Jeffery L. Morris is a founding partner of Think LLP in Costa Mesa, California, where he heads the credits and incentives practice.
In this article, Morris examines the employee retention credit under the coronavirus relief legislation and explains how employers can qualify for the credit based on suspended business operations.
To encourage the retention of employees, the Coronavirus Aid, Relief, and Economic Security (CARES) Act (P.L. 116-136) provides for a 50 percent retention credit on up to $10,000 of qualified wages paid between March 13 and the end of 2020 for businesses financially affected by COVID-19.
The benefit is realized through a reduction or refund of quarterly payroll taxes. Employers have been encouraged to take full advantage of the retention credit during the COVID-19 crisis.
However, guidance issued by the IRS in the form of FAQs has imposed greater restrictions on essential businesses than on nonessential businesses. The IRS should be lauded for providing such rapid guidance, but the distinction between essential and nonessential businesses does not appear to be supported by the legislation, nor is it consistent with the goal of voluntarily keeping employees on the payroll during the crisis. Moreover, FAQs are not binding on taxpayers. The IRS’s general information FAQs on the retention credit are preceded by the following disclaimer: “This FAQ is not included in the Internal Revenue Bulletin, and therefore may not be relied upon as legal authority. This means that the information cannot be used to support a legal argument in a court case.”
This article evaluates the qualification of essential businesses for the retention credit under the legal authorities issued to date. Of interest is the scope of activity and the scope of qualifying wages constituting a fully or partially suspended business. This article is directed toward larger employers — those with more than 100 employees — that did not obtain Paycheck Protection Program loans.
I. The Retention Credit Generally
Section 2301 of the CARES Act created a credit to encourage employers to voluntarily retain and compensate employees who were affected by COVID-19-related government-created closures. The “employee retention credit for employers subject to closure due to COVID-19” provides a method for qualifying employers to recover half of their qualifying payroll cost, capped at $5,000 per employee per calendar quarter.
According to a report by the Joint Committee on Taxation, the retention credit was modeled after past legislation that provided credits for the retention of employees affected by natural disasters. Unlike that disaster zone relief, which has taken the form of credits against income tax, the
COVID-19-related retention credit allows employers to realize the cash benefit sooner, as a reduction in quarterly employment taxes.
As discussed in the following sections, to qualify for the retention credit, a business must be an “eligible employer” and have “qualifying wages.”
II. Eligible Employer
An eligible employer is one that was carrying on a trade or business in 2020 and had either (1) a significant (at least 50 percent) reduction in gross receipts in the past year; or (2) a full or partial suspension of business operations caused by government orders. This article focuses on the latter
The statute refers to a trade or business whose operations during any calendar quarter in 2020 are fully or partially suspended “due to orders from an appropriate governmental authority limiting commerce, travel, or group meetings (for commercial, social, religious, or other purposes) due to the
coronavirus disease 2019 (COVID-19).”
Although Treasury has not issued regulations, IRS FAQ 28 clarifies that federal, state, or local government orders that affect an employer’s operation of its business are orders that can be considered for purposes of the retention credit:
Accordingly, the initial step in an essential industry retention credit analysis is to evaluate whether any federal, state, or local government orders limit commerce, travel, or group meetings because of COVID-19 in a manner that affects an employer’s business operations.
Treasury has not issued regulations defining what “fully or partially suspended” means. According to the JCT report, there must be a government order in the payroll quarter related to COVID-19 that causes a full or partial suspension of the business. There is no distinction made between essential businesses and nonessential businesses.
A. Essential Business
Generally, an essential business will be exempt from direct government orders suspending commerce, travel, or other activities.11 Thus, on the surface, it would appear that an essential business would not qualify for the retention credit. However, a deeper analysis reveals direct and indirect effects on commercial activity resulting from government orders related to COVID-19.
The FAQs outline specific fact patterns in which an employer is or is not an eligible employer. According to FAQ 30, if an essential business is excluded from a business suspension order, it will not be considered to have a full or partial suspension of operations for purposes of the retention
Despite the guidance that an essential business will not be considered suspended if it’s allowed to continue operations under governmental orders, FAQ 31 makes an exception for when the essential business cannot get materials because of government orders affecting its suppliers:
Example: Employer A operates an auto parts manufacturing business that is considered an essential trade or business in the jurisdiction where it operates. Employer A’s supplier of raw materials is required to shut down its operations due to a governmental order. Employer A is unable to procure these raw materials from an alternate supplier. As a consequence of the suspension of Employer A’s supplier, Employer A is not able to perform its operations. Under these facts and circumstances, Employer A would be considered an Eligible Employer because its operations have been suspended as a result of the governmental order that suspended operations of its supplier.
The key element of this FAQ is the acknowledgement that there may be circumstances under which an essential business is unable to perform its operations because the operations of a third party are suspended as the result of COVID-19-related government orders. The key takeaways are:
- identify vendors that have been affected by COVID-19-related government orders to suspend operations; and
- identify how those government orders have resulted in the essential business not being able to conduct specific activities within its business operations.
Demonstrating that an essential business has specific types of business activities that are affected by a vendor supply chain disruption would show that the essential business has been partially suspended. In contrast, according to FAQ 32, experiencing a reduced volume of business operations simply because customers are required to stay at home under governmental orders would not be viewed as partially suspending an essential business:
Example: Employer B, an automobile repair service business, is an essential business and is not required to close its locations or suspend its operations. Due to a governmental order that limits travel and requires members of the community to stay at home except for certain essential travel, such as going to the grocery store, Employer B’s business has declined significantly. Employer B is not considered to have a full or partial suspension of operations due to a governmental order. However, Employer B may be considered an Eligible Employer if it has a significant decline in gross receipts.
According to the FAQs, there is a nuanced distinction between (1) supply chain disruptions causing a suspension within part of the essential business operations and (2) reduced customer demand, which affects revenue but does not cause a partial suspension of operations. This distinction between “essential” and “nonessential” businesses is not in the statutory language of the CARES Act, and the distinction between governmental edicts that cause a partial suspension of the business because of reduced customer demand versus governmental edicts that cause a partial suspension of business operations because vendors are unable to perform does not seem well founded under the statute.
FAQ 32 appears inconsistent with the statute, which refers to the operation of a trade or business being “partially suspended . . . due to orders from an appropriate governmental authority limiting commerce, travel, or group meetings . . . due to the coronavirus disease 2019.” In the FAQ 32 example, the operations of the auto repair business have been affected by stay-at-home government orders. The resulting reduction in business will cause a partial suspension of the repair business activity, creating fewer working hours for employees.
It seems appropriate for the legislation to seek to keep the repair business employees voluntarily paid by their employer the same way that it seeks to keep the employees of a closed restaurant voluntarily paid by their employer. As noted, the statute simply links qualification to the identification of government orders limiting commerce, travel, or group meetings because of COVID-19. The distinction between customers or suppliers causing a suspension of operations appears arbitrary and contradictory to the intent of the law. Congress declared the purpose of the CARES Act as “providing emergency assistance and health care response for individuals, families, and businesses affected by the 2020 coronavirus pandemic.” It did not draw a distinction between businesses that were affected as the result of governmental orders affecting their suppliers, rather than their customers.
Even if a reduction in demand is insufficient to qualify as a partial suspension, the other possibility would be for the auto repair business in FAQ 32 to evaluate its qualification by considering potential direct and indirect effects on the business, such as: What government orders affected the auto repair business? Were limitations placed on operating hours? Was there any effect on the availability of parts to sell to customers? Were there travel restrictions limiting the ability to receive or make deliveries?
B. Effects on the Essential Business
Beyond customer demand, there are likely other effects that could qualify an essential business as an eligible employer. Because it’s difficult to apply all the qualifying criteria simultaneously, they can be reordered as:
- identify an order from government related to COVID-19 that limits (A) commercial activity, (B) travel, or (C) group meetings; and
- that partially suspends operations.
At a high level, there has been very little direct impact from COVID-19 on business. That is, the number of actual employees and customers suffering the effects of COVID-19 is relatively small compared with the total population. Most of the damaging effects on businesses have not been from the illness itself but rather from the government orders that have shut down or hurt almost every business, including essential businesses. Therefore, it may be more effective to start without a filter and focus on identifying all the COVID-19-related effects on the essential business. It is likely working from the bottom up — that is, the COVID-19-related effects on the business are related to government orders, not to the illness itself. This analysis could begin by reviewing the material segments of the business, posing these questions:
- What effect has COVID-19 had on the business?
- How was the COVID-19 impact connected to government orders?
- Will the connection between the government order and the COVID-19 impact qualify as a partial suspension of operations?
C. Locations That Are Partially Closed
Another path for essential business qualification would be to identify whether any facilities that remain open have been placed on some type of partial restriction because of government orders. FAQ 34 provides:
Yes. If an employer’s workplace is closed by a governmental order for certain purposes, but the employer’s workplace may remain open for other purposes, or the employer is able to continue certain operations remotely, the employer’s operations would be considered to be partially suspended.
Example 1: Employer D, a restaurant business, must close its restaurant locations to in-room dining due to a governmental order closing all estaurants, bars, and similar establishments for sit-down service. Employer D is allowed to continue food or beverage sales to the public on a carry-out, drive-through, or delivery basis. Employer D’s business operations are considered to be partially suspended due to the governmental order closing all restaurants, bars, and similar establishments to sit-down service.
Example 2: Employer E, a retail business, is forced to close its retail storefront locations due to a governmental order. The retail business also maintains a website through which it continues to fulfill online orders; the retailer’s online ordering and fulfillment system is unaffected by the governmental order. Employer E’s business operations would be considered to have been partially suspended due to the governmental order requiring it to close its retail store locations.
As these examples illustrate, an essential business may identify partially suspended activities by unbundling a partial suspension of the business elements that have been affected by COVID-19-related government orders. Similarly, an essential business may still be in operation but have a smaller workload because of government orders limiting the operations of its customers.
For example, a trucking company — an essential business — could be partially suspended because its customers have closed their physical locations in response to COVID-19-related government orders. All logistics and transportation businesses are likely to be indirectly partially suspended because of government orders affecting their customers or their customers’ suppliers. The trucking company might experience a partial suspension of its activity in servicing an auto factory if the automaker is shut down because it can’t obtain parts and other material from its suppliers.
D. Reduced Working Hours
Another path for an essential business qualification is to identify locations where operating hours may have been restricted. FAQ 35 provides:
Yes. An employer that reduces its operating hours due to a governmental order is considered to have partially suspended its operations since the employer’s operations have been limited by a governmental order.
E. Nationwide vs. Location Basis
Although not entirely clear, it appears that an essential business will be viewed as partially suspended if it can demonstrate that its operations are limited in some jurisdictions because of governmental orders, even if in other jurisdictions it’s an essential industry and not subject to the governmental edicts. FAQ 36 provides:
Is an employer that operates a trade or business in multiple locations and is subject to a governmental order requiring full or partial suspension of its operations in some jurisdictions, but not in others, considered to have a suspension of operations?
Yes. Employers that operate a trade or business in multiple locations and are subject to State and local governmental orders limiting operations in some, but not all, jurisdictions are considered to have a partial suspension of operations. Employers that operate a trade or business on a national or regional basis may be subject to governmental orders requiring closure of their locations in certain jurisdictions, but may not be subject to such a governmental order in other jurisdictions, including because it may be an essential business in some of those jurisdictions. To operate in a consistent manner in all jurisdictions, these employers may establish a policy that complies with the local governmental orders, as well as the Center for Disease Control and Prevention (CDC) recommendations and the Department of Homeland Security (DHS) guidance; in this case, even though the employer may not be subject to a governmental order to suspend operations of its trade or business in certain jurisdictions, and may merely be following CDC or DHS guidelines in those jurisdictions, the employer would still be considered to have partially suspended operations. Therefore, the employer would be an Eligible Employer with respect to all of its operations in all locations.
III. Qualifying Wages
Once it is established that an essential business has qualified as an eligible employer, the next step is to identify qualifying wages.
A. General Definition
To claim the retention credit, an essential business must identify the compensation paid to employees for hours that are unworked because of governmental orders. For this purpose, it is not entirely clear whether identifying any unworked but compensated hours of an eligible employer will qualify, or whether it is necessary to directly trace unworked hours to the partially suspended elements of the business. Ultimately, it may not be an important distinction if the employee is being compensated for unworked hours related to government COVID-19 orders.
CARES Act section 2301(c)(3) provides that for an eligible employer whose average number of fulltime employees (within the meaning of section 4980H) during 2019 was greater than 100, qualified wages are “wages paid by such eligible employer with respect to which an employee is not providing services due to circumstances described in sub-clause (I) or (II) of paragraph (2)(A)(ii).”
There are no regulations or other binding legal authorities that provide additional guidance to identify hours compensated for time that is not worked by employees. Thus, a reasonable approach based on the business-specific facts must be developed. The key factor is linking the reduction of work to a government order that caused a partial suspension in business. Once those activities are identified, a method must be developed to identify qualifying wages. The JCT report and the FAQs are the only source of guidance to date. Based on that guidance, qualifying wages should include two categories of compensated unworked hours:
- direct reduction of scheduled work hours; and
- reduced workload (compensated COVID-19 downtime).
B. Reduction of Work Hours
The JCT report provides an example of a direct reduction of scheduled work:
For example, if a restaurant that had an average of 150 full-time employees during 2019 meets the governmental order test, and the restaurant continues to pay kitchen employees’ wages as if they were working 40 hours per week but only requires them to work 15 hours per week, the wages paid to the kitchen employees for the 25 hours per week with respect to which the kitchen employees are not providing services are qualified wages. However, if the same restaurant reduces kitchen employees’ working hours from 40 hours per week to 15 hours per week and only pays wages for 15 hours per week, no wages paid to the kitchen employees are qualified wages.
FAQ 54 provides another example of compensation paid to employees whose work schedules have been directly reduced but who continue to be compensated. According to the FAQ, any reasonable method may be used to calculate hours for purposes of the retention credit, other than a calculation based on reduced productivity.
May an Eligible Employer that averaged more than 100 full-time employees during 2019 treat the wages paid to hourly and non-exempt salaried employees for hours for which they are not providing services as qualified wages for purposes of the Employee Retention Credit?
Yes. For an Eligible Employer that averaged more than 100 full-time employees in 2019, wages paid to hourly and non-exempt salaried employees for hours that the employees were not providing services would be considered qualified wages for the purposes of the Employee Retention Credit. For an employee who does not have a fixed schedule of work, the hours for which the employee is not providing services may be determined using any reasonable method. The method that the Eligible Employer would use to determine the employee’s entitlement to leave under the Family and Medical Leave Act (FMLA) would be a reasonable method for this purpose. Similarly, the method(s) that the Department of Labor has prescribed to determine the number of hours for which an employee with an irregular schedule is entitled to paid sick leave under the Families First Coronavirus Response Act (FFCRA) would be considered reasonable for this purpose. For more information, see Department of Labor’s Temporary Rule: Paid Leave under the Families First Coronavirus Response Act.
It is not reasonable for the employer to treat an employee’s hours as having been reduced based on an assessment of the employee’s productivity levels during the hours the employee is working.
Wages paid to the employees for hours for which they provided services are not considered qualified wages for purposes of the Employee Retention Credit.
When an employee’s work schedule has been reduced but the employee continues to be compensated for the unworked hours, it will be important to carefully review the employee’s activities to identify the proportion of compensation made by a reduced work schedule.
C. Reduction of Workload
The second qualifying category of qualifying wages is associated with reduced workload for employees who report to work but have downtime attributable to COVID-19 governmental orders that have caused a partial suspension of business activity. FAQ 54 provides an example:
FAQ 54 and FAQ 55 make it clear that the compensation paid to employees who have a reduced workload (downtime) because governmental orders have created a partial suspension of activity will include hourly employees, nonexempt salaried employees, and exempt salaried employees. FAQ 55 provides:
Yes. For an Eligible Employer that averaged more than 100 full-time employees during 2019, the wages paid after March 12, 2020, and before January 1, 2021, to exempt salaried employees for the time that they are not providing services would be considered qualified wages for purposes of the Employee Retention Credit. An Eligible Employer may use any reasonable method to determine the number of hours that a salaried employee is not providing services, but for which the employee receives wages either at the employee’s normal wage rate or at a reduced wage rate. Reasonable methods include the method (or methods) the employer uses to measure exempt employees’ entitlement to leave on an intermittent or reduced leave schedule under the Family and Medical Leave Act, or the method the employer uses to measure exempt employees’ entitlement to and usage of paid leave under the employer’s usual practices. It is not reasonable for the employer to treat an employee’s hours as having been reduced based on an assessment of the employee’s productivity levels during the hours the employee is working.
Example 1: Employer V, a large fitness club business that employed an average of more than 100 full-time employees in 2019, closed all of its locations in City B by order of City B’s mayor. Employer V continues to pay its exempt managerial employees their regular salaries. While the clubs are closed and there is not sufficient administrative work to occupy the managerial employees full-time, they continue to perform some accounting and similar administrative functions. Employer V has determined, based on the time records maintained by employees, that they are providing services for 10 percent of their typical work hours. In this case, 90 percent of wages paid to these employees during the period the clubs were closed are qualified wages.
Example 2: Employer W, a large consulting firm that employed an average of more than 100 full-time employees in 2019, closed its offices due to various governmental orders and required all employees to telework. Although Employer W believes that some of its employees may not be as productive while working remotely, employees are working their normal business hours. Because employees’ work hours have not changed, no portion of the wages paid to the employees by Employer W are qualified wages.
These examples illustrate the nuanced distinction between being less productive versus having less work to do. In Example 2 of FAQ 55, the consultants can continue to perform their work remotely and are not qualified even though they are less productive. However, would the employee wages qualify if the consulting firm could identify reduced work hours as the result of fewer consulting projects because its clients no longer have a budget for consulting projects? As noted earlier, it would seem consistent with the intent of the statute to encourage employers to retain salaried employees instead of cutting work hours and pay. Voluntarily paying nonexempt or exempt salaried employees appears to meet the statutory criteria if the reduced workload or work schedule is attributable to government orders that have caused a partial suspension in the business.
Essential businesses will have employees who continue to receive full-time compensation despite downtime related to COVID-19. Developing a reasonable method to identify the unworked hours, or an unworked ratio for affected categories of employees, attributable to the governmental orders causing a partial suspension of operations should allow an essential business to qualify for the retention credit.
An essential business should qualify as an eligible employer if it can demonstrate that it has been affected by COVID-19-related government orders that limit commercial activity, travel, or group activities. Although an essential business may generally be excluded from the scope of state and local orders, it should qualify as an eligible employer as the result of (1) direct government orders affecting its operations, and (2) indirect government orders affecting its customers’ operations.
Compensation paid by an eligible business to hourly employees, nonexempt salaried employees, and exempt salaried employees will qualify for:
- direct reduction of scheduled work hours; and
- reduced workload (COVID-19-related downtime).
And, as noted, employers will need to use reasonable methods to identify the compensation paid to employees who are not working because of COVID-19-related government orders.
Treasury, “Treasury Encourages Businesses Impacted by COVID-19 to Use Employee Retention Credit” (Mar. 31, 2020) (“‘We encourage businesses to take full advantage of the Employee Retention Credit to keep employees on their payroll during these challenging times,’ said Secretary Steven T. Mnuchin. ‘This new credit is available to all employers, regardless of size of business, and covers up to 50 percent of up to $10,000 in wages.’”).
Qualifying employers with fewer than 100 full-time-equivalent employees qualify for the retention credit on all wages. Employers that obtained Payroll Protection Program loans are not eligible for the retention credit.
CARES Act section 2301(a).
JCT, “Description of the Tax Provisions of Public Law 116-136, the Coronavirus Aid, Relief, and Economic Security (‘CARES’) Act,” JCX-12-20, at 31 n.17 (Apr. 22, 2020).
CARES Act section 2301(b)(1).
CARES Act section 2301(c)(2)(B).
CARES Act section 2301(c)(2)(A).
JCX-12-20, supra note 5, at 38 (“Under the first test (the ‘governmental order test’), such employer is an eligible employer if it experiences a calendar quarter in which the operation of the trade or business is fully or partially suspended during the calendar quarter due to orders from an appropriate governmental authority limiting commerce, travel, or group meetings (for commercial, social, religious, or other purposes) due to COVID-19.”).
See Department of Homeland Security Cybersecurity and Infrastructure Security Agency, “Advisory Memorandum on Identification of Essential Critical Infrastructure Workers During COVID-19 Response” (May 19, 2020) (listing workers in various industries who “conduct a range of operations and services that are typically essential to continued critical infrastructure viability,” including “workers who support crucial supply chains and enable functions for critical infrastructure”).
CARES Act, at 1.
IRS, supra note 12.
JCX-12-20, supra note 5, at 39.