IRS Moves Goal Posts on Employee Retention Credit for Partial Suspension

The employee retention credit is a refundable tax credit available to businesses that had either a significant decline in revenue (50% in 2020 or 20% in 2021) or that were fully or partially shut down due to government orders from Covid 19.

The IRS recently issued Notice 2021-20, which provided guidance on the changes to the law for the employee retention credit (ERC). This was very important because the credit was previously not available to businesses that took PPP loans. Most businesses chose PPP loans over the ERC. But, we needed rules to clarify exactly how the PPP worked with the ERC. The IRS did that well. (You can't use PPP payroll for the ERC. It's pretty straight forward.) The IRS also attempted to clarify the definition of a partial suspension of business. That was not as clear.

Who is eligible for the ERC? (Partial Suspensions of Business)

The rules regarding a decline in sales are straight forward. The rules for defining whether a business has been “partially suspended” were updated in a way that did not favor business owners. This is because the definition of "nominal" was changed to its dictionary meaning of "very small" to 10%ish (read on for an explanation).

First, let’s clarify the clearest way to qualify for a partial suspension of operations. All businesses that had a limitation of hours, whether due to an explicit curfew or other government limitation on hours, will qualify for the ERC. To be clear, if there was a curfew and your business was not affected by it because it is not normally open at that time, then you would not be eligible on that basis.

There are two other types of potential “partial suspensions of business operations:”: partial closures and business modifications. Previously, the IRS said that so long as the partial suspension or business modification had “more than a nominal effect on business operations,” then it qualified for the ERC. There was no test given for how to determine whether such a suspension or modification was more than nominal.

In the new guidance, the IRS provides a rule for determining if the suspension of business is more than nominal:

Partial Suspension of portion of Business: “A portion of an employer’s business operations will be deemed to constitute more than a nominal portion of its business operations if either 1) the gross receipts from that portion of the business operations is not less than 10% of the total gross receipts (both determined using the gross receipts of the same calendar quarter in 2019) or 2) the hours of service performed by employees in that portion of the business is not less than 10 percent of the total number of hours of service performed by all employees in the employer’s business (determined using the hours of service performed by employees in the same calendar quarter in 2019).”

We now know that when a portion of a business operation is shut down, that portion of the operation must account for either 10% of the gross receipts of the business or 10% of the total employee hours in the business. For example, if you are a restaurant owner in a jurisdiction where indoor dining was suspended, that government order will constitute a “partial suspension” if 10% or more of the revenue from the restaurant was from dine-in looking at the same quarter in 2019. Most restaurants have dine-in operations of 10% or more, so most would qualify under this standard for such a government order.

The big question that the IRS did not really clarify is how a business should deal with modifications that are required due to a government order. The best example is social distancing in a restaurant. Here is what the IRS says the rule is:

Modification of Business due to Order: “If all, or all but a nominal portion, of an employer’s business operations may continue, but the operations are subject to modification due to governmental order (for example, to satisfy distancing requirements), such a modification of operations is considered to be a partial suspension of business operations due to governmental order if the modification required by the governmental order has more than a nominal effect on the business operations under the facts and circumstances.”

The Notice goes on to give this example of a restaurant that had a modification of business to meet social distancing requirements.

The IRS says “this spacing constraint has more than a nominal effect on Employer F’s business operations.” What math did Employer F do to figure out that the spacing constraint has more than a nominal effect? That’s the question!

The IRS goes on to attempt to answer that question by saying “A governmental order that results in a reduction in an employer’s ability to provide goods or services in the normal course of the employer’s business of not less than 10 percent will be deemed to have more than a nominal effect on the employer’s business operations."

So, the reduction in the employer’s ability to run their business, must be not less than 10 percent. Ok, but not less than 10% of what? Is it 10 percent of the overall seats in the dining room? Is it 10% of the sales of the business? Also, how could anyone ever know what effect a restriction will have on business with such specificity?

Claiming the ERC: An Example

Let’s say we have three restaurants that faced the same following governmental orders:

- March 15 - May 31: No Indoor Dining Permitted

- June 1 – November 15: Indoor Dining Permitted, with 6 Feet Social Distancing

- November 16-December 31: 10pm curfew + Indoor Dining Permitted, with 6 Feet Social Distancing

Restaurant A is a fine dining establishment without a patio that does not offer take out. Restaurant B is a quick service restaurant with a 50/50 mix of take out and dine-in. Restaurant C is a fast food restaurant that is only a drive thru and has no dining room.

During the indoor dining ban, Restaurant A and Restaurant B would qualify for the ERC because indoor dining constitutes more than 10% of the revenues of each business looking at the same quarter in 2019. For Restaurant C, however, since it has no dining room, the indoor dining ban would not have more than a 10% impact on its sales.

Let’s go to the curfew period next and come back to the social distancing. Restaurants A and B normally close at 10pm anyway. So, Restaurants A and B would not qualify because of the curfew (although they may qualify because of continued social distancing). Restaurant C (the drive thru) closes at 1am. The drive thru would qualify for the ERC during this period.

Now, we get to the challenging one: do the restaurants qualify for the ERC during the period of time when the only restriction was to observe 6 feet social distancing for indoor dining, which would require the blocking or removal of some seats. The rule is that it must reduce the employer’s ability to operate the restaurant by more than 10%. 10% of what, we don’t really know.

Restaurant C is out on this one because they have no indoor dining. Restaurant A, which has 100% dine-in normally would certainly qualify. Restaurant B, the one with the 50/50 mix is a closer question. In theory, if 50% of the sales are dine in, and you have to remove 50% of the seats in the dining room, then 50% X 50% = 25% effect on the business. Is it that simple? If it is, why didn't the IRS just explain it like that? What if Restaurant B instead had a third indoor dining, a third delivery and a third take out? Now, the indoor dining limitation is more like 16.5%. Is that cutting it too close to the 10%?

The Bottom Line

If you believe that you are eligible for the ERC due to a partial suspension of business operations, you have to be able to articulate why you qualify. We have a generally good idea about how the law works, but when it comes to a modification of business operations, we do not know what the IRS is looking at when they say a “10% reduction in employer’s ability to provide goods and services.”

On one hand, it is scary to claim a tax credit that the IRS could make you repay under threat of criminal prosecution. There is some risk to claim the ERC based solely on social distancing requirements given the lack of clear guidelines by the IRS.

On the other hand, all throughout the examples, the IRS goes out of its way to mention restaurants having to limit seating due to social distancing – and in each case the IRS finds that the social distancing limitation did have more than a nominal effect on the restaurant. And, if it turns out to be the case that most restaurants like yours claim the ERC due to social distancing and you don’t, you have made a high stakes error, leaving tens of thousands of dollars on the table.

My advice is to start to look at your reasons for eligibility for the ERC and to document each reason. If you decide to claim the ERC for social distancing requirements as a restaurant, make your best argument on paper and have it ready for the IRS if they come knocking one day. That’s the best you can do with the information we have right now.