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Understanding the COVID-19 Tax Credits

Recent legislation designed to combat the COVID-19 pandemic offers businesses tax credits to support employee paid sick and family leave and discourage layoffs.

To address the immediate need for business cash-flow, the IRS has put in place three important procedures for claiming the COVID-19 relief credits in advance, rather than when the tax return is filed.

With the COVID-19 credits:

  • Businesses may reduce their employment tax deposits now in anticipation of receiving credits later.
  • Credits will apply against an expanded list of taxes.
  • Employers can request advance credit payments.

Reduce tax payments now

Because these credits can apply to wages already paid after March 12, 2020, employers can get access to these credits by reducing upcoming deposits. The requirement that employers withhold and remit to the IRS income taxes, Social Security and Medicare taxes is effectively put on hold for small and midsize businesses that expect to receive the paid sick and family leave and employee retention credits.

Employers can apply the credits in advance against the following taxes:

  • federal income tax withholdings,
  • the employee’s share of Social Security and Medicare taxes and
  • the employer’s share of Social Security and Medicare taxes.

The reduced employment tax deposits cover wages paid to all employees, not just wages paid to those whom the employer must provide paid leave. The IRS will provide instructions for Form 941 on how to reflect the reduced liabilities for the quarter related to the deposit schedule.

Tax Penalties Waived

Employers that reduce their employment tax deposits will not face the stiff penalties that usually apply to shortfalls. The IRS has waived the failure to deposit penalties for businesses entitled to the two credits. The waiver, in Notice 2020-22, covers a broad category of employment tax deposits, including withheld income taxes, FICA taxes and Railroad Retirement Act taxes for sick and family leave paid from April 1, 2020 through December 31, 2020. The penalty relief also applies to employment tax deposits reduced in anticipation of getting employee retention credits for wages paid from March 13, 2020 through December 31, 2020.

One word of caution: the penalty waiver only applies to the extent that the amounts not deposited are equal to or less than the amount of refundable tax credits to which the employer is entitled. Overestimating credits and depositing too little could cause an employer to incur a penalty.

Claim Advance Credits

If an employer cannot reduce the employment tax deposits to fully account for expected credits, the employer may request an advance payment of the credits by filing Form 7200, Advance Payment of Employer Credits Due to COVID-19. It is important that the employer not request an advance credit for amounts already taken into account when reducing employment tax deposits. Employers will need to account for the amounts received as an advance when they file Form 941, Employer’s Quarterly Federal Tax Return, for the relevant quarter.

Example: If an employer is entitled to an employee retention credit of $10,000 and was required to deposit $8,000 in employment taxes, the employer could retain the entire $8,000 of taxes as a portion of the refundable tax credit and file a request for an advance payment for the remaining $2,000 using Form 7200.

The basic rules for each credit and examples are show below.

Sick and Family Leave Credit

Small and mid-sized employers get a payroll tax credit equal to 100% of the qualified wages paid for mandated sick and family leave. This credit only applies to businesses with fewer than 500 employees. Businesses with 500 or more employees are not entitled to the new credit but may still use the existing Sec. 45S family and medical leave credit.

The credit is increased by the employer’s contribution to Medicare taxes imposed on an employee’s leave wages and also is increased by employer group health plan expenses allocable to those wages. There is no credit for the employer portion of social security tax because leave wages are not subject to this tax. The credit is available for wages paid for the period of April 1, 2020, through December 31, 2020. The refundable credit is applied against employment taxes on wages paid to all employees.

Examples

  1. An eligible Employer pays $10,000 in qualified sick leave and family leave wages in Q2 2020. It will owe $145 for the employer’s share of Medicare tax. The employer’s credits equal $10,145—the qualified wages plus the Medicare tax. This amount may be applied against any federal employment taxes that the employer is liable for on any wages paid in Q2 2020. Any excess over the federal employment tax liabilities will be refunded. Employers must still withhold the employee’s share of social security and Medicare taxes on the qualified leave wages paid.
  2. If an employer is entitled to a credit of $5,000 for sick leave wages, group health plan expenses and Medicare tax and is required to deposit $8,000 in employment taxes, the employer can reduce its federal employment tax deposits by $5,000. The employer would then be required to deposit the remaining $3,000 on its next regular deposit date.

CARES Act Employee Retention Credit

Employers get a refundable payroll tax credit for 50% of the first $10,000 in qualified wages paid to employees during the COVID-19 crisis. The credit is allowed against the employer portion of social security taxes and railroad retirement taxes on all wages paid to all employees.  The credit is refundable to the extent it exceeds the employer’s social security and railroad retirement tax liability for the quarter. The credit can be claimed in advance by reducing quarterly employment tax deposits including income tax withholdings, social security and Medicare taxes.

Eligible employers include those whose:

(1) operations are fully or partially suspended by government order due to COVID-19 during the calendar quarter or

(2) gross receipts declined by more than 50% compared to the same quarter last year.  (Once the gross receipts go above 80% of a comparable quarter last year, the employer no longer qualifies after the end of that quarter.)

The credit is allowed for wages paid or incurred from March 13, 2020 through December 31, 2020 and is available to all employers regardless of size, including tax-exempt organizations.

There are only two exceptions: state and local governments and small businesses who take SBA Paycheck Protection Program (PPP) loans.

Computing the Credit

The credit equals 50% of the qualified wages and group health plan expenses that an employer pays in a calendar quarter. The maximum amount of qualified wages taken into account for each employee for all calendar quarters is $10,000, so the maximum credit for qualified wages paid to any employee is $5,000, as shown in the examples below.

Example 1: An employer pays $10,000 in qualified wages to Employee A in Q2 2020. The amount of the employee retention credit available to the employer for wages paid to Employee A is $5,000.

Example 2: An 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 employer for the wages paid to Employee B is $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.

Example 3: An employer pays $10,000 in qualified wages to Employee A in Q2 2020. The Employee Retention Credit available to the employer for  Employee A is $5,000. This amount may be applied against the employer share of social security taxes that the employer is liable for with respect to all employee wages paid in Q2 2020. Any excess over the employer’s share of social security taxes is treated as an overpayment and will be refunded to the employer after offsetting other tax liabilities.

Qualified Wages

Wages taken into account are not limited to cash payments, but also include a portion of the cost of employer provided group health care. The determination of qualifying wages is based on the average number of employees a business had in 2019.

Employers with more than 100 employees: If an employer averaged more than 100 full-time employees during 2019, qualified wages are wages paid to employees for time that they are not providing services either (1) because operations were fully or partially suspended by order of a governmental authority due to COVID-19 or (2) due to the significant decline in gross receipts. These employers can only count wages up to the amount that the employee would have been paid for working the same amount during the 30 days immediately preceding the period of economic hardship.

Employers with fewer than 100 employees: If an employer averaged 100 or fewer full-time employees during 2019, qualified wages are wages paid to any employee during the period of economic hardship described in (1) and (2) above, regardless of whether or not the employees are providing services.

No Double Dipping

If an employer meets the qualifications for both the sick and family leave credit and the employee retention credit, the employer may receive both credits, but not for the same wage payments. Also, employers cannot claim the existing Sec. 45S credit for family and medical leave for the same wages claimed for Families First Act sick and family leave credit. However, the employer could take the Sec. 45S credit for any additional wages paid.

If an employer receives tax credits for sick and family leave wages, those wages are not eligible as “payroll costs” for purposes of receiving loan forgiveness under the SBA Paycheck Protection Program.

An employer may not receive the Employee Retention Credit if the employer receives a Small Business Interruption Loan under the Paycheck Protection Program that is authorized under the CARES Act.

Finally, employees are not counted for the employee retention credit if the employer is allowed a Work Opportunity Tax Credit.

Conclusion

The IRS’s guidance is good news for employers because they can keep the money they would send to the government as tax deposits to pay their workers. This process amounts to an advance on the tax credits that can be used now by cash-strapped employers, which is what Congress intended. This method also helps avoid a drawn-out process at the end of the year where the IRS would have to give large refunds to employers after their final tax returns are filed.

Talk to your Frazier & Deeter tax advisor to understand the options available for your business and what steps need to be taken to pursue appropriate tax credits based on your unique situation.

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