On Wednesday, the IRS released extensive new guidance in the form of frequently asked questions (“FAQs”) on the IRS website addressing various aspects of the employee retention credit.  This is the third in a series of articles addressing various aspects of these FAQs.  This article addresses the determination of qualified wages and allocable qualified health plan expenses.  Our first article discussed the IRS’s interpretation of the aggregation rules under section 2301(d) of the CARES Act and the determination of employer eligibility based on a full or partial suspension of operations due to a government order.  Our second article focused on employer eligibility for the credit based on a significant decline in gross receipts.  Subsequent articles will address issues related to the income and deduction treatment of qualified wages for employees and employers and issues related to the use of third-party payers.  Before the release of the IRS FAQs, we addressed how employers can claim the employee retention credit and its interaction with the deferral of employer social security tax deposits (see earlier article).

Although employers should carefully consider the FAQs, they should be mindful that these FAQs are not binding guidance but instead represent the current thinking of the IRS on the employee retention credit.

Background

Q&A-48 clarifies “qualified wages” for purposes of the employee retention credit as wages (as defined in section 3121(a) of the Code) and compensation (as defined in section 3231(e) of the Code), paid by an eligible employer to some or all of its employees after March 12, 2020, and before January 1, 2021.  Some practitioners had expressed concern that amounts in excess of the OASDI wage base ($137,700 in 2020) were excluded from qualified wages, but the FAQs make clear that the wage base is not applicable for purposes of determining the amount of qualified wages.  As discussed further below, qualified wages also include qualified health plan expenses allocable to wages.

As set forth in the text of the CARES Act, the size of the eligible employer will affect which wages are considered qualified wages—for eligible employers that averaged more than 100 full-time employees in 2019, qualified wages are those wages paid for time that an employee is not providing services either due to (1) a full or partial suspension of the eligible employer’s business operations by governmental order or (2) the business experiencing a significant decline in gross receipts (collectively referred to herein as a “qualifying event”).  For an eligible employer that averaged 100 or fewer full-time employees in 2019, qualified wages are all wages paid during any calendar quarter impacted by a qualifying event.

Counting Full-Time Employees

Determining the size of the eligible employer is critical to understanding how an eligible employer should calculate qualified wages.  Q&A-49 provides guidance on how to calculate the average number of full-time employees in 2019:

  • The CARES Act defined a full-time employee by reference to section 4980H of the Internal Revenue Code. Q&A-49 explains that a full-time employee means an employee who with respect to any calendar month averaged 30 hours of service per week or 130 hours of service per month, as determined in accordance with section 4980H of the Code.
  • For an eligible employer that operated for the entire 2019 calendar year, the average number of full-time employees equals the sum of all full-time employees in each month, divided by 12.
  • A similar calculation is involved for an eligible employer that started its business in 2019. The eligible employer should calculate the number of section 4980H full-time employees in each full calendar month in which the eligible employer operated its business, and then divide by the number of full calendar months of operation.  Based on this guidance, if an eligible employer started operations mid-month, that month should not be taken into consideration for purposes of determining the number of full-time employees in 2019.
  • If an eligible employer started its business in 2020, the number of full-time employees equals the sum of all full-time employees in each full calendar month in 2020 in which the eligible employer operated its business, divided by the number of full calendar months of operation.

As more fully discussed in a prior blog post, certain aggregation rules apply to the employee retention credit.  Q&A-50 emphasizes that these aggregation rules apply for all purposes, including the determination of the average number of full-time employees.  Therefore, employers required to be aggregated under section 2301(d) are treated as a single employer for purposes of determining the number of full-time employees.  For example, assume that two employers each employed an average of 75 full-time employees in 2019.  If the aggregation rule applies, those employers would be treated as a single employer with an average of 150 full-time employees in 2019 for purposes of the employee retention credit.

Qualified Wages

For an eligible employer that averaged 100 or fewer employees during 2019, Q&A-51 reiterates that qualified wages are all wages paid after March 12, 2020, and before January 1, 2021, during any calendar quarter impacted by a qualifying event (i.e., a full or partial suspension of the eligible employer’s business operations by governmental order or the business experiencing a significant decline in gross receipts) subject to a $10,000 maximum per employee for all calendar quarters.

As explained above, for an eligible employer that averaged more than 100 employees during 2019, calculating qualified wages is more complicated—qualified wages are those wages paid for time that an employee is not providing services. Q&As 52-55 set forth a number of rules for helping this class of eligible employers determine qualified wages:

  • Q&A-53 explains that for these larger employers, qualified wages may not exceed what the employee would have been paid for working an equivalent duration during the 30 days immediately prior to the qualifying event. For a variable hour employee, the IRS explains that an eligible employer may use any reasonable method to determine the average hours (including the methods prescribed by the DOL to determine the amount of pay to which an employee with an irregular schedule is entitled under the Families First Coronavirus Response Act).  The FAQ makes clear that this is not a cap on qualified wages, but is a rate of pay provision.  An employer cannot pay the employee at a higher rate of pay than he or she was being paid before the pandemic and claim a credit with respect to the increased pay (a credit may still be claimed for the rate of pay in effect prior to the pandemic).  It is not clear how the hourly restriction should be applied to seasonal employees who were hired before the pandemic, but whose work began shortly before or after the governmental order or decline in gross receipts made the employer eligible for the credit.  Presumably, an employer could use historical work history during the same time period to support its determination of average hours.
  • In Q&As 54 and 55, the IRS explains that an eligible employer may not treat an employee’s hours as having been reduced based on a determination that the employee is less productive. As an example, the IRS describes a large employer whose employees are required to telework following the forced closure of its office by government order.  Although the eligible employer believes that its employees may be less productive, so long as employees continue to work the same number of hours, no portion of the wages paid may be counted as qualified wages.
  • In Q&A-54, the IRS has provided the following examples as methods available to an eligible employer in calculating qualified wages:
    • for employees not providing any services due to closure of a work location, but who are still receiving all or a portion of wages, qualified wages would equal any wages paid—for example, if a location is closed due to a governmental order and a business continues to pay 50 percent of wages to employees not providing services, qualified wages would be equal to the wages paid;
    • for employees working a reduced schedule but receiving full pay, qualified wages would equal wages paid for hours not worked—for example, if hours were reduced by 40 percent, but the employee continues to receive full wages, qualified wages would equal the 40 percent of wages representing hours not worked;
    • if the eligible employer determines that employees are working a reduced schedule (it is not explained how the eligible employer should go about making this determination), qualified wages equal the difference between wages paid and hours actually worked—for example, if employees continue to receive full pay, but the eligible employer determines the employee is only working 20 percent of the time, the eligible employer is entitled to treat 80 percent of the wages paid as qualified wages.
  • Q&A-54 also makes clear that if there is a partial suspension of business due to governmental order, wages paid to employees working in a location not subject to closure may be qualified wages. In other words, once a governmental order results in a partial suspension of an employer’s business (or that of another employer with which it is required to be aggregated based on Q&A-37), any wages paid to employees nationwide who are not working are qualified wages for which the employer can claim a credit.
  • In Q&A-55, an eligible employer may use any reasonable method to determine the number of hours that a salaried employee is not providing services. Such reasonable methods include the method the eligible employer uses to measure exempt employee entitlement to leave on an intermittent or reduced leave schedule under the FMLA or the method used to measure entitlement to and usage of paid leave under the eligible employer’s usual practices.  Meanwhile, to determine the number of hours worked, the IRS suggests that an eligible employer could calculate qualified wages by reviewing time records maintained by employees.  Many companies do not maintain time records for exempt employees, however.  It is therefore unclear whether such eligible employers would be permitted to implement a time-tracking policy now, and, if so, how such a time tracking system should be implemented.  For example, is it sufficient for a supervisor to survey employees about the percentage of time they are engaged or must each employee independently track and report hours worked to the employer?

For an eligible employer that averaged more than 100 full-time employees in 2019, Q&A-56 clarifies that qualified wages do not include wages paid to employees pursuant to a pre-existing leave policy, since such policies represent benefits accrued during a prior period in which the employee provided services.  However, if an eligible employer averaged 100 or fewer full-time employees in 2019, qualified wages will include the payment of pre-existing leave.

Meanwhile, Q&A-57 takes the position that qualified wages do not include payments made to a former employee, such as severance payments.  Rather, the IRS explains that payments are considered qualified wages only if the payment is made to an employee who continues to be employed.  This rule with respect to severance is in contrast to the rule for furloughed employees —if an eligible employer continues to pay furloughed employees for a period of time and then terminates the employment relationship, the FAQs indicate that qualified wages would include amounts paid during the length of the furlough.  The distinction between current and former employees is not well-grounded in the statute.  The term “qualified wages” is defined by reference to wages as defined in section 3121(a) of the Code.  Treasury Regulations § 31.3121(a)-1(i) is clear that remuneration for employment constitutes wages for purposes of section 3121(a), regardless of whether the amount is paid after termination of employment.  As support for its position, the IRS cites the Supreme Court’s decision in U.S. v. Quality Stores, Inc., 572 U.S. 141 (2014), which somewhat paradoxically held that severance payments were in fact wages for purposes of section 3121(a).  The IRS seems to be suggesting that the severance payments are made for services previously performed by the employer, similar to the analysis for pre-existing leave accruals.  That position is significantly weaker, however, if the severance program was gratuitously implemented by the employer in response to the pandemic and the governmental orders that it triggered.  For example, if an employer has no standard severance policy and does not routinely provide severance, the argument that the employees earned the severance for prior service seems disingenuous.  Moreover, that argument could seemingly be applied to any payments made to employees who are not performing services.  There is generally no obligation that the employee perform services in the future and, by definition, the payments are not for the current performance of services.

Allocable Qualified Health Plan Expenses

Under Section 2301(c)(3)(C) of the CARES Act, qualified wages include qualified health plan expenses paid or incurred by an eligible employer that are allocable to such wages.  For example, 50% of qualified health plan expenses would be treated as qualified wages if an employee for whom 50% of the wages are paid are qualified wages.  Q&As 62-72 provide additional insight into how eligible employers should calculate qualified wages attributable to these qualified health plan expenses.

Specifically, Q&A-62 explains that qualified health plan expenses are the amount of expenses allocable to the hours for which an employee receives other qualified wages.  In other words, to be includable as qualified wages, qualified health plan expenses must be in addition to other qualified wages paid to the employee.  Qualified health plan expenses include the portion of costs paid by the eligible employer as well as the portion of costs paid by the employee with pre-tax salary contributions.  Qualified health plan expenses do not include amounts that the employee paid for with after-tax contributions, however.

As Q&As 64-66 explain, the IRS is taking the position that an eligible employer must pay some qualified wages in addition to qualified health plan expenses to take advantage of the credit.  For example, an eligible employer that pays furloughed employees 25 percent of their wages and 100 percent of the costs of providing health care coverage, can claim the credit against the 25 percent of wages, as well as the 100 percent costs associated with providing health care coverage, because both amounts constitute qualified wages.  However, if an employee has been furloughed and is not receiving any wages, the eligible employer cannot claim a credit even if the eligible employer has decided to fully cover the costs of providing health care coverage.  A straightforward reading of the Q&As suggest that all qualified health plan expenses for furloughed workers could be includable where an eligible employers pays a small or even de minimis wage to such employees.  For example, if an eligible employer pays furloughed workers a wage of $1 per week in addition to fully covering the costs of providing health care coverage, would both amounts be treated as qualified wages?  Would the extension of group-term life insurance in excess of $50,000, which is imputed as wages to the employee, to furloughed workers result in all qualified health plan expenses for those workers being qualified wages?  It would seem that both approaches may work.  As such, employers of furloughed workers who have extended health benefit coverage should consider providing cash or fringe benefits required to be included in wages for FICA tax purposes to furloughed employees, because the cost of doing so would likely be far less than the value of the credit for qualified health plan expenses.  UPDATE: On May 7, the IRS revised it FAQs to change the treatment of health plan expenses paid or incurred to provide health benefits to furloughed employees. (See update.)

Q&As 68-69 outline reasonable methods that an eligible employer may use to allocate qualified health plan expenses to qualified wages on a pro rata basis.

  • Fully-Insured Group Health Plans. For an eligible employer sponsoring a fully-insured group health plan, any reasonable method may be used to determine and allocate plan expenses, including the following: (1) the COBRA applicable premium for the employee typically available from the insurer, (2) one average premium rate for all employees, or (3) a method that takes into account the average premium rate determined separately for employees with self-only and other than self-only coverage.
  • Self-Insured Group Health Plan. An eligible employer sponsoring a self-insured group health plan may use any reasonable method to determine and allocate health plan expenses, including the following: (1) the COBRA applicable premium for the employee typically available from the administrator or (2) any reasonable actuarial method to determine the estimated annual expenses of the plan.