Employee Retention Credit for Startups and How to Use It

Section 2301 of the CARES Act outlines the rules of the ‘Employee Retention Credit for Employers Subject to Closure due to Covid-19’ which provides relief for startups and small businesses that were adversely affected by COVID-19 in two distinct ways. The bill has lots of legal jargon and is generally difficult to follow but we’ve broken it down into what it is that you need to know about the Employee Retention Credit for startups (“ERC”). We’ll break it down for you in the sections that follow.

What is it?

The ERC is a tax credit that employers can take against their portion of social security payments made to the federal government. If you’re an employer who is unfamiliar with how this works, open up your most recent payroll report. You’ll see that for every dollar (up until certain thresholds) that you pay to your employees you also are paying 6.2% of their wages into what is known as social security. On wages of $50,000 per year for one of your employees that amounts to $3,100 per year. The ERC allows you to forgo the taxes that you would otherwise have to pay on behalf of your employees, which reduces your overall payroll costs and keeps more cash in your pocket. Though the mechanics of it are a little bit more complex behind the scenes, this is essentially how the ERC will work for startups if you qualify for the credit.

Who qualifies?

In order to qualify for the credit you must be operating your business in 2020 and meet one of two tests outlined below:

Your operations were fully or partially suspended during any calendar quarter in 2020 because of an order from a government authority due to COVID-19 (i.e. a state-wide order to ‘shelter in place’ like we have in Illinois) or
You experienced a significant decline in gross receipts during a calendar quarter in 2020

What determines whether or not a business is ‘fully or partially suspended’ for the purposes of the ERC? The IRS helps us define this with the following:

The operation of a trade or business may be partially suspended if an appropriate governmental authority imposes restrictions upon the business operations by limiting commerce, travel, or group meetings (for commercial, social, religious, or other purposes) due to COVID-19 such that the operation can still continue to operate but not at its normal capacity.

Example: A state governor issues an executive order closing all restaurants, bars, and similar establishments in the state in order to reduce the spread of COVID-19. However, the executive order allows those establishments to continue food or beverage sales to the public on a carry-out, drive-through, or delivery basis. This results in a partial suspension of the operations of the trade or business due to an order of an appropriate governmental authority with respect to any restaurants, bars, and similar establishments in the state that provided full sit-down service, a dining room, or other on-site eating facilities for customers prior to the executive order.

If you’re located in Illinois, this would apply to you under the scenario above.

If you don’t satisfy the criteria above you may still qualify if you have a ‘significant decline in gross receipts’ which the IRS again defines (with an example) as follows:

A significant decline in gross receipts begins with the first quarter in which an employer’s gross receipts for a calendar quarter in 2020 are less than 50 percent of its gross receipts for the same calendar quarter in 2019. The significant decline in gross receipts ends with the first calendar quarter that follows the first calendar quarter for which the employer’s 2020 gross receipts for the quarter are greater than 80 percent of its gross receipts for the same calendar quarter during 2019.

Example: An employer’s gross receipts were $100,000, $190,000, and $230,000 in the first, second, and third calendar quarters of 2020, respectively. Its gross receipts were $210,000, $230,000, and $250,000 in the first, second, and third calendar quarters of 2019, respectively. Thus, the employer’s 2020 first, second, and third quarter gross receipts were approximately 48%, 83%, and 92% of its 2019 first, second, and third quarter gross receipts, respectively. Accordingly, the employer had a significant decline in gross receipts commencing on the first day of the first calendar quarter of 2020 (the calendar quarter in which gross receipts were less than 50% of the same quarter in 2019) and ending on the first day of the third calendar quarter of 2020 (the quarter following the quarter for which the gross receipts were more than 80% of the same quarter in 2019). Thus the employer is entitled to a retention credit with respect to the first and second calendar quarters.

If your business can satisfy either of those criteria, then continue on because you may qualify for the credit (absent some exceptions we cover later).

What types of costs qualify?

This is a payroll tax credit, so its only fitting that you are limited to certain wage and compensation costs in calculating this credit. Section 3121(a) and Section 3121(e) of our tax code include the following common payment types:

Gross wages
Commissions
Cash tips
Vacation or sick pay
Employer portion of health insurance

Note: Unlike calculations under the Payroll Protection Program this won’t include taxes.

Further, there is an additional test that has to be met in order to count the wages towards the credit amount, which is a function of how big your business is. If your business has more than 100 full time employees (on average) for 2019 then you can only count the wages of employees who are not working but still receiving pay. If your business has less than 100 employees (on average) in 2019 then all of the wages identified above will qualify. This could be very beneficial for startups, especially with those who have less than 100 employees and are in a state where a government mandated quarantine is in effect.

How can we determine the amount we’re eligible for?

First and foremost, there are limits on a per employee basis of $10,000 in gross wages and health care costs. Once you can establish the total wages and health care costs that qualify, you must reduce that by 50% to arrive at the eligible credit amount. The arithmetic here works out to a maximum credit of $5,000 per employee. Here are the examples that the IRS provides:

Example 1: Eligible Employer pays $10,000 in qualified wages to Employee A in Q2 2020. The Employee Retention Credit available to the Eligible Employer for the qualified wages paid to Employee A is $5,000.

Example 2: Eligible Employer pays Employee B $8,000 in qualified wages in Q2 2020 and $8,000 in qualified wages in Q3 2020. The credit available to the Eligible Employer for the qualified wages paid to Employee B is equal to $4,000 in Q2 and $1,000 in Q3 due to the overall limit of $10,000 on qualified wages per employee for all calendar quarters.

One detail to be mindful of is that you can only count wages and health care costs that are paid after March 12th 2020 and up to January 1st 2021 in your calculations. March 13th is the first day you can start claiming this credit.

How do we claim the Employee Retention Credit for startups?

The easy answer here is that your payroll provider should be able to do this for you. They will need to reconcile the credit amount calculated above with the total amount of taxes you would otherwise owe (or have withheld on behalf or your employees) on a quarterly basis. The IRS has indicated that this may be done on a “real time” basis and you won’t have to wait until the end of the quarter to get your credit amount and there is no penalty for failing to deposit on a timely basis so long as you’re properly reconciling the credit quarterly on your 941.

What is the fine print?

There are some rules you have to abide by. The first one is that if you received a loan under the Paycheck Protection Program, you’re not eligible for this credit. Second, if you are required to pay your employees leave under the Families First Coronavirus Response Act, the portion of those payments attributable to the leave rules under the FFCRA are not eligible for the ERC. Lastly, if you run into a situation where your credit amount is greater than the tax deposits you would have otherwise had to pay on a quarterly basis, the IRS will allow you to submit Form 7200 (here’s the DRAFT form for now) to get an advance payment on an expedited basis.

What next?

If you are lucky enough to not be facing a substantial enough amount of distress from COVID-19 that would qualify you for the Paycheck Protection Program loans, then the ERC is a great option for you to get up to $5,000 in tax credits for each eligible employee. For a team of 10 individuals, that $50,000 can go a long way. You should work with your CPA and payroll provider to make sure you qualify under the rules we outlined above and that you are making sure your payroll provider has a system in place to execute on the new provisions.

Need help? Schedule a FREE consultation with a CPA!

Curt Mastio