What is a Deemed Election and How Does it Affect Your Employee Retention Credit Refund?

Have you heard of ‘the butterfly effect’?

It’s a phrase used to illustrate the concept that small, seemingly insignificant actions or decisions can lead to, or result in other unpredictable and far-reaching consequences in life.

In the accounting world, we refer to this as “deemed elections” – a passive choice that occurs as a result of having made another choice. In other words, choosing one option might implicitly mean not choosing another.

In today’s blog, we’re going to share how certain choices you (or your accountant) make when applying for PPP loan forgiveness can impact your eligibility for the Employee Retention Credit (ERC) and ultimately affect the amount of tax benefits you receive from it.

Is the way you applied for the PPP loan preventing you from receiving thousands of dollars more from the IRS and the Employee Retention Credit? 

Let’s dive in and see. 

What is a Deemed Election?

To give you a better understanding of what a deemed election is, let’s first look at ‘‘tax elections”. 

A tax election is a choice or option that a taxpayer may make to determine how certain aspects of their income, deductions, or credits are treated for tax purposes. These elections can impact the amount of tax owed or the eligibility for certain tax benefits.

Alternatively, a deemed election is a passive choice. It’s a result of having made another choice, such as going right at a fork in the road, that results in losing out on something else (i.e., going left at the fork in the road means not going right). 

So what does this have to do with the Paycheck Protection Program (PPP) loan and Employee Retention Credit (ERC)?

We’ve mentioned in several other blogs that The Consolidated Appropriations Act (CAA), which passed in late December 2020, changed the rules to allow businesses who received a PPP loan to also be eligible to claim the Employee Retention Credit (ERC).

Since then, things have changed even more. 

On March 1, 2021, the IRS issued additional guidance addressing the ERC as it applies to qualified wages paid after March 12, 2020 and before January 1, 2021, as well as addressing its interaction with PPP loans. This guidance is only for 2020.

In other words, the IRS is mandating that an employer may not use the same wages it listed on its PPP Loan Forgiveness Application for the purposes of calculating the Employee Retention Credit. 

Merely listing the wages on the PPP application prevents taxpayers from using those wages for the Employee Retention Credit program, even if those wages were not needed.

So how are these PPP elections costing taxpayers thousands of dollars?

Well, stay with us (if you haven’t left already).  

We’ll give you a real-life example and some strategies we use for our Employee Retention Credit clients to help them recoup thousands of dollars.

First, it’s important to understand that the timing of this guidance made its effects retroactive.  

The notice came out in March 2021, long after many taxpayers had already filed for PPP forgiveness.  

And even after the IRS addressed this issue, most businesses were unaware of the deemed election criteria and completed the form without professional guidance.  

Many employers, unfortunately, reported only payroll costs on their PPP forgiveness application despite having paid other eligible expenses because it was easier and because employers could not originally claim both ERC and PPP at that point in time.  

If you were following our content, we tried to notify as many taxpayers as possible, but for many, it was already too late, or the guidance had been misunderstood.

Let’s go through an example together:

Example: Fantastic Fitness (FF) received a PPP loan of $200,000. FF is an eligible employer and paid $200,000 of qualified wages that would qualify for the ERC during 2020. FF also paid other eligible PPP expenses of $100,000. FF must report a total of $200,000 of payroll costs and other eligible expenses, with a minimum of $120,000 of those costs being payroll costs, to receive full forgiveness of its PPP loan (60% of the $200,000 PPP loan).

FF submitted its PPP Loan Forgiveness Application and reported $200,000 of qualified wages as payroll costs but did not report any of the $100,000 in other eligible PPP expenses. FF received a decision from the SBA to forgive the PPP loan in its entirety.

FF is deemed to have made an election to use the full $200,000 of qualified wages for purposes of the PPP program, which was the full amount of wages included in the payroll costs reported on the PPP Loan Forgiveness Application. It may not treat that amount as qualified wages for purposes of the employee retention credit, regardless of whether Fantastic Fitness had other eligible expenses that could have been used to meet the PPP requirements.

In this example adapted from the IRS FAQ, the taxpayer has lost out on up to $40,000 of Employee Retention Credit funds, a very costly mistake that could have been prevented if they had completed the PPP forgiveness application with the other eligible expenses listed.  

The IRS is taking a firm and clear position that when no other eligible expenses are listed, then no portion of the qualified wages reported as payroll costs may be treated as qualified wages for purposes of the ERC. That is, Fantastic Fitness cannot reduce its deemed election by the amount of other eligible expenses if those expenses were not on the original PPP forgiveness application.

Conclusion: In order to maximize the Employee Retention Credit, PPP borrowers filing for the ERC should carefully evaluate and calculate which qualified wages should be included as payroll costs on the Loan Forgiveness Application.

So, is there anything you can do about it now?

Here’s what we suggest:

Refer back to your original PPP forgiveness application and see how much of the PPP funds were listed as used on eligible payroll costs.  

In our experience, taxpayers who do not have a copy of the application may contact their bank for a copy of the original.  

If a taxpayer worked with an ERC provider who did not request this form, it’s possible and in our experience, highly likely, they incorrectly calculated your employee retention credit by thousands or even tens of thousands of dollars. 

It is our professional opinion that this type of oversight rises to the level of negligence on the part of the employee retention credit provider and is wholly unacceptable given the IRS’ clear guidance on the matter.

Taxpayers in this situation may have either underclaimed or overclaimed the employee retention credit by tens of thousands of dollars.

There is no way to amend or make changes to the PPP forgiveness application.  

An employer is bound to the terms of the original application even if they, like many other taxpayers, could have done something different at the time.  

What is frustrating for most taxpayers is that this requirement is retroactive. If taxpayers had known, many would have only listed that 60% of the PPP funds were used for qualified payroll expenses.

If we go back to the rules and regulations around PPP, you’ll remember that at least 60% of your PPP funds need to be used on employee wages, in order to have the PPP loan forgiven.

The best case is that your business marked 60% of your PPP money for eligible payroll costs or that your business used one of the earlier forgiveness applications that did not require an amount to be stated at all. 

What can you do to maximize the amount you receive from the Employee Retention Credit (ERC)?

If you do find that PPP requirements are reducing your ERC refund, there are advanced strategies for allocating PPP expenses.

Here are just some of the ways in which an experienced CPA will help you maximize your employee retention credit.

Tip #1 to Maximize ERC: Include the following as eligible PPP expenses before dipping into ERC eligible wages:

1. Employer paid state and local payroll taxes (like unemployment), retirement contributions, and healthcare costs
2. Wages paid to employees not eligible to be used for ERC purposes due to the related party rules found at IRC §51(i)(1)
3. Wages paid to an employee in excess of the caps on ERC qualified wages ($10,000 per year in 2020 and $10,000 per quarter in 2021)

Tip #2 to Maximize ERC: Use wages accrued towards the end of the PPP eligibility period but not yet paid. This is permitted by the IRS and allows the accrued wages to be applied to the PPP requirement and thus frees up wages to be allocated to the employee retention credit program.

In short, it is advantageous to allocate the smallest amount of payroll costs for PPP forgiveness.  Doing so will meet your PPP requirements and maximize the amount of Employee Retention Credit you can receive back. 

Sound confusing?

If this sounds confusing, it’s because it is. A lot of work goes into the calculations for the Employee Retention Credit in conjunction with the Paycheck Protection Program.

If you never received PPP funds, then your business calculations will be slightly less complicated.

But if you did (which I’m hoping is most of you!), you will almost certainly need to use an experienced CPA to get the most out of the Employee Retention Credit.

If you have yet to file for the Employee Retention Credit (ERC) and your business was impacted in some way, shape, or form by COVID-19, we encourage you to do so now!

As of the publishing of this blog in August 2023, funds are still available. 

You can use our quick quiz to find out if you qualify for the Employee Retention Credit (ERC) here: 

Alternatively, you can book a complimentary call with one of our team members here. 

And for those of you who have read all the way to the end, we wanted to give a shout out to the authors at Kaplan Financial Education who have given another concise and easy-to-understand interpretation of the deemed election SNAFU.

We’ve included an excerpt here:

A number of borrowers who applied for forgiveness in 2020 may have opted to only provide payroll costs on the application form when applying for forgiveness.  They may (and likely did) incur non-payroll costs that would have also counted towards forgiveness, but decided there was no reason to provide those costs when the borrower incurred more than enough payroll costs to obtain full forgiveness.  The time and effort to determine and document those expenses for the forgiveness application appeared to offer no benefit, so many borrowers made the reasonable decision to not do the work to provide that additional information with the application.

While an understandable conclusion given the then-existing law, that decision now may not work out well as the Notice looks only to what was provided on the application to determine the amount of ERC eligible wages that were used to obtain forgiveness—not what could have been provided in lieu of such expenses to allow a larger ERC to be claimed.  Generally, a borrower only needed to spend 60% of the loan proceeds on payroll costs, a category which is made up of certain costs not eligible for the ERC (such as employer contributions to retirement plans), as well as including wages that, themselves, may not have been ERC eligible.

Thus, a borrower with enough non-payroll costs paid during the covered period could, at worst, limit the deemed election wages to 60% of the loan proceeds and, quite often, lower the amount even more by selecting payroll costs that simply aren’t ERC eligible at all (retirement plan contributions) and wages that aren’t ERC qualified wages to make up as much of that 60% as possible.

But if such costs were not listed on the application, the taxpayer cannot now go back and demonstrate they had incurred such expenses that could have been listed.  The IRS looks only to what was listed on the actual application.

You can continue reading more here: 

https://www.currentfederaltaxdevelopments.com/blog/2021/3/2/irs-notice-indicates-how-to-determine-erc-eligible-wages-deemed-used-to-obtain-ppp-loan-forgiveness-in-2020

Until next time!