If you’re reading this, you know about the $100,000 recovery startup business employee retention credit.
You know, for example, that if you start a new trade or business after February 15, 2020, you can get up to a $50,000 credit for both the third and again for the fourth quarter of 2021. So, $100,000 in total. Just for starting the new venture.
You maybe even know the credit formula gives you up to seventy percent of the first $10,000 in wages you pay each worker in a quarter.
You may even have worked out that you need employee wages for slightly more than seven employees, minimum, to get the $50,000 credit for the third quarter. And then again for the fourth quarter.
But the tax law leaves some awkward questions unanswered. So, this blog post asks those questions. And it gives my guesses as to how they get answered.
One other note: My thinking here flows from the statutes, the one revenue procedure, and then the three IRS notices that had appeared as of August 16, 2021.
Awkward Question #1: Does the New Trade or Business Need its Own Employees?
The employee retention credit looks at wages an employer pays employees. Accordingly, you might assume that an entrepreneur’s new startup venture needs to pay wages to get the credit.
That’s incorrect though. The entrepreneur just needs one of the trades or businesses he or she owns to pay wages.
Example 1: An entrepreneur owns and operates a restaurant which employs eight employees who together make $72,000 during the third and fourth quarters of 2021. The entrepreneur also opens a second trade or business in early 2021, a plant nursery. But the plant nursery hires no employees in 2021. Nevertheless the new plant nursery trade or business lets the entrepreneur get the $50,000 of employee retention credits on the restaurant employee wages.
What happens, by the way, is the trades or businesses an employer operates get aggregated. That’s why the new trade or business doesn’t necessarily need its own wages. Which is weird, I grant you…
Awkward Question #2: Can the New Trade or Business have Activity Prior to February 15, 2020?
A new trade or business needs to start sometime after February 15, 2020 in order to qualify an employer for recovery startup business employee retention credits. The IRS guidance also makes it clear the new trade or business needs to be fully operating and a going concern in order to get the credit.
Here is the language the only IRS guidance provides on this matter (from IRS Notice 2021-49):
In general, for purposes of section 162, a taxpayer has not begun carrying on a trade or business “until such time as the business has begun to function as a going concern and performed those activities for which it was organized.”
But this begs another awkward question: What if investigation of the new venture begins before the required start date? Or what if preopening activities occur in, say, 2019? Or in January of 2020?
My best-guess answer here: I think the recovery startup business doesn’t start for employee retention credit purposes until a new trade or business meets the Section 162 definition (shown above) and is past the Section 195 startup phase. In other words, what happens before the thing being created actually starts? That doesn’t matter.
This approach means investigation and pre-opening activities (including market research and feasibility studies) occurring on or before February 15, 2020 should not matter.
One would want to be very cautious about a position where some activity half starts in January of 2020 and then only reaches full going concern status after February 15, 2020. But in that situation, that new trade or business would seem to create eligibility for the employee retention credit.
Awkward Question #3: Does the New Trade or Business need to Operate in Third and Fourth Quarter of 2021?
That $50,000 credit a firm may get in 2021 for quarter 3 and again for quarter 4? You’d assume the trade or business that triggers that credit needs to operate in quarter 3 or 4. But I don’t think that requirement in fact does exist.
The requirement says a new trade or business needs to start after February 15, 2020. A new trade or business started on, say, February 16, 2020 might have started, operated and then closed before the start of the third quarter of 2021.
I know. Weird. But that’s the way Congress wrote the law.
One other weirdness here. In order to get a credit for that third quarter of 2021? The new trade or business started after February 15, 2020 needs to start before the end of September 2021. And in order to get a credit for the fourth quarter of 2021? The new trade or business started after February 15, 2020 needs to start before the end of December 31, 2021.
But note that a business started in March of 2020 which then closes in, say, March of 2021? That timing works.
Again, I know. Weird…
Awkward Question #4: What if the New Trade or Business Fails?
A related awkward question: What if the new business fails? Is that a problem?
I think not. Congress knows businesses fail. Presumably, it enacted the recovery startup business credit to address the fact that millions of small businesses have failed during the COVID-19 pandemic.
But here, for the record, I think the business owner needs to be careful. The Section 162 standard for what qualifies as a trade or business? It says the entrepreneur needs to be seeking profits and operating with regularity and continuity.
A real, legitimate trade or business might conceivably fail very quickly. But if the new venture fails too quickly? Gosh, one may want consider the possibility that a quick failure would push an IRS auditor to think about whether the regularity and continuity requirements get met.
Accordingly, if employee retention credits are in play? Possibly a business owner needs to show a little extra patience before deeming the venture a failure and then ending operations.
I also think if you’re trying a risky venture that will probably fail but also might potentially generate a giant reward? You probably want to have a business plan that documents that risk-reward trade-off.
Awkward Question #5: Is there a Minimum Length of Operation Requirement?
A second related question: Is there a minimum length of time the new trade or business needs to operate to get the credit?
The answer here? No, not really. Once you meet the continuity requirement.
And by the way? If you’re thinking this whole recovery startup business credit makes less and less sense, just as policy? Yeah, that thought pops into my head every so often too.
Awkward Question #6: Is there a Size or Income Requirement?
Another good question to ponder, at least for a few minutes: Is there a size or income requirement for the new trade or business?
I think the answer is “No, but…”
Theoretically someone with an existing business generating two million dollars of revenue in 2020 might start a tiny micro-business that generates a few hundred dollars of profits in 2021. And that technically sort of half works.
A quick sidebar: To get the recovery startup business credit, the three-year average revenues for the aggregated employer need to not exceed $1,000,000 a year. So, a firm that generates $100,000 of gross receipts in 2018, $900,000 in 2019 and then $2,000,000 in 2020 has a three year average equal to $1,000,000. And that works.
But I think the problem appears when one looks at the requirement that the new trade or business be operated for profit. Someone with a big small business probably isn’t starting a new microbusiness that generates a few hundred or a few thousand dollars of profit in the pursuit of profit.
Let Me Show You Some Examples
But this would be very relative, at least in my mind.
Example 1: Tom operates a small business that generates $500,000 in annual profits but potentially qualifies for the recovery startup business employee retention credit. He wonders if he can start a new tiny business that will generate $5,000 a year in profits.
Example 2: Pete, Tom’s brother, also operates a small business. It generates $30,000 in annual profits and potentially qualifies for the recovery startup business employee retention credit. He also plans to start a new tiny business that will generate $5,000 a year in profits.
Think about the two preceding examples… It’s hard to argue that Tom’s new tiny business seeks profits if Tom operates a trade or business that already makes a mid-six-figures profit.
Pete’s situation differs from Tom’s situation in my mind. A new business that adds $5,000 a year to his existing $30,000 a year of profits? A nearly seventeen percent bump in profits? Gosh, yeah, sure. That seems very likely profit motivated.
One other thing about this to consider. You the entrepreneur make a decision to pursue some venture based on what you hope might happen. If your tax return with the employee retention credit ever gets examined by the IRS? The IRS auditor will be looking at what revenues or income your venture actually generated. This difference in perspective might cause issues during an audit.
Example 3: You start a business you hope generates $100,000 in annual profits. You spend hundreds of hours working on the opportunity. And you get $100,000 of employee retention credits. The venture fails to live up to your expectations, unfortunately, producing only $1,000 of annual profits. If the IRS audits your employee retention credits, it may view the venture as less profit motivated than it actually was.
The only thing I can come up with here? Do a business plan. Document the hope that the new venture may deliver a big reward.
Awkward Question #7: Does Rental Property Count as a Trade or Business?
I’m a little nervous about this. But yes, I think you buying a new rental property probably can count as a new trade or business.
An earlier blog post here goes into the details: The $100,000 real estate employee retention credit windfall.
Awkward Question #8: Can an Acquisition of an Already Operating Trade or Business Count?
Good question… So just to be clear, if you go open up a new retail store that probably counts as a new trade or business. This should be the case, for example, if you’re not already a retailer.
But what about if you go buy a retail store that’s already operating. The retail trade or business is new to you. The way a used car is new to you. Does that count?
I think so based on the language that comes right out of the statute Congress wrote and the President signed:
The term “recovery startup business” means any employer… which began carrying on any trade or business after February 15, 2020,
So mull that over. And then consider the scenario where you or I go out and buy an already operating retail store sometime after February 15, 2020… That would pretty clearly seem to be you or me beginning the “carrying on” of a trade or business after February 15, 2020.
Awkward Question #9: What are the Chances of Audit?
A final question: What chance or risk is there you’ll be audited?
First the stipulation: Whether or not you risk an audit should make no difference in you claiming the credit. What matters is whether you can meet the law’s and the notices’ requirements.
I know, I know. We both already know that. But I wanted to say it anyway.
But second, this comment because some folks will maybe tend to think about the employee retention credits like the Paycheck Protection Program (PPP) operated by the Small Business Administration.
In comparison to the PPP, where your odds of getting audited run very, very low, I think the odds of an audit of an employee retention credit refund claim run pretty high. In relative terms.
This is back of the envelope math. But my thinking focuses on fact that the Treasury Department and the IRS employ a large number of employees including an army of IRS auditors. So way, way way more manpower to deploy in looking at employee retention credits. (The IRS employs more than 80,000 employees. The Small Business Administration employs about 3,000 employees.)
And then far fewer employee retention credits look to be claimed than PPP loans got made. More than five million borrowers got PPP loans. At mid-year, according to news reports, maybe 30,000 employers had requested employee retention credits.
Combine the larger number of auditors with the small number of taxpayers, voila, I think the odds of a firm getting audited on an employee retention credit run way higher than the odds of a PPP audit by the SBA.
A wild guess? Say a thousand times higher?
The point I’m offering up then: Don’t think the employee retention credit opportunity works like the PPP loans. You’ll need to be more careful. And do a better job with your calculations.
You know those people who didn’t get PPP loans because they just couldn’t believe they were real? You don’t want to make that sort of mistake with employee retention credits. No way…
But spend some time asking the awkward questions now. If you do get asked the same questions later on, you will have better answers by doing so.
You can get our Maximizing Employee Retention Credits book from Amazon here: Maximizing Employee Retention Credits.
Dan Chodan’s blog post about owner wages. explains how owner wages plug into the employee retention credit formulas. That’s really important stuff.
This blog post talks more about the Recovery Statup Business Employee Retention Credit.
Finally, this blog post talks about steps an employer can take to boost their credits: Three Tips for Bigger Employee Retention Credits.