigger a full IRS audit, and owners could face personal liability.

The IRS established programs to help businesses that were misled. A special withdrawal process allows employers to retract a pending claim that has not yet been paid. This is distinct from the Voluntary Disclosure Program, which ran through March 22, 2024, for businesses that had already received an improper payment. That program allowed businesses to repay the credit with reduced or waived penalties.