Accounting Considerations for Employee Retention Tax Credits
Throughout 2020, Congress released numerous pieces of legislation designed to lessen the impact of the COVID-19 disruption, particularly for organizations that struggled to maintain their headcounts. One provision involved a refundable credit that organizations could apply against qualified wages and certain health insurance costs ? the Employee Retention Tax Credit (ERTC).
The ERTC became an even more appealing option when year-end stimulus legislation allowed it to be combined with the Paycheck Protection Program. It has subsequently received an extension to cover 2021 disruption. This combination of factors raises some important questions about how to account for the ERTC. We have compiled a brief primer below that may help your organization understand its options.
Quick Recap of ERTC Mechanics and Its Legislative Evolutions
The Coronavirus Aid, Relief, and Economic Security (CARES) Act, passed in March 2020 first authorized the tax credit for use between March 12, 2020, and Jan. 1, 2021. Under the CARES Act, organizations that experienced either a full or partial suspension of the operation of their trade or business during any calendar quarter because of governmental orders limiting commerce, travel or group meetings due to COVID-19, or a significant decline in gross receipts could apply for an ERTC credit. For 2020, an employer generally qualified if gross receipts in a calendar quarter of 2020 were below 50% of gross receipts for the same calendar quarter in 2019. However, an employer would become ineligible if in the preceding 2020 quarter its gross receipts exceed 80% as compared to the same calendar quarter in 2019.
For 2020, ERTCs were worth 50% of wages and certain healthcare costs up to $10,000 per eligible employee. Organizations with more than 100 employees could use the credit for employees not currently providing services due to COVID-19-related disruptions or declines in business. Organizations with 100 or fewer employees could use the credit for all employees, regardless of whether the employees were providing services.
Subsequent to the CARES Act, several pieces of legislation authorized and expanded applicability and amount of the ERTC. The Consolidated Appropriations Act, 2021 (the Act) passed in December 2020 enabled employers that received Paycheck Protection Program (PPP) loans to also take advantage of the ERTC to expenses not being covered by PPP loan proceeds.
Under the Act, eligible employers could take credits up to 70% of qualified wages and also expanded the all-employee limit from 100 to 500 for 2021. Rather than $10,000 total, the ERTC limit became $10,000 per employee per quarter for the first two quarters of 2021. To use the ERTC in 2021, organizations will have to experience at least a 20% drop in gross receipts in the quarter compared to the same quarter in 2019.
The ERTC received an additional modification with March 2021’s American Rescue Plan (ARP) Act. The ARP Act expanded the credit to be 70% of qualified wages through every quarter in 2021. Entities could determine eligibility by comparing gross receipts in the immediately preceding calendar quarter (rather than the corresponding quarter in 2019).
Bottom line: accounting for ERTCs will affect 2020 and 2021 financial statements for many organizations. The changes made subsequent to the passing may also mean that organizations that were not eligible for the credit in 2020 may be eligible in 2021.
Challenges to Accounting
For-profit entities in particular may have difficulty determining how to account for funds received through the ERTC. When assessing the appropriate accounting model to use, entities should first understand that the ERTC is operated through a refund of payroll taxes and not income taxes. Therefore ERTC is not subject to ASC Topic 740 Income Taxes. In addition, unlike the PPP, the ERTC is structured as a refundable credit and not a loan. This is true even in the case of an entity receiving an advance on their credit. Because the ERTC has a different structure, it would not be accounted for under ASC Topic 470 Debt. Since the ERTC is not an income tax and not debt, generally most entities would consider the ERTC a form of government grant when determining which accounting models may be appropriate.
Similar to the accounting PPP loans, the accounting options of an entity will depend on whether they are for-profit or not-for-profit entity. For-profit entities should account for the ERTC as a government grant by analogy to either ASC Subtopic 958-605 (Subtopic 958-605) or International Accounting Standards 20 (IAS 20). If your organization received a PPP loan and used either Subtopic 958-605 or IAS 20, it would be expected to apply the same method to the ERTC.
U.S. GAAP specifies that a not-for-profit entity accounts for a government grant under Subtopic 958-605 and therefore not-for-profit entities would apply that accounting model, including disclosure and presentation requirements. A not-for-profit entity would not be able to elect to analogize to IAS 20.
Considerations if Using ASC Subtopic 958-605
A for-profit entity that elects to apply the guidance in Subtopic 958-605 would consider the ERTC as a nonexchange transaction with a governmental entity that is accounted for as a conditional contribution. Organizations have to meet certain conditions in order to claim the credit: for example, the entity experiences a decline in gross receipts and uses the credit against qualifying payroll and health care costs.
If your organization receives the ERTC as an advance, it will record a liability for the cash received until such time that the conditions to earn the credit are substantially met. When conditions are met, a not-for-profit entity is required to record the income as revenue, while a for-profit entity may record the amount as grant revenue or other income. Subtopic 958-605 does not permit an entity to net the grant against qualifying costs. For example, if you received an advance of $5,000 and are eligible for a 50% credit, your organization would recognize $5,000 of other income upon paying $10,000 in qualifying wages or health insurance costs, assuming all other conditions are substantially met.
Accounting under Subtopic 958-605
The evaluation of whether all conditions are substantially met will require the use of judgment. Uncertainty regarding whether an entity qualified for a refund would generally indicate that the conditions were not substantially met at period end. Since the accounting model under Subtopic 958-605 requires that substantially all conditions are met to recognize the grant into income, entities will also need to consider whether preparing and submitting the filing is a more than administrative task.
Under Subtopic 958-605, your organization would present the amount of a refund receivable or an unearned refund advance as a current asset or liability. Your statement of cash flows should include the changes in the balances of the receivable or advance liability as a change in current assets or liabilities within the operating activities section. Disclosures should include information about the accounting model applied, significant terms of the program, and a description of the relevant line items and amounts recognized within financial statements. When amounts have not been recognized because conditions have not been substantially met, these conditions should be disclosed. This includes any amount expected to be received and any amounts recognized on the balance sheet if estimable.
Considerations if Using IAS 20 for ERTC Accounting
IAS 20 would account for the ERTC as a grant related to income. Entities recognize grants related to income by using a systematic basis over the periods in which the organization recognizes the expenses for which the grant is intended to compensate. Put another way, the full grant is not recognized upon receipt but over the period of benefit (March 12-Dec. 31, 2020) or for 2021, on a quarterly basis.
Accounting under IAS 20
If using IAS 20 for your ERTC accounting method, your organization will need to estimate the amount of the tax credit it is expected to retain. This estimation includes the evaluation of whether your organization has “reasonable assurance” (the IAS equivalent of U.S. GAAP’s “probable” criteria) that it will comply with the conditions of the program and that the credit will be received. Reasonable assurance is generally considered a lower threshold than the “substantially met” threshold that applies under Subtopic 958-605.
Organizations that go through their reasonable assurance evaluation and are uncertain about whether they comply with the ERTC requirements as of the financial statement period end will recognize the amount of the ERTC received as a liability until the reasonable assurance criteria assertion has been met.
Based upon your organization’s accounting policy election, the gain recognized for the ERTC benefit may be reported either net of the expenses for which the ERTC is intended to compensate or on a gross basis. If your organization has previously adopted an accounting policy for reporting similar programs (such as PPP loans), that policy is expected to be applied consistently.
One of the largest changes in the Act passed in December 2020 was permitting entities that received a PPP loan to also be permitted to receive the ERTC if certain conditions are met. Calendar year end organizations applying Subtopic 958-605 or IAS 20 that received a PPP loan and retroactively claim the ERTC as a refund for qualifying expenses paid would assess whether the receipt of the refund is a recognized subsequent event. Considerations include whether the criteria for receipt of the ERTC were met as of the calendar year end. Judgment will be involved to determine whether criteria were met.
Organizations that were eligible for a refund but issued 2020 calendar year end financial statements before applying for the refund will need to evaluate facts and circumstances to determine if it is appropriate to account for the refund on a prospective basis in 2021.
If your organization only qualifies for the ERTC on a go-forward basis because of the changes made by the ARP Act, you would account for the ERTC as an unrecognized subsequent event because your organization was not eligible for the program on its calendar year end balance sheet date.
Regardless of the decision of which method is used to account for ERTC, the financial statements will need to include disclosures about the accounting method applied, significant terms of the programs, a description of the relevant line items and amounts recognized in the financial statement.
For More Information
For more information about accounting considerations for the ERTC, please contact a member of our team. Published on May 18, 2021