The Employee Retention Credit (ERC) was created to reward a wide variety of eligible employers for retaining employees during specific periods of the pandemic. In the simplest terms, the ERC is a refundable payroll tax credit for “qualified wages” paid to employees in specific calendar quarters of 2020 and 2021. Remarkably, the refundable credits often exceed the initial payroll tax liabilities themselves!
It is important to remember that if a business qualifies for the ERC, the ERC only applies to “qualified wages” (i.e., compensation and healthcare costs). And “qualified wages,” in turn, depends on whether the business is considered a “small employer” or “large employer” for ERC purposes.
Employers understandably have many questions about the ERC, including questions regarding the theme of today’s blog. Frequently, we are discovering that businesses are confronting confusing sources of information regarding (i) whether an eligible employer is a small eligible employer or large eligible employer, and (ii) when wages paid to employees who are not full-time employees may be treated as qualified wages. After reading this, you should be able to confidently answer those questions.
For ERC purposes, small employers are allowed the ERC on wages paid to employees whether they worked or not. On the other hand, large employers are limited to including only those wages paid to employees for not providing services. Simply:
Large Employer Example: Assume Enterprise, Inc. is a large employer. It paid Mary for 40 hours in January 2021. Mary only actually worked 10 hours, because governmental orders suspended 30 hours’ worth of her normal working hours. In this case, Enterprise, Inc. will exclude any wages it paid Mary for working when calculating the credit. Instead, only the wages that it paid Mary for not working (30 hours) are qualified wages and eligible for this credit.
Small Employer Example: Assume Botany Bay, Inc. is a small employer. It paid Mary for 40 hours in January 2021. Mary only actually worked 10 hours, because governmental orders suspended 30 hours’ worth of her normal working hours. In this case, Botany Bay will include all of the wages (40 hours) it paid Mary for working when calculating the credit.
*Note that for both examples, the assumption of large and small employers' status is based on the necessary assumption that the average number of full-time employees employed during 2019 either exceeded the applicable threshold amount or did not, as discussed next.
Unsurprisingly, small employers and large employers are distinguished based on the number of employees. Per the CARES Act, whether a business is a small or large employer depends on whether “the average number of full-time employees (within the meaning of section 4980H of the Internal Revenue Code of 1986)” employed during 2019 exceeded the applicable threshold amount.
The applicable threshold amount to be used depends on the calendar year. The 2020 ERC threshold is 100 full-time employees, and the 2021 ERC threshold is 500 full-time employees.
It should be very clear at this point that, ultimately, the number of employees is determined by the number of “full-time employees.” While that seems like a rather straightforward matter, it didn’t start off that way.
Instead, in the CARES Act, Congress decided that “full-time employees” for ERC purposes would be used as it is defined by the Affordable Care Act (ACA). Per the ACA, a “full-time employee” (FTE) is an employee who worked either 30 hours per week or 130 hours per month.
But the ACA also recognizes full-time equivalent employees. Conceptually, full-time equivalent employees are a pool of employees—each of whom individually is not an FTE, but when considered collectively, are equivalent to an FTE, based on the total number of hours worked in a month divided by 120.
At this point, for some people, the question became:
“For purposes of determining whether I am a small or large employer . . . do I count only FTEs, or do I include full-time equivalent employees?”
The short, and happy answer is:
“You only need to count FTEs—not full-time equivalent employees.”
So, why are we so sure the short and happy answer is: “You only need to count FTEs—not full-time equivalent employees”? Two reasons: careful statutory analysis, and subsequent IRS guidance issued in Notice 2021-49.
First, full-time equivalent employees were incorporated into IRC §4980H(c)(2)(E) “solely for purposes of determining whether an employer is an applicable large employer under this paragraph.” (Emphasis added). This means that the “full-time equivalent employees” concept is applicable only for IRC §4980H(c)(2)—not for the entirety of IRC §4980H.
Thus, even before Notice 2021-49, it was relatively well-understood that (1) while the CARES Act references the ACA’s definition of FTEs—it does not expressly reference the statutorily limited “full-time equivalent employees” concept, (2) IRC §4980H provides a specific FTE definition, without any “full-time equivalent employees” notion, and (3) the usage of the “full-time equivalent employees” concept is expressly limited to the definition of “applicable large employer” for ACA purposes.
Unfortunately, a statement in a footnote of the Joint Committee on Taxation’s explanation of the CARES Act disregarded (carelessly disregarded, in this author’s opinion) the critical “solely for purposes” language in IRC §4980H(c)(2)(E) noted above, and confused many individuals, stating:
The provision states that the metric is the “average number of full-time employees (within the meaning of section 4980H of the Internal Revenue Code of 1986).” This language includes full-time equivalents as referred to in section 4980H(c)(2)(E).
Fortunately, the IRS also erased ambiguity in the matter when it issued Notice 2021-49 stating that:
For purposes of determining whether an eligible employer is a large eligible employer or a small eligible employer, eligible employers are not required to include full-time equivalents when determining the average number of full-time employees.”