By now, we have all heard or read up thoroughly on the Employee Retention Credit (ERC), which was put into place to assist employers in funding wages while recovering from COVID. This program has been touched and changed by multiple pieces of legislation. Most recently, the Infrastructure Investment and Jobs Act, which was signed into law on November 15, 2021, retracted the program for most taxpayers to end on September 30, 2021 (previously the program ran through the end of the year).
As is the case with most tax laws, there are nuances and exceptions, but generally for employers with fewer than five hundred employees in 2019, ERC allows for a credit of up to $7,000 per employee for any of the first three quarters of 2021 if a company is eligible. The basic premise for qualification being that using 2019 quarterly revenue as a pre-COVID baseline, you would have to show a 20% drop in revenue for the same quarter in 2021. However, due to pre-COVID backlog, many contractors do not believe they have enough of a decrease to allow them to claim ERC. Given the dollars available, this is a lucrative credit to miss out on.
The revenue calculation to determine qualification is based strictly on Federal Income Tax reporting. While it is too late to change revenue reported for 2019, there may be an opportunity to change how revenue is recognized for 2021. Assuming the taxpayer has not done so recently, small businesses could be eligible to make an automatic change of accounting method which would have the effect of reducing the revenue of the business for 2021. Currently, a small business is one which has less than $26 Million in gross receipts on a three-year average (aggregation rules apply). This automatic change request would be attached to a timely filed 2021 return, so there is still time to act.
Changing accounting methods for contractors does not impact the income recognition of contracts in process at the beginning of the year of change but would take effect on all jobs started up in that tax year. So, this won’t change the revenue relating to older jobs, but would allow for shifting of revenues on new jobs depending on the method chosen.
Methods that small business owners are eligible to switch to include percentage of completion, completed contract, cash, accrual, and a few others. Of these, switching to cash basis (recognize revenue when received) or completed contract (recognize zero revenue until job is complete) would likely result in the largest shifts of revenues between quarters.
Let’s walk through an example of a small business moving from percentage of completion to completed contract to see how it may change their ERC calculation. I will make the following assumptions:
- Reported $10 Million of revenue in 2019 and in 2021 on a Percentage of Completion basis. They have no seasonality in their work and for each quarter of those years, they show $2.5 Million of revenue.
- Switching to Completed Contract has the effect of changing the $2.5M per quarter income in 2021 and would result in in revenues of $2.5M in 2021 Q1, 1.0M in 2021 Q2, 1.5M in 2021 Q3, $2.5M in 2021 Q4, and $2.5M in 2022 Q1.
- The company has 40 full-time employees that make over $40K each annually.
We can see that by staying on the percentage of completion method, there is no drop in revenues between 2019 and 2021, so no ERC is available. However, upon switching to the completed contract method we don’t have a drop in 2021 Q1, but now drop enough in 2021 Q2 and 2021 Q3 to qualify. This would result in ERC of $560,000 (40 employees x $7,000 cap x two quarters of qualification).
Changing accounting methods to obtain ERC eligibility does not come without a cost and businesses will need to weigh the pros of this one-time benefit versus the cons. Potential downsides include:
- Losing conformity between book and tax reporting
- Additional work needed by tax accountants to make this switch and account for it annually
- Inability to easily switch back to prior method
- Alternative Minimum Tax (AMT) requires percentage of completion reporting
- New accounting method may result in additional income tax
Given the potential amount of these credits available, contractors that qualify as small taxpayers should not overlook this. Be sure to discuss with your tax advisor to help determine the options and benefits available before this opportunity goes away.
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This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.