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Determining Whether a Business Qualifies Can Be Complicated

By Scott Foster & Jacob Kosakowski

 

Scott Foster

Scott Foster

Jacob Kosakowski

Jacob Kosakowski

Business owners have been bombarded recently with solicitations from firms offering to help them realize millions of dollars through the IRS’s Employee Retention Credit (ERC) program, which was included in the CARES Act adopted in the early phases of COVID-19. The CARES Act also contained the popular, and well-documented, Paycheck Protection Program (PPP), with forgivable loans that kept many businesses afloat.

Originally, if a business received a PPP loan, it was not eligible to receive ERC. The initial IRS guidance on this could not have been more clear: “an employer may not receive the Employee Retention Credit if the employer receives a PPP loan that is authorized under the CARES Act. An Eligible Employer that receives a PPP loan, regardless of the date of the loan, cannot claim the Employee Retention Credit.”

However, subsequent legislation, namely the Taxpayer Certainty and Disaster Tax Relief Act of 2020, enacted Dec. 27, 2020; the American Rescue Plan Act (ARPA) of 2021, enacted March 11, 2021; and the Infrastructure Investment and Jobs Act, enacted Nov. 15, 2021, greatly expanded eligibility for ERC.

While some of these firms are offering legitimate services and will help businesses file accurate and legitimate claims for ERC, business owners should proceed with extreme caution due to several factors: the very complex rules regarding eligibility for an ERC, the IRS’s near-automatic acceptance of these filings (and payment of the credit, of which the firm usually collects 25% or more), the very strong likelihood that these filings will be audited in years to come (the IRS has up to five years to audit ERC returns), and the equally strong likelihood that the less-reputable ERC firms will have closed their doors and have liquidated all assets before those audits are completed, leaving the business holding the proverbial bag for tax penalties, fines, and interest.

“Perhaps the most complicated facet of determining eligibility under ERC relates to how its provisions interact with the Internal Revenue Code’s special aggregation rules for businesses.”

The IRS issued a warning on Oct. 19, 2022, stating that some firms “are taking improper positions related to taxpayer eligibility for and computation of the credit.” The IRS warning goes on to explain that firms “often charge large upfront fees or a fee that is contingent on the amount of the refund and may not inform taxpayers that wage deductions claimed on the business’ federal income-tax return must be reduced by the amount of the credit.”

Determining whether a business qualifies for ERC can be quite complicated. If the business was fully or partially suspended due to a governmental order limiting commerce, travel, or group meetings related to COVID, then it may qualify for the time during which it was so suspended. If the business was not suspended but suffered a “significant decline in gross receipts,” it may also qualify. A significant decline in gross receipts is measured on a quarterly basis, comparing 2020 quarterly receipts to 2019 quarterly receipts (50% or greater decline), 2021 quarterly receipts to 2019 (20% or greater decline), or Q4 2020 receipts to Q4 2019 receipts (20% or greater decline).

Perhaps the most complicated facet of determining eligibility under ERC relates to how its provisions interact with the Internal Revenue Code’s special aggregation rules for businesses. Under the aggregation rules, multiple businesses may be combined into an ‘aggregated group’ based on common ownership, where all employees of an aggregated group will be treated as employed by a single employer. The members of an aggregated group are determined based upon the stock or membership interest ownership of a business entity. If multiple businesses are comprised of similar ownership, those businesses might be combined into an aggregated group.

The ownership of a business might be comprised of individuals, trusts, partnerships, or corporations. The ownership composition of a potential aggregated group must be closely examined because the aggregation rules and thresholds will differ based on whether the group consists of corporations, LLCs, or partnerships. Further, the relationship of individuals to one another will also impact how the aggregations rules operate.

By way of example, imagine three individuals: Alice, Brady, and Carol. Each own a one-third interest in each of Alpha LLC, Bravo LLC, and Charlie LLC. Under the aggregation rules, the three LLCs would form an aggregated group, known as a ‘brother-sister controlled group,’ based on their common ownership structure. All employees of all three LLCs would be treated as employed by a single employer. As another example, now assume that Alice and Brady own a one-half interest in Alpha LLC, Brady and Carol own a one-half interest in Bravo LLC, and Carol and Alice own a one-half interest in Charlie LLC. Under the aggregation rules, none of the LLCs would form an aggregated group with each other because any potential aggregated group would not meet the requisite ownership threshold requirements.

An aggregated group will impact how the members of such group are treated under the ERC provisions. Most notably, the aggregation rules affect the determination of a business’ average number of full-time employees, as well as what constitutes a ‘significant decline’ in gross receipts among members in an aggregated group. The aggregation rules also impact how suspensions due to governmental orders are enforced among members of an aggregated group. Businesses should consider carefully examining their ownership compositions so beneficial business aggregations are not missed.

And remember, if it sounds too good to be true, it likely is.

 

Scott Foster chairs Bulkley Richardson’s Business/Finance Department, and Jacob Kosakowski is an associate in the firm’s Trusts & Estates Department.

Banking and Financial Services

More Relief from the CARES Act

By Lisa White

On March 27, the Coronavirus Aid, Relief, and Economic Security (CARES) Act was signed into law. Since its inception, much of the focus has been on the establishment of additional funding sources, such as the Paycheck Protection Program (PPP), or on the creation of new tax credits, such as the Employee Retention Credit.

However, the act also made some significant revisions to existing tax law to provide additional relief to affected businesses. This article takes a closer look at two of these provisions and delves into how the related benefits associated with the changes might be derived.

Technical Correction for Qualified Improvement Property

The Protecting Americans from Tax Hikes (PATH) Act of 2015 created a new category of asset called ‘qualified improvement property’ or QIP. This term referred to any improvement to an interior portion of non-residential real property, but excluded expenditures for elevators or escalators, enlargements, and interior structural components. Although this category of asset technically had a 39-year cost-recovery period, it was specifically identified as being eligible for bonus depreciation.

When the Tax Cuts and Jobs Act (TCJA) was signed into law at the end of 2017, the intention was to assign a shorter, 15-year recovery life to qualified improvement property, thus ensuring its eligibility for the enhanced 100% bonus depreciation provision also included in the TCJA. Unfortunately, the necessary wording was not included in the final bill, resulting in qualified improvement property retaining its 39-year cost-recovery period, but excluding it from being eligible for bonus depreciation.

Lisa White

Lisa White

“With proper planning and timely tax-advisor consultation, realizing additional relief during these unprecedented times can be achieved.”

Not only did the CARES Act include the technical correction necessary for QIP to have its originally intended 15-year cost-recovery period, but the correction was directed to apply retroactively to all eligible assets placed in service after Dec. 31, 2017.

Then, in mid-April, the IRS provided guidance on how to capture this additional benefit from the change in the depreciable life and the possible eligibility for bonus depreciation. Primarily, the two methods are to either file amended returns for the impacted year(s) or to file a Change in Accounting Method (Form 3115), which allows a ‘catch-up’ for the differences in the recovery periods and applicable depreciation methods.

Here’s an example: A business holds commercial rental property and operates on a Dec. 31 year-end. On July 15, 2018, the business incurred expenses of $150,000 in costs that meet the QIP definition. Assume Section 179 expense was not taken. Due to the technical error in the law, only $1,763 of depreciation expense was allowed in 2018, and $3,846 of depreciation expense would be allowed in 2019. With the technical correction, bonus depreciation can now be taken on the entire amount of the qualified improvement property even though it was placed in service in 2018:

• If the 2019 tax return has already been filed, an amended return should be filed for both the 2018 and 2019 tax years. Taxable income in 2018 will be reduced by the additional $148,237 ($150,000 – $1,763) of accelerated depreciation expense, and taxable income in 2019 will be increased by the removal of the $3,846 of depreciation expense originally recognized.

• If the 2019 tax return has not yet been filed, filing a Form 3115 might provide the easier option. Instead of filing two years of returns, only the 2019 tax return is filed, and the $148,237 of additional accelerated depreciation expense not captured in 2018 is included in the 2019 tax return as a section 481(a) adjustment.

It is important to note that there are certain circumstances where either an amended return or an administrative adjustment request (AAR) must be filed. It is important to consult with your tax advisor to determine the best course of action.

Changes to the Business Interest Limitation

Although most of the provisions enacted as part of the TCJA were intended to be favorable to taxpayers, some new components had the opposite effect. One of these was the revision and expansion of the business-interest-limitation rules. If subject to the new rules, the regulation essentially limited the amount of business interest expense to 30% of taxable income adjusted for, among other things, depreciation.

The interest expense in excess of this 30% threshold would not be deductible in the current year but would instead be carried forward to the following tax years.

The TCJA also included an option for certain businesses to elect out of having this regulation apply. Instead, these businesses that met the definition of a ‘real property trade or business’ could make an irrevocable election to realize a longer recovery period for the cost of real property and to forego any bonus depreciation that would otherwise be allowed on that real property.

Prior to the retroactive change under the CARES Act, the differences in the recovery periods were not substantial, and none of the real property was eligible for bonus depreciation. However, with the CARES Act’s retroactive fix to qualified improvement property, that property is now eligible for bonus depreciation. The loss of being able to take that accelerated depreciation, in addition to another CARES Act provision increasing the limitation threshold from 30% to 50% (for all businesses except partnerships) for 2019 and 2020, might now result in the impact of the irrevocable election having an undue, unfavorable result.

To provide relief to those businesses that made the irrevocable election and that could now benefit from the shorter recovery period, and the applicable depreciation methods, the IRS has issued guidance that provides for the irrevocable election to be rescinded for tax years 2018 or 2019. This is accomplished by filing an amended return for the year the election was made. If 2018 was the election year, and 2019 has already been filed, 2019 must be amended as well to reflect any changes to taxable income resulting from withdrawing the election.

So, What Now?

The CARES Act provides several relief provisions, including a number that can be realized through proper tax planning. Owners of non-residential (i.e. commercial) real property should review any expenditures that were capitalized in 2018 and 2019 to see if any of these costs can be realized now under the new qualified improvement property measures.

Also, it would be prudent to review any elections made during those tax years that might need to be revisited to make sure those elections still result in the most favorable tax position.

As with most things related to the tax code, the final answer is usually complex and nuanced and somewhere in the grey. But with proper planning and timely tax-advisor consultation, realizing additional relief during these unprecedented times can be achieved.

Lisa White, CPA is a tax manager at Holyoke-based accounting firm Meyers Brothers Kalicka, P.C.; (413) 536-8510.