Revisiting (Again!) Shareholder Wages and the ERC

UPDATE 8/4/21 WITH AN OFFICIAL ANSWER: IN MOST CASES, SHAREHOLDER WAGES WILL NOT COUNT. SEE IRS NOTICE 2021-49, AND MY MOST-RECENT BLOG POST ON THE SUBJECT. 

ALL OF THE ANALYSIS BELOW IS RENDERED MOOT BY NOTICE 2021-49. ALSO NOTE THAT SOME OF THE LINKS BELOW MAY NO LONGER WORK, AS I HAVE SIMPLY DELETED OLDER POSTS ON THIS SUBJECT AS NEW INFORMATION HAS COME ALONG.

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See this post from Federal Tax Developments, which I think changes my mind on this subject. https://www.currentfederaltaxdevelopments.com/blog/2021/4/3/tax-advisers-area-51-employee-retention-credit-and-majority-shareholders

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The National Association of Tax Professionals addressed the subject of shareholder wages and the employee retention credit in their weekly news alert last week.

In the “You Make the Call” segment, the question was regarding whether or not shareholder wages count for the ERC. NATP’s judgment is, NO the wages do not count.

I respect NATP, and their You Make the Call segment is one of the best things about the organization. Just like their monthly and quarterly journals, the material is always real-world and based on things that actually apply to average tax professionals. So when they say something, I pay attention. 

This segment caused me to go back to my prior analysis, found here and here. It has reached a point where I can argue both sides quite well! But I still think the answer is “probably they DO” when it comes to shareholder wages. 

My re-review took me to the CARES Act, Sections 51 and 152 of the tax code, the regulations under Section 51, and PPC/Checkpoint analysis of the Work Opportunity Credit.

(Side note: isn’t this such a sad indictment of how convoluted our tax system is?)

ACT 1: The CARES Act

The CARES Act created the ERC, but it does not address what wages do not qualify. Instead it says is that the rules of Section 51(i)(1) apply. Section 51 is the Work Opportunity Credit.

ACT 2: The Work Opportunity Credit

Section 51(i)(1)(A), (B) and (C) of the Internal Revenue Code lay out restrictions relating to the Work Opportunity Credit. It reads as follows regarding employees who does not qualify for this credit:

An individual who — bears any of the relationships described in subparagraphs (A) through (G) of section 152(d)(2) to the taxpayer, or, if the taxpayer is a corporation, to an individual who owns, directly or indirectly, more than 50 percent in value of the outstanding stock of the corporation, or, if the taxpayer is an entity other than a corporation, to any individual who owns, directly or indirectly, more than 50 percent of the capital and profits interests in the entity (determined with the application of section 267(c)

ACT 3: Attempt at Interpreting

I think that the key here involves how you interpret the words that come before and after the first “or.” 

The first clause about A through G of Section 152 refers to people related to the owner. Children, grandchildren, grandparents, siblings, aunts, uncles, nieces, nephews, plus in-laws such as mother-in-law, etc.

Then we get to the crux of the issue. There is an “or” stuck in between commas. What follows is the phrase “an individual who owns … more than 50 percent of the value of the outstanding stock of the corporation.” 

Is that phrase a standalone phrase? Does the “or” introduce a totally new topic? That is how NATP (and many others) are interpreting this. The phrase “more than 50 percent etc etc etc” refers to eliminating the shareholder themselves. 

I am no grammarian, but I am not so sure that this is the correct analysis. I think the “or” joins the first clause with the “50 percent blah blah blah” part. 

So a relationship with an “taxpayer” who owns the company (i.e. a sole proprietor), “or” a relationship with an individual who owns 50 percent or more of a corporation. The “or” continues the thought, not creates a new one.

(And people wonder why I am so grumpy and cynical all the time. Good lord, just try living in this world and trying to interpret this stuff, and then let me know about YOUR mental state after awhile!)

ACT 4: The Work Opportunity Credit Regulations

There is 1 regulation under Section 51, which is Regulation 1.51-1.

Regulation 1.51-1(e) says the following regarding employees whose wages don’t count for the Work Opportunity Credit:

For purposes of section 51(a), “qualified wages” does not include any amounts paid or incurred by a taxpayer to any of the following individuals:

1.51-1(e)(1)(i)(i) An individual who is related (within the meaning of any of paragraphs (1) through (8) of section 152 (a)) to the taxpayer;

1.51-1(e)(1)(ii)(ii) An individual who is a dependent (within the meaning of section 152(a)(9)) of the taxpayer;

1.51-1(e)(1)(iii)(iii) An individual who is related (within the meaning of any of paragraphs (1) through (8) of section 152(a)) to a shareholder who owns (within the meaning of section 267(c)) more than 50 percent in value of the outstanding stock of the taxpayer, if the taxpayer is a corporation;

1.51-1(e)(1)(iv)(iv) An individual who is a dependent (within the meaning of section 152(a)(9)) of a shareholder described in paragraph (e)(1)(iii) of this section;

1.51-1(e)(1)(v)(v) An individual who is a grantor, beneficiary or fiduciary of the taxpayer, if the taxpayer is an estate or trust;

1.51-1(e)(1)(vi)(vi) An individual who is a dependent (within the meaning of section 152(a)(9)) of an individual described in paragraph (e)(1)(v) of this section; or

1.51-1(e)(1)(vii)(vii) An individual who is related (within the meaning of any of paragraphs (1) through (8) of section 152(a)) to an individual described in paragraph (e)(1)(v) of this section.

Analysis: this regulation is old and has not been updated for 2005 law changes to Section 152. This is why it references 152(a)(1-9), which no longer exists. However, if we look back at the “old” Section 152, it’s detailing the same basic limitations as Section 152(d)(2) as described above. Nowhere in this regulation is the shareholder themselves mentioned. Only relatives of the shareholder. And note how grantors and beneficiaries of a trust ARE specifically mentioned.

ACT 5: What the Guidebooks Say

Here is what the RIA Federal Tax Coordinator Analysis says regarding the Work Opportunity Credit:

No credit is generated by hiring an individual having any of the following relationships to the taxpayer-employer: son, daughter or descendant of either; stepson, stepdaughter; brother, sister, stepbrother or stepsister; father or mother, or ancestor of either; stepfather, stepmother; son or daughter of brother or sister; brother or sister of father or mother; son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law. If the taxpayer is a corporation, a person standing in any of the above relationships to anyone who owns, directly or indirectly, more than 50% in value of its outstanding stock won’t qualify. If the taxpayer is a noncorporate entity, a person standing in any of the above relationships to anyone who owns, directly or indirectly, more than 50% of the capital and profits interests in the entity also won’t qualify.

Note that there is no reference to the shareholder themselves being ineligible. 

ACT 6: Section 51(i)(1)(B) of the Code

What we’ve looked at above is Section 51(i)(1)(A) of the Code. If we move on to 51(i)(1)(B), we get a section that deals with estates or trusts and the Work Opportunity Credit. In this section, beneficiaries of the estate (which would be a rough equivalent of shareholders in a corporation) DO NOT qualify, and they are specifically excluded (my emphasis added in bold):

A person is excluded if the entity is an estate or trust, and the person is a: “grantor, beneficiary, or fiduciary of the estate or trust, or is an individual who bears any of the relationships described in subparagraphs (A) through (G) of section 152(d)(2) to a grantor, beneficiary, or fiduciary of the estate or trust.”

Note the subtle difference here? Grantors, beneficiaries and fiduciaries of an estate or trust (who are basically like shareholders in a corporation) are specifically mentioned in 51(i)(1)(B). Whereas 51(i)(1)(A), which deals with other types of businesses, makes no mention of owners or shareholders themselves anywhere in it … only to related parties to those owners or shareholders.

ACT 7: Don’t Forget Section 51(i)(1)(C)

Section 51(i)(1) contains one more clause, (C), which says anyone else who could be claimed as a dependent of the business owner (even if not related) on the business owner’s tax return, doesn’t qualify either.

CONCLUSION: My Head Hurts

Does your head hurt? IT SHOULD! Mine does! 

Based on this analysis, it seems — and I am open to people arguing with me on this — that wages paid to the shareholder and their spouse (spouse’s are never mentioned anywhere in any of the above limitations…) probably DO count toward the ERC, but wages paid to relatives do NOT count. 

WARNING: under no circumstances should any reader of this post use this post for final decision making. This is complicated. If you are an accountant, do your own research and come to a conclusion. If you are a taxpayer, consult with your accountant and come to a conclusion you can both agree on. This stuff is hard.