Jeffery L. Morris
Jeffery L. Morris is a founding partner at Think LLP in Costa Mesa, California.
In this article, Morris analyzes Notice 2021-49, arguing that the IRS has misinterpreted how business owner and related-party wages qualify for the employee retention credit.
On August 4 the IRS issued Notice 2021-49, 2021-34 IRB 316, which addresses the qualification of wages paid to business owners and their related family members for the employee retention credit.
As expected, the notice excludes the wages of family members of a majority business owner who “bears any of the relationships described in section 152(d)(2)(A)-(H),”1 including (A) child or descendant of a child; (B) brother, sister,
stepbrother, or stepsister; (C) father or mother, or an ancestor of either; (D) stepfather or stepmother; (E) niece or nephew; (F) aunt or uncle; and (G) son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law.
Oddly, the notice goes further, applying section 267(c) to conclude that the business owners’ wages don’t qualify if the owners have any family members. 2 In a Salvador Dalí-like way, the owner metamorphoses into the family member, transforming themselves into a disqualified family member for purposes of the ERC:
Further, because each of those family members is considered to own more than 50 percent of the stock of the corporation after applying section 267(c), the direct majority owner of the corporation would have a relationship as defined in section 152(d)(2)(A)-(H) to the family member who is a constructive majority owner. Therefore, the direct majority owner is a related individual for purposes of the employee retention credit.3
Like Freaky Friday, the owner’s mom would magically become her daughter, disqualifying her wages for the purposes of the ERC:
Example 2: Corporation B is owned 100 percent by Individual G. Individual H is the child of Individual G. Corporation B is an eligible employer with respect to the first calendar quarter of 2021. Individual G is an employee of Corporation B, but Individual H is not. Pursuant to the attribution rules of section 267(c) of the code, Individual H is attributed 100 percent ownership of Corporation B, and both Individual G and Individual H are treated as 100 percent owners. Individual G has the relationship to Individual H described in section 152(d)(2)(C) of the code. Accordingly, Corporation B may not treat as qualified wages any wages paid to Individual G because Individual G is a related individual for purposes of the employee retention credit.4
Thus, only a childless orphan owner with no other familial relationships would qualify for the ERC.5
In the example below, presumably married owners have no parents, grandparents, siblings, nieces, nephews, aunts, uncles, or children (natural or in-laws), so their wages would qualify for the ERC:
Example 3: Corporation C is owned 100 percent by Individual J. Corporation C is an eligible employer with respect to the first calendar quarter of 2021. Individual J is married to Individual K, and they have no other family members as defined in section 267(c)(4) of the code. Individual J and Individual K are both employees of Corporation C. Pursuant to the attribution rules of section 267(C) Individual K is attributed 100 percent ownership of Corporation A, and both Individual J and Individual K are treated as 100 percent owners. However, Individuals J and K do not have any of the relationships to each other described in section 152(d)(2)(A)-(H) of the code. Accordingly, wages paid by Corporation C to Individual J and Individual K in the first calendar quarter of 2021 may be treated as qualified wages if the amounts satisfy the other requirements to be treated as qualified wages.6
Could it really be that Congress intended not to include the backbone owner-employees of small businesses in the ERC calculation unless they happen to be childless orphans?
Legal Authorities
For small businesses, the Coronavirus Aid, Relief, and Economic Security Act allows the ERC for wages paid to all employees without any expressed limitations for wages paid to owneremployees:
(II) With respect to an eligible employer described in subclause (II) of such paragraph, wages paid by such eligible employer with respect to an employee during such quarter.7
The CARES Act doesn’t specify application of the attribution rules in the way applied by the IRS. The CARES Act statute references the section of the IRC that provides the work opportunity tax credit (WOTC) rules that disallow the credit on wages paid to related family members:
(e) CERTAIN RULES TO APPLY. — For purposes of this section, rules similar to the rules of sections 51(i)(1) and 280C(a) of the Internal Revenue Code of 1986 shall apply.8
The choice to reference rules similar to section 51(i)(1) leaves open the following question: What does “similar to” mean? The WOTC cannot be claimed on wages paid to an individual who is a related family member:
51(i)(1) Related Individuals No wages shall be taken into account under subsection (a) with respect to an individual who —
51(i)(1)(A)
Bears any of the relationships described in subparagraphs (A) through (G) of section 152(d)(2) to the taxpayer, or, if the taxpayer is a corporation, to an individual who owns, directly or indirectly, more than 50 percent in value of the outstanding stock of the corporation, or, if the taxpayer is an entity other than a corporation, to any individual who owns, directly or 4 indirectly, more than 50 percent of the capital and profits interests in the entity (determined with the application of section 267(c)).9
It seems clear that the wages of majority owners’ family members referenced in section 152(d)(2) (and restated in Notice 2021-49) don’t qualify for the ERC.10 That includes siblings, parents, and children. However, it is less clear how the section 267(c) rules should be applied.11
Congress didn’t state an intent in the statute or in its committee reports for owners’ (and their spouses’) wages to be disqualified from the ERC.12 All the statute indicates is that rules similar to the rules used to determine qualifying wages for WOTC purposes should be applied.13 The purpose of the WOTC is to create jobs for disadvantaged individuals (for example, those living in poverty and veterans). The purpose of the small business provisions of the ERC is to help avoid the failure and collapse of small businesses around the country.14 Interpreting how the law should be read requires understanding the context and difference in purpose between the WOTC and ERC.
The WOTC doesn’t apply to most small business owners’ wages because the owners generally wouldn’t meet the other qualifying criteria for the WOTC. In contrast, small business owners generally do meet the other ERC qualifying criteria.15 With that in mind, it seems likely that an incentive program specifically targeted to help small businesses would include the wages earned by the employee-owners of small businesses. Further, it isn’t clear that applying rules similar to section 51(i)(1) was intended to be applied beyond the reference to section 152(d) defining the familial relationships that don’t qualify for the ERC.16 Moreover, the IRS mash-up reference to sections 152(d) and 267(c) doesn’t appear consistent with the statutory language.
Further confusing the matter is the departure from the statute for noncorporate entities, taking the view that owners of other legal entities cannot be employees of noncorporate legal entities:
This discussion is limited to a majority owner of a corporation because the owner of a partnership, or other incorporate entity, generally cannot be an employee of that entity, and therefore cannot be paid wages within the meaning of section 3121(a) of the code. A partner or other self-employed individual is not eligible for the employee retention credit on the individual’s earned income.17
In the IRS’s interpretation, wages paid to owners don’t qualify because the owners are deemed to be their nonqualifying family members — that is, the family members are deemed to own the stock of the owners. Continuing in a circular loop, the family members are deemed to indirectly own the owners’ shares in the entity under section 257(c), meaning wage payments to the owners are deemed impermissible payments to the family members, thus not qualifying for the WOTC or ERC. Applying this rationale, unless the owners have no family who will be deemed to own their entity interest under section 267(c), the owners’ wages won’t qualify under this interpretation of the law. That is how the IRS concludes that childless orphan owners’ wages qualify for the ERC, but wages of owners with any living relatives don’t.
Will Rogers said something like, “The problem with common sense is it ain’t that common.” While it is theoretically possible to double attribute your way to an owner being deemed a relative, common sense would tell you that Congress couldn’t have possibly expected small business owners to have inferred this from the code. If Congress meant for owner wages not to qualify for the ERC, it would have said so. Congress listed every possible family member and left out the most obvious party in the mix: the owners themselves.
A more common-sense reading of the law suggests that the IRS hasn’t applied section 51(i)(1) correctly. Section 51(i)(1) says:
Related Individuals: No wages shall be taken into account under subsection (a) with respect to an individual who. [Emphasis added.]
Then subsection 51(i)(1)(A) proceeds to specify that a related individual is one that:
bears any of the relationships described in subparagraphs (A) through (G) of section 152(d)(2) to the taxpayer.
Full stop here. The wages to an individual who is a family member don’t qualify for the ERC, but there is no limitation under this section on wages paid to the owners (working husband and spouse). Section 51(i)(1)(A) continues by addressing circumstances when the taxpayer is a corporation or other type of business entity. Because a corporation or other type of business entity (for example, partnership) cannot have related family members, the statute must specifically address application of the disallowed family member wages for corporations and other business entities.
Reading the statute carefully, you can see that it continues its reference to disallowed payments made to the individual (that is, the section 152(d) family members) that own directly or indirectly through attribution more than 50 percent of the business entity. Generally, if the owners control more than 50 percent of the business entity, then the family members would be deemed to own more than 50 percent of the entity for this purpose:
51(i)(1)(A) . . . or, if the taxpayer is a corporation, to an individual who owns, directly or indirectly, more than 50 percent in value of the outstanding stock of the corporation, or, if the taxpayer is an entity other than a corporation, to any individual who owns, directly or indirectly, more than 50 percent of the capital and profits interests in the entity (determined with the application of section 267(c)).18
That entire section is conditioned on the term “or.” The section is meant to set forth the rules that a corporation or an entity other than a corporation apply when payments are made to an individual, which has been defined as payment to family members listed under section 152(d)(2) (that is, mom, dad, sis, and the kids).
Appling the statute in this manner, the objective of section 51(i)(1) is accomplished, no payment to related family members qualifies for the WOTC or ERC. Nowhere does this section identify the business owner or spouse as one of the individuals not qualifying for the WOTC. The WOTC regulations provide further support for this view, identifying all the family members whose wages don’t qualify without ever mentioning the owners of the business.19 Further support for this view comes directly from the Joint Committee on Taxation, which provides the only information we have about what Congress intended by the statutory reference to rules similar to rules:
If a taxpayer claims a credit under this provision, rules similar to the rules of sections 51(i)(1) and 280C(a) apply. Thus, for example, an employee retention credit may not be generated by an individual employer hiring his or her children. [Emphasis added.]
Had Congress intended to exclude the owners’ wages, this example would have clarified here that owner wages don’t qualify for the ERC. Certainly, clarity would have been provided to address a circumstance that applies to nearly all small businesses versus a relatively rare circumstance involving a child working in the business. When given the opportunity to provide greater clarification nearly a year later, the JCT uses the exact language again to illustrate that an owner cannot claim the ERC on their child’s wages.20 To date there have been three bills that have affected the ERC, including the CARES Act, the American Rescue Plan Act of 2021 (P.L. 117-2), and the Consolidated Appropriations Act, 2021 (P.L. 116-260). Not one of those bills provided language limiting the ERC on wages paid to business owners. Instead, as detailed before, each bill significantly expanded the ERC benefits targeting small business.
It is understandable that there could be abuse if those with familial relationships weren’t excluded from the ERC. On the other hand, there wouldn’t appear to be any potential for abuse from working owners obtaining the ERC. With the emphasis on helping small businesses survive COVID-19, it seems inconsistent for working owners to be excluded from the ERC calculation. This would be consistent with numerous statements from Congress regarding the intent to help small businesses through the ERC.21
For example, for large businesses, only those employees paid for not providing services qualify for the ERC. In contrast, qualifying small businesses are allowed the ERC for all employee wages, regardless of whether they provide services. Further, the definition of a small business was expanded from 100 to 500 employees in ARPA, and the amount of credit per employee was increased from up to $5,000 per quarter in 2020 to $7,000 per quarter in 2021 ($28,000).22 It seems inconsistent with the broadbased inclusion of all small business employees to then exclude the small business employee-owners from the ERC. Wouldn’t the very concept of assisting “small business” be meant to assist the working owners who have kept small businesses functioning and maintaining jobs during the crisis?
Conclusion
Based on Notice 2021-49, all owners are transformed into disqualified family members, eliminating their wages for the ERC.23 Because Notice 2021-49 is legal authority, owner wages shouldn’t be included in the computation of the ERC without consideration of the IRS legal position for ERC computations filed after the August 4 notice date. It appears that there is a well-reasoned position that the IRS analysis of section 51(i)(1) is incorrect. Further, the JCT report’s example involving a child of the owner illustrates an intent to apply these rules to the family members, not the business owners. However, the challenge on audit would be sustaining this position absent some express view of this issue from Congress via a technical amendment or other direction from Congress to Treasury.24