Podcast: COVID-19: Disputing Tax: CARES Act Payroll Tax Provisions and Factors Employers Should Consider in Their Coronavirus Response
In this episode of Ropes & Gray’s podcast series, Disputing Tax, Pascal Mayer, a senior attorney in the employment, executive compensation & employee benefits group, is joined by Kat Gregor and Loretta Richard, partners in the tax, employment & benefits practice and co-founders of the tax controversy group, to discuss the payroll tax provisions of the Coronavirus Aid, Relief and Economic Act (also known as the CARES Act) and factors that employers should consider in their coronavirus response. Enacted on March 27, and commonly referred to as “Phase 3” of the federal government’s response to the coronavirus pandemic, the CARES Act provides immediate financial relief to eligible employers by allowing them to retain some payments that would otherwise be owed to the federal government, through employee retention credits and deferral of the employer portion of social security tax payments. This assistance may be critically important to employers who are struggling to meet costs when faced with diminishing revenues or who had their operations fully or partially suspended due to governmental orders.
Pascal Mayer: Hello, and thanks for joining us today on Disputing Tax, a Ropes & Gray podcast series, focused on tax controversy related matters and developments. I’m Pascal Mayer, a senior attorney in the employment, executive compensation & employee benefits group. Joining me are Kat Gregor and Loretta Richard, partners in the tax, employment and benefits department and co-founders of the tax controversy group. We’ll be discussing the payroll tax provisions of the Coronavirus Aid, Relief and Economic Act, commonly known as the CARES Act, and factors that employers should consider in their coronavirus response.
The CARES Act was enacted on March 27, and is commonly referred to as Phase 3 of the federal government’s response to the coronavirus outbreak. Phases 1 and 2 related to emergency funding to develop vaccines, and provisions related to paid sick leave, additional unemployment benefits and expanded food assistance, among other things. The CARES Act provides immediate financial relief to eligible employers by allowing them to retain some payments that would otherwise be owed to the federal government, through employee retention credits and deferral of the employer portion of social security tax payments. This assistance may be critically important to employers who are struggling to meet costs when faced with diminishing revenues.
Kat, can you please give us an overview of the CARES Act’s employee retention credit?
Kat Gregor: Sure. As of right now, the employee retention credit is a fully refundable tax credit for employers that is equal to 50% of “qualified wages” that eligible employers pay to their employees, which includes both wages and the cost of certain qualified health plan expenses. Qualified wages are those paid after March 12, 2020 and before January 1, 2021. Qualified wages for any employee are capped at $10,000 in the aggregate, for all calendar quarters. Because the credit is equal to 50% of qualified wages, this means the amount of the credit is capped at $5,000 per employee.
Pascal Mayer: Thanks, Kat. What employers are eligible for the employee retention credit?
Kat Gregor: Well, at the most basic level, employers must carry on a trade or business during calendar year 2020. Importantly, this explicitly includes tax-exempt organizations.
After that, there are two categories of eligibility. First, employers are eligible if their operations are fully or partially suspended during any calendar quarter in 2020 due to orders from an appropriate governmental authority that limit commerce, travel, or group meetings due to COVID-19. Second, employers can also be eligible if they experience a significant decline in gross receipts during the calendar quarter. This is an “either/or” test, meaning that if an employer does not meet the “gross receipts” test, that employer may still be eligible for the tax credit so long as it qualifies under the “full or partial suspension” test.
It’s also important to note who is not eligible. Governmental employers, most household employers, and self-employed individuals are not eligible. Employers who received an SBA Loan (under the Paycheck Protection Program, or PPP) cannot also claim employee retention credits. Credits for a prior quarter must be repaid if an SBA Paycheck Protection Program Loan is taken in a subsequent quarter, although further guidance from the IRS on the mechanics of such repayment has not yet been provided.
Pascal Mayer: Digging into that first category of eligibility, that an employer’s operations have been fully or partially suspended by a government order: Loretta, practically speaking, what does it mean to have partially suspended operations?
Loretta Richard: Pascal, we’re seeing many businesses who are allowed to continue in some manner, but who are not allowed to operate at full capacity. Any employer who is allowed to continue operations, but not at normal capacity, may be eligible for the credits. There are two key factors to consider when undergoing this analysis: first, are the reduced operations a result of the COVID-19-related order from an appropriate governmental authority? And second, is the employee not working due to that order?
For example, governors have issued executive orders requiring closure of all restaurants, bars, and similar establishments in order to reduce commerce and group meetings to contain the spread of COVID-19. These businesses are allowed to continue food or beverage sales on a carry-out, drive-through, or delivery basis. This is a partial suspension of operations, and these businesses would be eligible for the employee retention credit in respect of qualified wages and qualified health care expenses incurred in respect of some or all of its employees.
Pascal Mayer: OK, but what qualifies as an order from an appropriate governmental authority?
Loretta Richard: Well, the order has to come from a federal, state, local, or tribal government. This means that orders enacted by local governments would be eligible, even if there is no statewide order. For example, despite there being no statewide order, residents of a city have been ordered to stay at home and non-essential businesses have been ordered closed. This municipal-level order constitutes “appropriate governmental authority,” and impacted employers may be eligible for the retention credit. Alternatively, an order by a public school board requiring closure of schools would also qualify, since school closures are aimed at reducing group meetings for purposes of containing the spread of COVID-19. However, if the order excludes essential business from closure or restrictions, those businesses, generally, would not qualify under this category.
Impacted employers likely include at least two categories of employers: first, those employers that are forced to modify operations, and second, employers whose business relies on others that have been forced to modify operations. For example, if an employer is unable to obtain essential supplies because the suppliers themselves have been forced to modify operations. That employer would then qualify as having operations that are partially suspended due to a government order limiting commerce because of COVID-19.
Pascal Mayer: Thanks, Loretta. Turning back to Kat, now that we’re reopening around the country, what happens to those employers who operate on a national or a regional basis whose operations are subject to suspension in one jurisdiction, but not in others?
Kat Gregor: That’s a good question. Whether an employer is partially suspended is determined on a “controlled group” basis, meaning that the operations of an employer in a state in which there is no longer a suspension order could still be considered partially suspended if it operates in another state in which a suspension order remains in effect. However, such treatment is available only if the employer establishes a policy that complies with guidance from local government orders and/or recommendations from the CDC and the Department of Homeland Security. For example, an employer that operates restaurants in multiple states, not all of which are subject to suspension of dine-in orders, is still eligible for the credit if it implements a policy of social distancing.
Pascal Mayer: What about employers whose operations are deemed essential and not subject to a governmental order—can they ever qualify for the credit?
Kat Gregor: Well, in general, an employer that operates an essential business is not considered to have a full or a partial suspension if the government order allows the employer to remain open. However, there are circumstances in which an essential business may be considered to be fully or partially suspended. First, where a portion of a business is treated as essential, the non-essential portion of the business may be treated as fully or partially suspended. For example, as previously mentioned, a restaurant whose operations are limited to carry-out, drive-through, or delivery would qualify since only part of its business is essential. Second, if an essential business is unable to obtain critical goods or materials from its suppliers who were required to suspend business, the essential business could be considered to have a full or partial suspension itself. Third, if an employer is an essential business in one state, but not in another, but maintains a nationwide policy that complies with guidance from local governmental orders and/or recommendations from the CDC and Department of Homeland Security, as previously discussed, then that employer would be considered to have a full or partial suspension as well, even if it is considered an essential business that can remain open in certain jurisdictions. Finally, an essential business can always qualify for the credit if it experiences a significant decline in gross receipts.
Pascal Mayer: Thank you, and I guess that’s a great segue to the second alternative category of eligibility, which is employers’ experiencing a significant decline in gross receipts. Loretta, what exactly qualifies as a significant decline in gross receipts?
Loretta Richard: Pascal, thanks. 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 the gross receipts for the same calendar quarter in 2019. The significant decline ends with the first calendar quarter that follows the first calendar quarter for which the employer’s 2020 gross receipts for the calendar quarter are greater than 80 percent of its gross receipts for the same calendar quarter during 2019. In other words, if in Q1 2020, an employer’s gross receipts were 45% of what they were in Q1 2019 and business does not pick up such that gross receipts do not return to at least 80% of what they were until Q3, then the significant decline ends on September 1, 2020, and they are eligible for that credit in respect of the qualified wages paid from March 13, 2020 to August 31, 2020.
Pascal Mayer: When measuring the decline, how are the gross receipts calculated?
Loretta Richard: The method for determining gross receipts will vary based on the tax accounting method used by the eligible employer. Generally speaking, however, it is the total amount received or accrued under the applicable accounting method for purposes of computing taxable income. In other words, it’s generally aimed at tracking revenues for tax purposes.
It’s important to note that the CARES Act requires aggregation of gross receipts for entities that are connected because of either vertical ownership or horizontal ownership. Vertical ownership means that all entities controlled by one another in a chain are counted as one. Horizontal ownership, for this purpose, means that all entities that are controlled by a similar group of investors are counted as one. For example, assume that a parent entity owns more than 50% of two subsidiaries with distinct lines of business, one of which does very poorly and suffers more than a 50% decline in gross receipts in a quarter. However, this decline in gross receipts is more than offset by the other subsidiary’s increase in gross receipts in the same quarter. In that case, the entities, as a group, do not meet the “gross receipts” test; however, the credit still may be available, Pascal, if the subsidiary with the decline in gross receipts suffered a full or a partial shutdown and continued to pay qualified wages.
If you believe that you qualify pursuant to the “gross receipts” test, we recommend that you work with your tax preparers and other financial and legal advisors to confirm eligibility. This is a pretty complicated test and the aggregation rules require that you should have some advice on whether or not it applies to you.
Pascal Mayer: Thanks, Loretta and Kat for explaining the two categories of employers who are eligible for the credit. These two categories being employers whose operations have been fully or partially suspended by a government order, or employers whose gross receipts have declined significantly. Now, let’s turn to understanding the amount of the credit. As we said earlier, the credit is 50% of qualified wages. So, Loretta, what are qualified wages?
Loretta Richard: Pascal, qualified wages are broadly defined to include any amount that constitutes “wages” or “compensation” for tax purposes. Although this is an oversimplification, it essentially includes any amount reportable as income to the employee. In addition, qualified wages include qualified health plan expenses, including the employer contributions to a medical plan, dental plan, vision plan, health flexible spending account or health reimbursement arrangement, even if those amounts are otherwise excluded from income. Put another way, as with other programs that have been implemented by the government during this crisis, the employer credit operates to partially “make whole” an employer for the “all in” costs of keeping employees on payroll (including the cost of maintaining their health and welfare benefits). So, Kat, has the IRS given any guidance on what constitutes qualified wages?
Kat Gregor: It has. The IRS has issued informal guidance on, among other things, what constitutes qualified wages, in the form of Frequently Asked Questions. The FAQs make clear that the IRS views qualified wages to not include severance payments, for example. Initially, the IRS had also taken the view that health plan expenses provided to employees who are on unpaid furlough or who have been laid off, but were receiving health benefits, were not qualified wages. The IRS reversed itself on this point following written comments by a bipartisan Congressional group that stated that the IRS’s position was contrary to Congressional intent. While as a legal matter, if litigated, the FAQs are not binding on either the IRS or the taxpayer, it will be difficult for the IRS to take a position on audit that is contrary to the FAQs.
Pascal Mayer: It will also be interesting to see how the IRS informal guidance does—or does not—develop. Does the size of the employer matter when calculating qualified wages?
Kat Gregor: That’s a great question. This is how the scope of the application of the credit is ultimately narrowed:
- So, for employers who have had more than 100 full-time employees in 2019, only those wages and qualified health plan expenses paid to or on behalf an employee who is on payroll, but is not providing services, will qualify.
- But, for employers who had fewer than 100 full-time employees in 2019, all wages and qualified health plan expenses paid to or on behalf of any employees of an eligible employer, whether or not they were working, will qualify. This means that effectively, if you’re a small employer with under 100 full-time employees, you can actually take the credit even if you were fully operational as long as your business was in some way partially suspended.
Pascal Mayer: And, is there any guidance for employers to figure out the size of their workforce and whether or not they have more or less than 100 full-time employees?
Kat Gregor: Yes. The CARES Act requires a lookback to an employer’s average full-time employees in 2019. And, the determination of whether an employee is or is not a full-time employee is determined with reference to the methods outlined under the Affordable Care Act—generally employees who work on average more than 30 hours per week are considered full-time employees. Interestingly, only U.S.-based employees are counted for this purpose; however, all U.S. employees within a related group of companies under the aggregation rules, discussed before, must be counted. Therefore, a parent entity who had, in 2019, 1,000 employees, say in the UK, but only 90 full-time employees in the U.S. would receive a credit in respect of all U.S. employees; however, two U.S. subsidiaries of a parent entity with 52 full-time employees each (in other words, 104 employees in total) would receive a credit in respect of wages, but only if they are paying employees who are not providing services.
Pascal Mayer: Thanks, Kat. And Loretta, what does “not providing services” mean? For example, what if an employee is still providing some services, but not at his or her full capacity, which I think is often the case in these days.
Loretta Richard: Yes, Pascal. For employers with more than 100 full-time employees, whether wages and qualified health expenses are being paid for “not providing services” is going to be very company-and employee-specific. For example, where an employee has been sent home and is not providing any services, the “not providing services” test has clearly been met. However, where employees are providing some service, but not at full capacity, the portion of the amount of wages paid that is eligible for the employee retention credit is less clear. What we’re advising clients is that each employer take an approach that is reasonable and defensible as to particular employee populations and make sure there is adequate documentation of the approach taken. We’re also advising employers to quantify, in hours, the time for which their employees are being paid, but are not working. For example, one employer has simply reduced the hours of its workforce by 50% (for example, workday is now 9:00 a.m. to 1:00 p.m. as opposed 9:00 a.m. to 5:00 p.m.) has clearly communicated this to its workforce and continues to pay the employee for full time wages.
Pascal Mayer: Thanks, Loretta. So, it sounds like it’s important to keep good documentation here. Kat, are there any other limitations on what constitutes qualified wages?
Kat Gregor: Yes. To prevent “double dipping,” the amount of sick and family leave wages for which the employer received tax credits under the Families First Coronavirus Response Act (also known as the FFCRA or Phase 2) do not count as qualified wages for purposes of the retention credit. However, wages and qualified health expenses paid in excess of amounts eligible for an FFCRA credit could count.
Also, as mentioned earlier, severance paid to a terminated employee would not count as qualified wages, and any PTO that was accrued prior to the suspension but is paid during the suspension period pursuant to pre-existing policies does not count. The treatment of PTO generally remains uncertain. For example, it’s not clear whether PTO that both accrues and is paid during the suspension period would count as qualified wages, as an example.
Pascal Mayer: So, assuming that an employer has qualified wages, what exactly is it that employers get? In other words, what is a “fully refundable credit?”
Kat Gregor: Put simply, receiving a fully refundable credit from the IRS means that an eligible employer can keep money that it would otherwise have to pay to the IRS, and then request a payment or refund from the IRS for any amount above what the employer would have had to pay.
As mentioned, for each employee for whom qualified wages are paid, an eligible employer will receive a credit of up to $5,000 per employee. The employer can receive the benefit of this credit in two different ways.
First, the eligible employer can engage in what is colloquially referred to as “self-help,” by reducing the amount of federal employment taxes it deposits for the quarter by half of the amount of qualified wages paid in such calendar quarter. For example, assume that an employer in the third quarter of 2020 owes to the IRS $8,000 in federal employment taxes for wages paid in Q3. However, that employer also has an employee retention credit of $5,000. Instead of paying $8,000 to the IRS, the eligible employer can simply pay $3,000.
Alternatively, assuming that the employer only owes $2,000 in federal employment taxes for wages paid in the third quarter of 2020, but has an employee retention credit of $5,000. In that case, the employer can pay nothing to the IRS and seek a refund of the $3,000 balance. In fact, if an employer expects a refund, they can request the refund on a rolling basis as wages are paid by filing a Form 7200 with the IRS. Separately, they can also wait to file their Form 941 at the end of each quarter and request a refund on that form.
Pascal Mayer: Thanks Kat, that’s a pretty valuable benefit. To finish off, Loretta, what are some immediate steps that employers should be taking so that they can benefit from the employee retention credit?
Loretta Richard: Pascal, employers who believe that they are eligible for the employee retention credit in respect of wages paid from March 13-31, 2020 should ensure that they keep track of and properly report such credit on the Form 941 for the second quarter of 2020 (which is due on July 31, 2020). In addition, employers should, on a rolling basis, calculate anticipated credits from ongoing operations and retain deposits regardless of the source (including employee withholding) up to the amount of the anticipated credits or, if payroll deposits are likely insufficient to offset the credit, file a Form 7200 for an advance refund. At this point, employers that are still working on calculating their credits may find it more efficient to claim the refund on their Form 941, which is to be filed at the end of July.
Kat Gregor: Also, companies should keep an eye out for changes to the CARES Act. The House recently passed the Health and Economic Recovery Omnibus Emergency Solutions Act or the “HEROES Act” and the proposal currently outstanding would dramatically expand the availability of retention credits. This would include increasing the credit from 50% to 80% of qualified wages and increasing the cap of qualified wages to $15,000 per employee per quarter (for a total of $45,000) of qualified wages in 2020. While we are waiting for the Senate to take this up, a lot of businesses are also waiting to see where this lands.
Pascal Mayer: Thanks, Kat and Loretta, for giving us so much helpful information about the employee retention credit. Let’s shift our focus to another benefit the CARES Act provides – it allows employers to defer the employer’s share of social security tax credits. What exactly can be deferred, Kat?
Kat Gregor: The CARES Act provides that an employer can defer its share of social security taxes due from March 27, 2020 to January 1, 2021. The employer portion of social security taxes is equal to 6.2% on the first $137,700 of wages paid to an employee in 2020.
This applies to “payments” due during this period, meaning that the deferral also applies to the employer portion of social security taxes for wages paid prior to March 27, 2020 but where the social security taxes may be due to the IRS on or after such date.
Once deferred, the social security taxes are payable in two installments: first, they must pay 50% on December 31, 2021 and then a second installment of 50% is due on December 31, 2022.
It’s important to note that while the CARES Act originally provided that companies could not defer once they had an SBA loan forgiven under the Paycheck Protection Program, the very recent Paycheck Protection Program Flexibility Act changed this. So now, all companies can defer regardless of whether they have had a loan forgiven under the Paycheck Protection Program or not.
Pascal Mayer: Thanks Kat. How does the employee retention credit work with the social security tax deferral?
Loretta Richard: Pascal, the IRS FAQs state that an employer is entitled to both the full amount of the employee retention credit as an advance refund and may separately defer the full amount of the employer portion of the social security contributions.
For example, assume that the employer deferred $1,000 in social security obligations to 2021 and 2022. After such deferral, it owes no other social security taxes. Assume that the employer also has a $1,000 retention credit. In that case, the employer could engage in self-help by reducing the amount of other payroll withholding (such as Medicare tax or employee withholding by the $1,000).
As this shows, the deferral of the employer portion of social security contributions is quite valuable, and employers should immediately cease depositing their share of social security obligations (or coordinate with their payroll providers to do so).
Pascal Mayer: Kat and Loretta, I want to thank you for sharing these insights. It was very helpful to learn about the employee retention credit and the payroll deferral. For our listeners, please visit the Tax Controversy Newsletter webpage at www.disputingtax.com, or of course, www.ropesgray.com for additional news and commentary about other important tax developments as they arise. If we can help you to navigate this complex and rapidly developing area of the law, please do not hesitate to contact us. You can also subscribe to our Disputing Tax podcast series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thanks again everybody for listening.