Employee retention credit – eligibility under the suspension test

In August, the IRS released extensive guidance on the employee retention credit (ERC), providing helpful clarity on several questions previously surrounding the credit. For additional details, please see our previous tax alerts on Notice 2021-49 and Revenue Procedure 2021-33. However, areas of uncertainty remain, and the IRS has informally remarked that it does not anticipate issuing additional guidance on the ERC, at least in the near future. As such, in some cases, taxpayers will need to take reasonable positions absent concrete guidance with respect to eligibility and the computation of the credit. It is imperative that such positions have foundational merit to bolster their chances of being sustained in the event of an IRS audit.

Suspension test

The area of the ERC that arguably remains most unclear is the suspension test for determining credit eligibility. An employer will satisfy this test, if they experience a full or partial suspension or modification of operations during any calendar quarter in 2020 or 2021 (though the Senate version of the bipartisan infrastructure plan would revoke the availability of the credit in the fourth quarter of 2021 as a revenue-raiser) due to orders from an appropriate domestic governmental authority (federal, state or local) limiting commerce, travel or group meetings (for commercial, social, religious or other purposes) due to COVID-19. It is critical to note that to be eligible under this test, the employer must be more than nominally impacted by the suspension or modification or could not continue comparable operations through telework.

The highly subjective, facts-and-circumstances nature of the suspension test analysis makes it difficult to conduct; it also consequently leaves a great deal of room for interpretation. Questions we have received regarding eligibility via suspension include:

1. Can eligibility be achieved by following recommendations provided in guidance issued by the Centers for Medicare and Medicaid Services?
2. Can auto dealers qualify under the suspended supplier exception on account of the ongoing global shortage of semiconductor chips?
3. Can the inability to hold a group meeting or “changing the way” an employer does business qualify?

With respect to the first two items, while an employer’s business could certainly be materially impacted as a result of both scenarios, critically absent from both is a COVID-19-related government order impacting the employer. As such, the employer would not be eligible under the suspension test in either instance, regardless of any resulting detriment. As for the third item, again, absent a government order fitting the criteria described above, the test is not met. However, for the sake of argument, if the inability to hold a group meeting or the change to the business operations were, in fact, mandated by a COVID-19-related government order, the employer would need to demonstrate how their business was more than nominally impacted. With respect to the group meeting scenario, it is difficult to envision how this requirement would be satisfied.

“Nominal portion” versus “nominal effect”

The manner in which an employer can demonstrate it has been more than nominally impacted by a COVID-19-related government order is another area of the suspension test that often causes confusion. IRS Notice 2021-20 provides two safe harbors for employers to use under specific circumstances — the “more than nominal portion” and “more than nominal effect” tests.

The former applies when part, but not all, of an employer’s operations have been suspended by a government order. An employer in this scenario will be considered partially suspended and eligible for the ERC if the component(s) of its business shut down represent “more than a nominal portion” of its operations. Via safe harbor, a portion of an employer’s operations will be considered more than nominal for the quarter in which eligibility is tested if either:

1. The gross receipts from that portion of the business make up at least 10% of the employer’s total gross receipts (both determined using the gross receipts from the same calendar quarter in 2019), or
2. The hours of service performed by employees in that portion of the business make up at least 10% of the employer’s total employee service hours (both determined using the service hours performed by employees in the same calendar quarter in 2019).

The latter applies when no portion of the employer’s operations have been suspended, but rather are subject to a government-ordered modification. The safe harbor covering this fact pattern provides that a modification will have “more than a nominal effect” on the employer’s operations if it results in a 10% or more reduction in an employer’s ability to provide goods or services in its normal course of business. Unfortunately, no useful parameters are provided for how this standard is to be measured.

It is critical to note that these tests are not interchangeable under the available guidance — each applies in the respective specific instances described above. Notice 2021-20 does provide the following helpful example to illustrate the difference between the concepts (modified for length):

Employer F, a restaurant business, must close its restaurant to on-site dining due to a governmental order closing all restaurants, bars and similar establishments for sit-down service. Employer F is allowed to continue food or beverage sales to the public on a carryout, drive-thru or delivery basis. On-site dining is more than a nominal portion of Employer F’s business operations. Employer F’s business operations are considered to be partially suspended because, under the facts and circumstances, more than a nominal portion of its business operations — its indoor and outdoor dining service — is suspended due to the governmental order.

Three months later, under a further governmental order, Employer F is permitted to offer indoor dining service, in addition to outdoor sit-down and carryout service, provided that all tables in the indoor dining room must be spaced at least 6 feet apart. This spacing constraint has more than a nominal effect on Employer F’s business operations. During this period, even though Employer F resumed all categories of its business operations, Employer F’s business operations continue to be partially suspended because, under the facts and circumstances, the governmental order restricting its indoor dining service has more than a nominal effect on its operations.

Risks of taking aggressive ERC positions

As stated above, it is imperative that ERC positions taken in the absence of clear guidance be based on reasonable interpretations of current law and the available guidance. While it is clear Congress intends for the ERC to be a powerful means to provide relief to employers who have been impacted by COVID-19, it should not be misconstrued as being universally available. The fact that the American Rescue Plan Act extended the statute of limitations for assessment of payroll tax returns on which the ERC is claimed to five years and the Treasury Department issued regulations that provide erroneous refunds of the ERC will be treated as underpayments of Social Security or Medicare taxes and subject to assessment, should make it clear the IRS will be examining employer eligibility and the amount of credits claimed with heightened scrutiny. Additionally, the IRS can assess interest and potential penalties on these erroneously claimed credits. ERC calculations producing lucrative results certainly make them alluring to a prospective employer; however, if pursued without technical merit, a successful IRS challenge could result in substantial payment back to the government.

The potential adverse consequences of taking aggressive ERC positions further extend to an employer’s financial statements. In order to recognize credits received as revenue for GAAP purposes, they must have a 75% or greater chance of being sustained in the event of an IRS audit, if using International Accounting Standard 20, or ASC 410. Further, for not-for-profit or for-profit entities using ASC 958-605, the threshold increases to nearly 100%. In the event that these thresholds for recognition are not met, the employer would need to record a corresponding liability, which would remain on the financial statements until the earlier of the expiration of the statute of limitations or the IRS allowing the credit to be upheld upon examination. Disclosure would additionally be required to include an explanation of why the employer was unable to recognize the revenue associated with the credit (i.e., the position is unsupported by current law and guidance).

To be clear, since the ERC is a payroll tax, not an income tax credit, this does not create an ASC 740 (accounting for income taxes) issue. An ASC 740 issue could, however, arise if deductions for qualified wages and qualified health plan expenses were not properly disallowed in the amount of the credits claimed.

Given the challenges presented by evaluating eligibility under the suspension test, we strongly encourage you work with your Baker Tilly advisor to ensure proper conclusions are reached.

For more information on this topic, contact our team.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely.  The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.