Employee Retention Credit: Step-by-Step ExampleTax Planning
With the Consolidated Appropriations Act, 2021, millions of small-business owners like you now qualify for the employee retention credit (ERC) thanks to three big changes:
- You can now obtain the ERC and the Paycheck Protection Program loan, but not on the same wages.
- This new rule applies retroactively to 2020.
- The new law adds an enhanced ERC for 2021.
And thanks to the latest new law, the American Rescue Plan Act of 2021 (ARPA), the already enhanced 2021 ERC is extended for an additional six months, through December 31, 2021.
The ERC is a big deal. It can put tens of thousands of dollars directly in your pocket to help offset your cost of paying employees during the COVID-19 pandemic.
Planning note. If you operate your business as a corporation and receive a W-2 from your corporation for the work you do, your W-2 wages qualify for the ERC.
The one downside to this tax credit: you have to deal with some complexity to determine your eligibility and to calculate your tax credit.
But not to worry. In this article, we’ll walk you step-by-step through a small-business example so you can see how
you determine eligibility, calculate the credit amount, and claim your cash.
It’s 2021, and you operate your dental practice within an S corporation. You are the sole shareholder.
In the first quarter of 2021, you paid the following wages to your employees:
- Employee 1—$10,000
- Employee 2—$12,000
- Employee 3—$15,000
You are not related to your three employees.
You also pay $500 per month on behalf of each employee to provide them group health coverage. The employees don’t pay taxes on this benefit.
Your state had COVID-19 business restrictions in place for all of the first quarter of 2021. But your dental practice is an essential business under the state order, and its operations were not affected.
You’ve had the following gross receipts in the first quarter over the past three years:
Step 1: Eligibility
First, you have to determine whether your first quarter qualifies for the employee retention credit by meeting either
- the suspended operations test, or
- the gross receipts test.
Your business, as an essential business whose operations continued under the government orders, does not meet the suspended operations test.
To determine whether you meet the gross receipts test, you compare your 2019 gross receipts with your 2021 gross receipts. If your 2021 gross receipts are less than 80 percent of your 2019 gross receipts, you qualify.
Good news! You qualify. Your 2021 first-quarter gross receipts are 78 percent of your 2019 first-quarter gross receipts ($195,000 ÷ $250,000 = 0.78).
Important. The decline in gross receipts doesn’t have to be COVID-19-related to qualify under this test.
Step 2: Qualified Wages
For each 2021 quarter, an eligible employer can credit up to $10,000 in qualified wages per employee.
For employers with fewer than 500 full time employees in 2019, all wages paid to all employees during the 2021 quarter qualify based on the gross receipts test.
Important note. The wages of business owners and their spouses generally qualify for the credit; however, the wages of most family members of more-than-50-percent owners do not qualify for the credit.
In addition, qualified wages include the amount you pay for group health insurance for your employees, as long as those amounts qualify as tax-free to your employees under tax code Section 106(a).
Important note. More-than-2-percent S corporation employee-shareholders don’t qualify for the Section 106(a) taxfree treatment because their health insurance is included in their W-2 wages. Because that increases the wages, there’s no loss of ERC benefits for the insurance cost.
Since you paid each employee at least $10,000 in cash wages in the first quarter of 2021, your total qualified wages for the quarter are $40,000 ($10,000 per employee for each of the four employees).
Here’s the detailed breakdown of your qualified wages for the first quarter of 2021:
Step 3: Credit Amount
For 2021 quarters, the credit rate is 70 percent.
Your ERC for the first quarter of 2021 is $28,000, or 70 percent of $40,000.
Step 4: Claiming the Credit
For 2021 quarters, since your business had 500 or fewer full-time employees in 2019, you must choose one of the following options to claim the credit:
- Reduce your payroll tax deposits by the amount of your anticipated credit. If your anticipated credit is more than your payroll tax deposits, request an advance refund using Form 7200.
- Claim the credit on your Form 941 quarterly payroll tax return, and receive a refund from previously paid tax deposits.
In this example, you didn’t know you would qualify for the ERC until after you calculated your first-quarter 2021 gross receipts. So, you didn’t reduce your payroll deposits or use Form 7200 to receive an advance refund.
Therefore, you must complete Worksheet 1, which you will find in the instructions for Form 941, and then claim the ERC directly on your Form 941.
Step 5: Tax Return Effects
Taxable income. You can’t deduct wages equal to the amount of the ERC.15 Therefore, your net business income increases by $28,000 during tax year 2021 due to claiming the credit.
Moneywise, this not an issue. You obtain the tax credit, which is a dollar-for-dollar reduction in your payroll, and then lose the tax deduction for the tax credit money you put in your pockets.
Example. You pay 30 percent in federal taxes. You pocket $28,000 in tax credits. You pay $8,400 in taxes on the $28,000 increase in your taxable income. You win this game by $19,600 ($28,000 – $8,400).
Section 199A. Here’s more good news. If you are over the taxable income threshold for your 20 percent Section 199A deduction, you don’t reduce your Section 199A wages by the non-deductible wage amount.16 Instead, you base your Section 199A wages on the W-2.
After the changes to the ERC from the Consolidated Appropriation Act, 2021, and ARPA, millions more small business owners like you can qualify for this tax credit for tax years 2020 and 2021.
You claim your ERC for each quarter by following the five steps we explain in this article:
- Determine whether your business meets either (a) the suspended operations test or (b) the decline in gross receipts test.
- Calculate your total qualified wages.
- Calculate your ERC using the rate applicable to that quarter.
- Receive your credit by either getting an advance payment or claiming a refund when you file your Form 941 quarterly payroll tax return.
- Reduce your deductible wage expense on your income tax return by the amount of your ERC.