On March 27, 2020, President Trump signed into law the Coronavirus Aid, Relief, and Economic Security (CARES) Act. In addition to providing economic support for hospitals and testing for coronavirus disease 2019 (COVID-19), the Act provides over $2 trillion of relief for the US economy, including individual stimulus payments, small business loans, and several business tax provisions. Israeli companies that have offices or subsidiaries in the United States may benefit from the CARES Act. This update outlines the business tax provisions in the Act.
Employer cash flow and employee retention
A primary goal of the Act is to free up cash flow for employers experiencing significantly diminished receipts, thereby permitting them to retain and pay their employees. In furtherance of this goal, the Act grants employers an “employee retention credit” and allows employers to defer payment of payroll taxes due in 2020.
Employee retention credit (ERC). Businesses are generally responsible for matching an employee’s Social Security payroll taxes (the Employer Portion) imposed at 6.2 percent of wages paid to the employee. The Act provides a one-year-only credit to businesses against the Employer Portion for wages paid between March 13, 2020 and December 31, 2020, if in that calendar quarter in 2020 (i) the business continues to pay its employees despite being forced to fully or partially suspend operations due to governmental order or (ii) the business continues operations but experiences at least a 50 percent decline in gross receipts as compared to the same calendar quarter in 2019. Once an employer sustains a 50 percent decline in gross receipts for a calendar quarter in 2020, it continues to be eligible to claim the ERC in succeeding calendar quarters in 2020 until its gross receipts have recovered to equal at least 80 percent of the comparable gross receipts for the same quarter in 2019 and then it can no longer claim the ERC in the next quarter in 2020. See Internal Revenue Service (IRS) ERC FAQ #39. The credit against the Employer Portion which may be claimed on a quarterly basis, subject to certain limitations (described below), is equal to 50 percent of “qualified wages” paid to each employee for the relevant quarter.
The term “qualified wages” (i) includes payments by an employer of “qualified health plan expenses” to cover employees (even if they do not receive any wages in the same quarter) and (ii) is limited to $10,000 in aggregate per employee for all quarters in 2020. Thus, the ERC is capped at $5,000 per employee for the entire 2020 (ie, 50 percent x $10,000 per employee). If an eligible employer has 100 or fewer full-time employees in 2019, all employee wages are considered qualified wages. For employers who average more than 100 full-time employees in 2019 (as determined under a monthly averaging rule based on the number of full months that the employer operated its business, see IRS ERC FAQ #49), qualified wages are limited only to those wages paid to employees who are not providing services due to operations being suspended by governmental order or where there is a 50 percent or greater decline in the business’ gross receipts.
There are, however, limitations to claiming the ERC. First, the ERC cannot be taken on the same wages for which the employer receives other tax credits, such as the Work Opportunity Tax Credit under Internal Revenue Code (IRC) Section 51 or the Employer Credit for Paid Family and Medical Leave under IRC Section 45S. See IRS ERC FAQs #14 and 56. Second, any payments (including severance payments) made by an employer to former employees following the termination of their employment are not treated as qualified wages. Payments will be treated as qualified wages only if such payments are made to an employee who continues to be employed by the employer. See IRS ERC FAQ #57. Third, qualified wages are calculated without regard to federal taxes imposed or withheld, including the employee’s or employer’s share of social security taxes and Medicare tax, and federal income taxes required to be withheld. See IRS ERC FAQ #57. Fourth, for employers that averaged more than 100 full-time employees during 2019, qualified wages paid to an employee cannot exceed the amount the employer would have paid the employee for working an equivalent duration during the 30 days immediately preceding the commencement of the full or partial suspension of the operation of the trade or business or the first day of the calendar quarter in which the employer experienced a significant decline in gross receipts. See IRS ERC FAQ #53.
Additionally, the Act provides that rules similar to IRC Section 280C(a) will apply for purposes of applying the ERC. See IRS ERC FAQ #85. IRC Section 280C(a) disallows deductions for the portion of wages paid equal to the sum of certain credits determined for the tax year. Thus, employers who take advantage of the ERC will have their aggregate deductions reduced by the amount of the credit received.
The aggregation rules provided under IRC Section 52(a) & (b) and Section 414(m) & (o) can also limit affiliates from claiming the ERC. Those aggregation rules treat multiple entities and affiliates as a single employer when determining an employer’s eligibility for, and the amount of the available, ERC. See IRS ERC FAQs #25-27. IRC Sections 52 and 414 generally apply aggregation rules to determine whether related entities are treated as a single employer for purposes of the application of tax credits, retirement, and other employee benefits under the IRC, whether those entities are corporations or partnerships, and those rules are incorporated by reference into the ERC provisions of the Act.
More specifically, IRC Section 52(a) provides aggregation rules for parent-subsidiary controlled groups and brother-sister controlled groups. A parent-subsidiary controlled group includes a chain of corporations where one or more corporations own, directly or constructively, more than 50 percent of the voting stock of a corporation or more than 50 percent of the value of all the outstanding stock of such corporation and there is a common parent corporation that owns more-than-50 percent of the vote or value of the stock of at least one of those other corporations. A brother-sister controlled group generally consists of two or more corporations where five or fewer persons (eg, individuals, trusts or estates) own more than 50 percent of the vote and value of each corporation. IRC Section 52(b) contains similar aggregation rules for partnerships and sole proprietorships; however, the common control test focuses on whether more than 50 percent ownership of the profits interest or capital interests of the partnership (or 100 percent of the interests in a sole proprietorship) are owned by a common owner.
Under IRC Section 414(m), even if there is not sufficient ownership or control of one entity to form a controlled group, an “affiliated service group” will be treated as a single employer based on rules related to the performance of services by one entity for another entity or by one entity in association with another entity for third parties. Foreign entities are generally excluded for determining eligibility of its US affiliates for purposes of the ERC, unless the foreign entity has a US trade or business.
Entities that are members of a controlled group or an affiliated service group are considered a single employer for purposes of making the following determinations relating to the ERC:
- Whether the employer has a trade or business operation that was fully or partially suspended due to ordered related to COVID-19 pandemic from an appropriate governmental authority
- Whether the employer had a significant decline in gross receipts compared to the same quarter in 2019
- Whether the employer averaged more than 100 full time employees in 2019 (see IRS ERC FAQs #49-50) and
- Whether the application of the rules that preclude an employer from claiming the ERC if any member of the aggregated group received a Paycheck Protection Program (PPP) loan will apply to such employer.
The application of these aggregation rules may impact private equity sponsors that own portfolio companies in different businesses which could be treated as a single employer for purposes of determining the combined group’s eligibility for, and the amount of the available, ERC. For example, consider a private equity firm, PE, which owns 80 percent of X Corp, 50 percent of Y Corp, and 30 percent of Z Corp. X Corp, Y Corp, and Z Corp have 60, 50, and 90 employees, respectively. Under the aggregation rules, X Corp and Y Corp will be treated as a single employer and would have over 100 employees due to PE owning more than 50 percent of both X Corp and Y Corp, however, Z Corp will have under 100 employees as Z Corp would not be aggregated with X Corp or Y Corp since PE owns less than 50 percent of Z Corp. Even more unfavorable, the aggregation rules would preclude X Corp from claiming the benefits of the ERC if Y Corp had received a PPP loan.
The ERC is a refundable credit if the amount of the credit exceeds the payroll taxes to be deposited by the employer for that quarter (including the employee portion and employer portion of the Social Security and the Medicare tax and any income taxes withheld from the employee’s wages) since the employer can offset the ERC against the payroll taxes it otherwise would deposit with the IRS. The employer reports the ERC relating to qualified wages paid during the period from March 13, 2020 to June 30, 2020 on the payroll tax form (Form 941) for the second quarter of 2020 and reports the ERC relating to qualified wages paid during the third quarter and fourth quarter of 2020 on the corresponding Forms 941 for those quarters. The employer can use a Form 7200 to claim an advance cash payment against its anticipated refundable credit if that form is filed by the due date of the Form 941 for that quarter. Further, after offsetting any employment taxes and federal income tax withholding reported on a Form 941, the employer can receive a refund for any excess ERC for that quarter. An employer can file an amended payroll tax return (Form 941-X) to claim any adjustment relating to the ERC, provided that the employer has not elected to waive the ERC for a given quarter in 2020 because employers can affirmatively elect not to have the ERC apply to any particular quarter in 2020.
Payroll tax deferral. In order to further free up employers’ cash flow, the Act permits all employers to defer payment of the employer portion of payroll taxes (ie, 6.2 percent) due for wages paid between March 27, 2020 and December 31, 2020. The entirety of such payroll taxes due from employers, and 50 percent of payroll taxes due from self-employed persons, qualify for the deferral. Half of the deferred payroll taxes of an employer or a self-employed person are due on or before December 31, 2021, with the remainder due on or before December 31, 2022.
In effect, the ERC and the payroll tax deferral can simultaneously provide employers with credits in 2020 for the employer portion and allow deferral of the actual payment of the employer portion until 2021 (50 percent) and 2022 (50 percent).
Paycheck protection loans. The Act also provides businesses with fewer than 500 employees access to certain “paycheck protection loans” fully guaranteed by the federal government. While the provision of PPP loans is not a tax change, it is important to note that any business receiving a PPP loan is not eligible for the employee retention credit. This includes the situation where one affiliate receives a PPP loan, then none of the affiliates with which it is treated as a single employer under the aggregation rule can claim the ERC.
Further, while Section 2302(a)(3) of the Act had provided that an employer whose PPP loan was forgiven, in whole or in part, could not take advantage of the payroll tax deferral.However, the Paycheck Protection Program Flexibility Act of 2020, which was recently signed into law on June 5, 2020, retroactively repeals Section 2302(a)(3) of the ACT. Id. at Section 4. Thus, there is no longer any limitation on an employer continuing to take advantage of the payroll tax deferral after it has had its PPP loan forgiven, in whole or in part.
Modification of certain revenue raisers and other provisions in the 2017 Tax Cuts and Jobs Act
In December 2017, sweeping tax reform was enacted in the form of the Tax Cuts and Jobs Act (the TCJA). In order to offset cuts in individual and corporate income tax rates, the TCJA included a number of provisions designed to increase revenue. Without intervention, the perilous economic situation brought on by the COVID-19 pandemic is expected to magnify the effect of these revenue raisers to the detriment of taxpayers; the Act therefore contains a number of provisions designed to ameliorate, albeit temporarily, the effect of these TCJA provisions.
Net operating losses (NOLs). Prior to the TCJA, a company with NOLs generally could (i) carry back those losses to the preceding two tax years, and (ii) carry forward those losses 20 years and offset up to 100 percent of taxable income in those later years. For losses arising after 2017, the TCJA eliminated carrybacks of NOLs and allowed indefinite carry-forwards, but limited the use of those losses in later years to 80 percent of taxable income.
Since it is expected that many businesses will generate tax losses in 2020, the Act in effect temporarily repeals the NOL limitations in the TCJA. Specifically, NOLs arising in years beginning in 2018, 2019, or 2020 must be carried back up to five tax years, unless the business makes an irrevocable election to forgo the carryback for one or more tax years. The NOL limit of 80 percent of taxable income is further suspended for tax years through 2020, so businesses may use 100 percent of their NOLs to offset their taxable income in prior years.
The IRS, in Rev. Proc. 2020-24 and Notice 2020-26, provided additional guidance on the application of these new NOL provisions. First, Rev. Proc. 2020-24 addressed the mechanics for waiving the carryback for NOLs arising in tax years beginning in 2018, 2019, or 2020. Specifically, under Rev. Proc. 2020-24, an irrevocable election to waive the carryback period arising in a taxable year beginning in 2018 or 2019 must be made no later than the due date, including extensions, for filing the taxpayer’s federal income tax return for the first taxable year ending after March 27, 2020. A business that can carry back NOLs to pre-2018 taxable years can take advantage of using losses that arise in years where the corporate income tax rate is 21 percent (under the TCJA) against income arising in pre-TCJA years where the corporate income tax rate was 35 percent.
Rev. Proc. 2020-24 addressed how to waive a carryback period, reduce a carryback period, or revoke any election to waive a carryback period for a taxable year that began before January 1, 2018, and ended after December 31, 2017. Specifically, any such elections for such taxable years with an NOL will be treated as timely filed if filed no later than July 27, 2020.
Finally, Notice 2020-26 outlines the procedures for obtaining refunds generated as a result of these new rules under IRC Section 6411(a). Specifically, for taxable years beginning after December 31, 2017, taxpayers may apply for a quick refund from the carryback of an NOL by filing Form 1045 (for individual taxpayers) or Form 1139 (for corporate taxpayers). Upon filing, the IRS is required (following verification of the application) to issue a refund by the later of the 90 days from (i) the date on which Form 1045 or Form 1139 is filed or (ii) the last of the month of the due date of filing the return for the NOL carryback year. Normally, in order to obtain a quick refund, Form 1139 or Form 1045, as applicable, must be filed during the period beginning on the date of filing the return for the NOL taxable year and ending on the date 12 months from the last day of such taxable year. For example, for the calendar year 2018, the deadline for the quick refund application was December 31, 2019. Although the Act itself did not provide any extension of this deadline, Notice 2020-26 granted a six-month filing extension for a tentative carryback adjustment under Section 6411 with respect to the carryback of an NOL that arose in any taxable year beginning in 2018 and ended on or before June 30, 2019. Thus, for NOLs arising in 2018, taxpayers had only until June 30, 2020, to file an application under Section 6411 for a quick refund; since this date has passed, taxpayers who were eligible to (but did not) avail themselves of this extension must file an amended return for the year to which the NOL is carried back within three years of the earlier of the extended due date or date of filing for the year the NOL was incurred. In addition, in its frequently asked questions website regarding Form 1139 and Form 1045, the IRS has noted that it will temporarily allow taxpayers to submit these forms via fax instead of requiring physical copies.
For NOLs arising in taxable years beginning before January 1, 2018, and ending after December 31, 2017, a taxpayer may make an application under Section 6411(a) on either Form 1045 (for individual taxpayers) or Form 1139 (for corporate taxpayers) for a quick refund of taxes with respect to a carryback of such NOL provided the application is filed no later than July 27, 2020.
On July 2, 2020, the Treasury Department and the IRS simultaneously issued proposed regulations and temporary regulations that provide guidance for consolidated groups regarding these recent changes to the NOL rules. In particular, because the Act allows certain NOLs to be carried back five years, the temporary regulations allow certain acquiring consolidated groups to make an election to waive all or a portion of the pre-acquisition portion of the extended carryback period for certain losses attributable to certain acquired members of the consolidated group The temporary regulations are immediately effective and apply both to NOLs of the consolidated group arising in a taxable year ending after July 2, 2020, and taxpayers may apply those same rules under the temporary regulations to any NOLs of the consolidated group arising in a taxable year beginning after December 31, 2017. Additionally, the proposed regulations would remove obsolete provisions from the rules for consolidated groups that contain both life insurance companies and nonlife insurance companies. While the proposed regulations are intended to be effective only upon their publication in final form, the Treasury Department and the IRS have permitted taxpayers to rely on the proposed regulations concerning the federal income tax treatment of post-2017 NOLs even before their issuance in final form, provided that the taxpayer relies on the proposed regulations in their entirety and in a consistent manner.
Individual losses. IRC Section 461(l), enacted as part of the TCJA, limits the amount of “net business loss” an individual may use in a year to offset other sources of income to $250,000 (or $500,000 if married filing jointly). Any loss in excess of this limit is converted into an NOL and subject to the TCJA’s more stringent limitations on the use of NOLs. The Act suspends IRC Section 461(l) not only for 2020, but retroactively for 2018 and 2019 as well. However, IRC Section 461(l) would be reinstated for 2021 and future years.
Business interest expense limitation. The TCJA made significant changes to the ability of businesses to deduct business interest expense from taxable income. For post-2017 tax years, the TCJA limited the allowable deduction for business interest to 30 percent of the taxpayer’s adjusted taxable income for the year (plus business interest income), with any disallowed interest expense carried forward to future years (akin to an NOL). This limitation does not apply to taxpayers with average annual gross receipts for the prior three years below an inflation-adjusted amount (which, for 2020, is $26 million). The Act increases the limitation to 50 percent of the taxpayer’s adjusted taxable income for 2019 and 2020. A taxpayer can elect out of this increased limitation for either tax year. Further, in calculating its limitation for 2020, a taxpayer may elect to use adjusted taxable income for 2019, since it is expected that many taxpayers will have significantly lower taxable income in 2020, which could significantly reduce their ability to deduct interest expense. There are additional special rules for partnerships.
We note that the TCJA’s business interest expense limitations did not apply to a taxpayer that is an “electing real property trade or business.” Following the TCJA’s changes, many real estate businesses elected out of the business interest expense limitations, even though that election required such taxpayers to use the alternative depreciation system (ADS). Once such an election is made, it is generally irrevocable. In Rev. Proc. 2020-22, in order to allow taxpayers the opportunity to reconsider a decision to be an “electing real property trade or business” in light of the changes made by the Act, the IRS provided that taxpayers subject to the business interest deduction limitations could make late elections or withdraw earlier-made elections to be an “electing real property trade or business.” The decision to make or unmake such an election should take into account not only the new interest expense limitations, but also changes the Act made to the ADS rules (discussed immediately below).
Qualified improvement property. The TCJA provided for full expensing in the first year that the taxpayer acquired depreciable property, known as “MACRS property”, with a prescribed recovery period of 20 years or less. Throughout the drafting process, it was clear that Congress intended to make all “qualified improvement property” (which generally had, with certain exceptions, a 39-year recovery period) eligible for this 100 percent bonus depreciation. However, when the TCJA was finalized, Congress failed to make this change, with the result that all “qualified improvement property,” including the categories that had been excepted, was ineligible for full expensing. This mistake is known as the “retail glitch,” as it overwhelmingly affected small retail business and restaurants.
The Act defines “qualified improvement property” as 15-year property, thereby allowing for full expensing of improvements in the year made and making this change retroactive to January 1, 2018. This change will permit taxpayers negatively affected by the retail glitch to amend their tax returns and capture the benefits of full expensing of improvements made in 2018 and 2019. According to the Senate Finance Report that accompanied the Act, this technical amendment “increases companies’ access to cash flow [and] incentivizes them to continue to invest in improvements as the country recovers from the COVID-19 emergency.”
The IRS issued Rev. Proc. 2020-25 to provide guidance to taxpayers seeking to change their depreciation method for “qualified improvement property” as revised by the Act. Specifically, Rev. Proc. 2020-25 permits taxpayers to file an amended return, an administrative adjustment request, or Form 3115 (Application for Change in Accounting Method) to change their method of depreciation in the 2018, 2019 or 2020 taxable year for qualified improvement property placed in service after December 31, 2017. Rev. Proc. 2020-25 does not apply to “qualified improvement property” placed in service by a taxpayer that made a late (or withdrew) a “electing real property trade or business” election under the business interest expense limitation rules, but it does address changes to depreciation resulting from a late or withdrawn election.
This alert is a high-level overview of the business tax provisions of the Act. Those provisions are more complex than as described and are subject to limitations and exceptions that are not addressed in this alert and are also subject to a change in their interpretation by the Treasury Department, the IRS and the courts. Further, Congress continually works on additional legislation and any such future legislation, if enacted, can expand or restrict the rules summarized in this alert. We also encourage taxpayers to consider the impact of rapidly changing economic conditions on their global legal entity structure, including foreign losses and intercompany pricing. There can also be state and local tax consequences relating to the items discussed in this alert, and those issues are not addressed in this alert.
As the impact of COVID-19 continues to evolve, DLA Piper is available to assist in helping companies manage the various legal implications of the outbreak. If you have any questions regarding these new requirements and their implications, please contact the authors or your DLA Piper relationship attorney.
This information does not, and is not intended to, constitute legal advice. All information, content, and materials are for general informational purposes only. No reader should act, or refrain from acting, with respect to any particular legal matter on the basis of this information without first seeking legal advice from counsel in the relevant jurisdiction.