On March 10, 2021, the House passed the fifth major COVID-relief legislation, the American Rescue Plan Act (the “Act”), which it originally passed last week before its amendment and passage by the Senate on March 6.  President Biden is expected to sign the Act on Friday, March 12, 2021.

The Act adopts a new payroll tax credit that is similar to the employee retention credit, which was originally enacted as part of the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) and amended by the Consolidated Appropriations Act, 2021 (the “CAA”).  The new credit will be in effect from July 1, 2021, through December 31, 2021.  In addition, the Act significantly increases the exclusion for employer-provided dependent care assistance for 2021, and makes prospective changes to extend the availability of paid leave credits similar to those originally adopted as part of the Families First Coronavirus Response Act (the “FFCRA”) and that are set to expire on March 31.  Finally, the Act will extend the deduction limitation under section 162(m) to additional employees.

New Employee Retention Credit

Under the Act, the enhanced employee retention credit would be codified in section 3134 of the Internal Revenue Code and extended through January 1, 2022.  As described in our previous post, on December 21, 2020, another round of COVID relief legislation was included in the CAA, providing an enhanced employee retention credit with various new features and greater benefit amounts.  It was subsequently enacted when President Trump signed the law on December 27.  Among other things, this last round of legislation extended the availability of the employee retention credit to July 1, 2021.

The new credit is largely based on the version in the CAA.  The credit remains fixed at 70% of qualified wages up to $10,000 per calendar quarter.  Moreover, employers remain eligible for the credit if they experience a 20% year-over-year decline in quarterly gross receipts or a full or partial suspension of business due to an applicable governmental order.  As was previously the case, employers with up to 500 full-time employees may continue to claim the credit without regard to whether the employees for whom the credit is claimed actually perform services.

Beginning on June 30, 2021, the codified credit will also have several new key features.  First, certain small startups (each a “recovery startup business”) that began operating after February 15, 2020, will be eligible for a maximum credit of $50,000 per quarter, even though the business has not experienced an eligible decline in gross receipts or been subjected to a full or partial suspension.

Second, beginning with the third quarter of 2021, additional flexibility is built into the employee retention credit for “severely financially distressed” employers who have suffered a decline in quarterly gross receipts of 90% or more compared to the same calendar quarter in 2019.  Such employers may treat all wages paid during quarters of eligibility as qualified wages up to the $10,000 cap, regardless of how many employees they have and whether such employees provide services (i.e., employers with over 500 employers, under severe financial distress, will be permitted to claim the credit with under the rules applicable to smaller employers).  The delayed effective date of the provision will likely limit the number of companies that will qualify, unless more significant lockdowns and quarantine orders come into effect in the future.  As under the CAA, employers may use the prior calendar quarter to determine their eligibility for the credit on the basis of a significant decline in gross receipts.

Third, consistent with the changes made by the CAA, employers may generally claim the employee retention credit if they have received a Paycheck Protection Program (“PPP”) loan, but may not do so with respect to wages taken into account in connection with an application for PPP forgiveness or certain other COVID relief programs (e.g., the new restaurant revitalization grants enacted as part of the Act).  Prior to the CAA’s enactment, the CARES Act prohibited PPP borrowers from claiming the employee retention credit.  The IRS recently released Notice 2021-20 providing guidance for PPP borrowers on how to calculate qualified wages.

Finally, the statute of limitations for assessments under the credit is extended to 5 years after the date of the return claiming the credit is filed or treated as filed.  Accordingly, Forms 941 filed for the third and fourth quarters of 2021 that claim the credit will be open for IRS audit until April 15, 2027, although any assessment after three years will be limited to the amount of credit claimed.

Increased Dependent Care Limits

The Act more than doubles the annual limit on employer-provided dependent care assistance for 2021.  Although most commonly provided through dependent care flexible spending accounts, which allow employees to use pre-tax dollars to pay for dependent care, employer-provided dependent care also includes the value of employer-operated daycare facilities, and employer-subsidized day care (including emergency backup care).  For 2021, the Act will increase the annual limit under section 129 of the Code from $5,000 ($2,500 for taxpayers who are married and file separately) to $10,500 ($5,250 for taxpayers who are married and file separately).  Employers may retroactively amend their plans through the end of the year to permit the increased limit, provided the plan is operated in accordance with the amendment from the effective date of the plan amendment.

New Paid Leave Credits

The Act adds two new payroll tax credits to the Code.  The credits are based on the payroll credits for required paid sick leave for required paid family leave included in sections 7001 and 7003, respectively, of the FFCRA, enacted in March 2020, which we have discussed in previous posts.  The new credits, however, would make significant changes to the FFCRA credits.  The Act contains similar provisions for self-employed individuals.

The credits would apply to qualified sick leave wages and qualified family leave wages, as applicable, between April 1, 2021, and September 30, 2021, paid by employers with fewer than 500 employees.  Accordingly, the new credits will take effect after the March 31, 2021, expiration of the FFCRA credits, as extended by the CAA.

Under the Act, both credits would be available in additional situations compared to the FFCRA credits.  In particular, the Act expands the definition of qualified family leave wages and qualified sick leave wages to include wages paid to (1)  an employee who is waiting for the results of COVID-19 testing or a medical diagnosis of COVID-19, if either the employee has been exposed to COVID-19 or the employee’s employer has requested the test or diagnosis, and (2) an employee who is obtaining COVID-19 immunization or recovering from any injury, disability, illness, or condition related to a COVID-19 immunization.

Below, we discuss specific details about each credit, and the common design features.

Paid Sick Leave Credit

Under the Act, the credit is equal to the amount of wages required to be paid for emergency paid sick leave under the FFCRA if the leave mandates under the FFCRA are still in effect.  Under the Act, the credit is limited to $200 per employee per day.  The daily limit is increased, however, to $511 per employee per day with respect to wages paid to employees who are under government quarantine orders, who are self-quarantining at the instruction of a healthcare provider, or who are experiencing COVID-19 symptoms and seeking diagnosis.  For purposes of the paid sick leave credit, the daily limit applies after the addition of collectively bargained costs (discussed below), so that if the applicable limit is $200 with respect to an employee, the amount of wages paid to the employee plus allocable collectively bargained costs cannot exceed $200.  Allocable health plan expenses are not subject to the limitation.  The credit claimed with respect to any employee is effectively capped at 10 days.  Because the provision takes effect at the beginning of the second quarter, employers may still take the credit in the first quarter of 2021 based on the extension of the FFCRA credits included in the CAA.

Paid Family Leave Credit

The Act removes the 10-day unpaid exclusion period for paid family leave under the FFCRA, so that an employer may provide paid family leave immediately and claim the credit. The Act does not modify the $200 per-employee per-day credit limit, but does increase the cumulative per-employee cap from $10,000 to $12,000, in recognition of the elimination of the exclusion period.  Accordingly, an employer may claim the credit for up to 60 days of paid family leave provided to an employee, compared to the 50 days provided under prior law.  Like the paid sick leave credit, the daily and aggregate limits apply after the addition of collectively bargained costs (discussed below).  Allocable health plan expenses are not subject to the limitation.

Common Design Features

Increases to Credit Amount.  As under the FFCRA, allocable qualified health plan expenses are included when determining the amount of the credit.  However, the Act expands the payroll tax credits to include costs associated with certain collectively bargained agreements, to the extent those costs are attributable to qualified sick leave or qualified family leave wages.  Under the Act, the credit is increased by the cost of contributions to an employer’s collectively bargained defined benefit plan and apprenticeship program.  The Act sets out criteria for determining whether costs are allocable to qualified sick or family leave wages, generally based on the hourly rate of contributions and the hours of qualified sick or family leave wages paid to collectively bargained employees.

Also as under the FFCRA, the credits are increased by the amount of employer Medicare taxes imposed on qualified sick or family leave wages.  However, unlike the FFCRA, the Act does not exclude qualified sick or family leave wages from employer Social Security taxes.  This change is likely due to rules around the budget reconciliation process that was used to move the Act through the Senate.  To cover those costs, the Act allows the credit to be increased by the employer share of Social Security taxes on qualified sick or family leave wages, as applicable.

Credit Mechanics. Both the paid sick leave and paid family leave credits are against an employer’s share of Medicare tax.  This change was also made to ensure the Act did not run afoul of the budget reconciliation rules.

Similar to the existing credits, an employer may not claim the credits with respect to wages that are subject to other credits, or which the employer is claiming as payroll costs under other COVID-19 relief measures, such as the PPP or the new restaurant revitalization grant program included in the Act.  However, if a PPP loan is not forgiven, the employer may apply the credit toward those wages.

The Act extends the statute of limitations from three years to five years, providing the IRS with additional time to examine Forms 941 claiming the credits.  Accordingly, Forms 941 claiming the credits will be open for examination until April 15, 2027, provided they were filed no later than April 15, 2022.  As with the new version of the employee retention credit, any assessment after the expiration of the standard limitations period on April 15, 2025, would be limited to the amount of the credits claimed on the return.  Employers may request an advance payment of the credits, presumably using the existing Form 7200 process, and no failure-to-deposit penalties will be imposed if an employer reduces its employment tax deposits in anticipation of the credits.

Nondiscrimination.  The Act would preclude employers from claiming the credits for any calendar quarter in which the employer makes qualified leave available in a discriminatory manner that favors highly compensated employees, full-time employees, or on the basis of length of service with the employer.  Employers should consult with payroll tax counsel and employment counsel to discuss their practices and assess eligibility for the credit.

Deductions for Executive Compensation

The Act will also further limit deductions for compensation paid to a publicly traded company’s highest paid employees for tax years beginning after December 31, 2026.  Section 162(m) of the Code limits a publicly traded company’s deduction for compensation paid to “covered employees.” Following the 2017 amendment by the Tax Cuts and Jobs Act (“TCJA”), a company’s covered employees are its principal executive officer (“PEO”), its principal financial officer (“PFO”), and its three highest compensated officers other than the PEO and the PFO.  In addition, the TCJA also treats an individual as a covered employee for all future tax years once the individual is a covered employee in any tax year beginning after December 31, 2016.  A company’s deduction for compensation paid to a covered employee is generally limited to $1,000,000 for the year.

The Act modifies the definition of covered employee to include the five highest paid employees of the company during the tax year that are not the PEO, the PFO, or one of the three highest compensated officers of the company.  Accordingly, the amount that an employer may deduct for compensation paid to individuals who are highly paid but are not officers will now be limited by Section 162(m).  However, employees who are treated as covered employees under the expanded definition do not retain their status as covered employees in future tax years.