Employment Credits (Work Opportunity, Employee Retention)

26.3 Employment Credits (Work Opportunity, Employee Retention)

Employment tax credits are powerful incentives for businesses seeking to reduce their federal tax liability while encouraging social and economic objectives. For CPA candidates preparing for the Tax Compliance and Planning (TCP) section, understanding the nuances of employment tax credits—particularly the Work Opportunity Tax Credit (WOTC) and the Employee Retention Credit (ERC)—is essential. This chapter explores key eligibility criteria, computation details, documentation requirements, and best practices for these credits. Through practical illustrations, diagrams, and tables, we aim to clarify these credits’ complexities and help you excel on exam day.

Introduction and Rationale

Both the WOTC and ERC reward employers for hiring specific categories of workers—whether defined by historical disadvantage or by unforeseen economic pressures such as the COVID-19 pandemic. While the WOTC focuses on targeted groups, especially those facing barriers to employment, the ERC was introduced as a lifeline for businesses retaining employees during periods of governmental shutdowns or significant declines in gross receipts. Each credit comes with distinct rules concerning eligible wages, calculation methodologies, and maximum credit limits.

Work Opportunity Tax Credit (WOTC)

The WOTC is a long-standing federal tax credit designed to encourage the hiring of individuals in certain target groups. It has been reauthorized or extended multiple times and is codified in IRC §51.

Purpose and Legislative Context

• The primary goal is to incentivize employers to hire individuals who have historically faced challenges in entering the workforce.
• Over time, Congress has refined the targeted groups to address evolving employment issues (e.g., veterans, ex-felons, recipients of SNAP benefits).

Targeted Groups and Eligibility

To claim WOTC, an employer must hire an individual from one of the following targeted groups:

• Qualified IV-A Recipient (Temporary Assistance for Needy Families – TANF)
• Qualified Veteran
• Ex-Felon (within one year of conviction or release from prison)
• Designated Community Resident (individual residing in an Empowerment Zone or Rural Renewal County)
• Vocational Rehabilitation Referral
• Summer Youth Employee (residing in an Empowerment Zone)
• Recipient of Supplemental Nutrition Assistance Program (SNAP) benefits
• Recipient of Supplemental Security Income (SSI) benefits
• Qualified Long-Term Unemployed Individuals (introduced in recent expansions, subject to certain legislative updates)

Workers must generally be certified by the appropriate state workforce agency within 28 days of new employment. Employers must complete IRS Form 8850 (“Pre-Screening Notice and Certification Request for the Work Opportunity Credit”) to secure certification.

WOTC Computation

The WOTC credit rate depends on the number of hours worked by the qualified employee and the wages paid. In general:

• Employers may claim 25% of first-year wages (up to a specific limit) if the employee works at least 120 hours.
• Employers may claim 40% of first-year wages (up to a specific limit) if the employee works at least 400 hours.
• Certain targeted groups, such as qualified veterans or employees on long-term family assistance, have higher maximum wage limits or extended eligibility into a second year.

Below is a simplified overview of maximum first-year credits for selected groups:

Depending on an employee’s circumstances, additional constraints or adjustments may apply. Typically, wages used to claim WOTC must be net of any related subsidies (e.g., if the wages are also used for other federal credits, careful calculations are required to avoid double counting).

Documentation and IRS Compliance

Employers must maintain:
• Form 8850, pre-screening notice.
• ETA Form 9061 or 9062, used by the Department of Labor for eligibility certification.
• Payroll records to substantiate hours worked and wages paid.

Prompt filing and strong internal controls are vital—record-keeping omissions can lead to disallowed credits.

Employee Retention Credit (ERC)

Originally introduced under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, the ERC was designed to encourage businesses to keep employees on payroll despite COVID-19-related hardships. While various legislative acts amended the ERC, understanding its evolution and complexities is crucial for CPA exam readiness.

Legislative History

• CARES Act (March 2020): Created the ERC, limiting the credit to 50% of qualifying wages paid after March 12, 2020, and before January 1, 2021.
• Consolidated Appropriations Act, 2021 (CAA): Extended and expanded the ERC into 2021, raising the credit percentage to 70% for wages paid during January 1, 2021 – June 30, 2021.
• American Rescue Plan Act, 2021 (ARPA): Further extended the ERC through December 31, 2021, with certain modifications, though legislation has since curtailed some of the credit for Q4 2021 for most employers.

Despite legislative changes, the ERC’s core intent remained: reimburse eligible employers for a portion of employee wages paid during specific periods if they met certain shutdown or gross receipts decline thresholds.

ERC Eligibility Requirements

To be eligible for the ERC, employers typically must meet one of the following criteria during the applicable calendar quarter:

1. Governmental Order Shutdown
   • An employer’s operations were fully or partially suspended due to government orders limiting commerce, travel, or group meetings for COVID-19.
   • The credit generally applies only to wages paid while the operation was suspended.

2. Significant Decline in Gross Receipts
   • For 2020: At least a 50% drop in gross receipts compared to the same quarter in 2019.
   • For 2021: At least a 20% drop (some threshold modifications) in gross receipts compared to the same quarter in 2019.

Small vs. Large Employer Determinations:
• The threshold for determining whether “qualified wages” include all wages paid vs. only wages paid to employees not providing services depends on average full-time employees. In 2020, that threshold was 100 employees; in 2021, it was raised to 500 employees.

ERC Computation and Credit Rates

Below is a summary chart highlighting major ERC provisions by time period:

Some employers (particularly Recovery Startup Businesses) received specialized ongoing ERC eligibility through 2021, but subsequent legislation (i.e., the Infrastructure Investment and Jobs Act) limited or repealed the ERC for certain quarters unless the employer qualified as a Recovery Startup Business. Always check current legislative guidance when working with the ERC to ensure accurate compliance.

Interaction with PPP (Paycheck Protection Program)

Under early CARES Act provisions, employers could not double-dip payroll costs for both ERC and loan forgiveness under the PPP. Later revisions permitted businesses to claim the ERC on wages not forgiven by the PPP loan. Proper record-keeping and expense allocations are critical to avoid duplicative claims.

Practical Example

Consider an employer forced to partially shut down under local COVID-19 orders for Q2 2021. The employer has 450 full-time employees and suffers a 25% drop in gross receipts compared to Q2 2019. Because they meet the gross receipts decline test, they can claim the ERC on wages paid (including health plan expenses) to both working and nonworking employees (under the applicable small/large employer rules, ≤500 employees for 2021) during that quarter.

• Assume each employee earned $12,000 in Q2 2021 in qualified wages. Only $10,000 is considered for the credit. The credit is 70% of $10,000 = $7,000 per employee.
• For 450 employees, the maximum for Q2 2021 could be 450 × $7,000 = $3,150,000, subject to any adjustments or limitations.

Diagram: Overview of Employment Credits Process

Below is a Mermaid diagram summarizing the high-level steps for employers to claim either WOTC or ERC.

    flowchart LR
	    A[Identify Potential Eligibility] --> B[Gather Required Documentation]
	    B --> C[Calculate Eligible Wages]
	    C --> D[Apply for Certification (WOTC) or Determine ERC Criteria]
	    D --> E[File Applicable IRS Forms (e.g., Form 5884 for WOTC, Form 941 for ERC)]
	    E --> F[Maintain Records for Audit]

Diagram Explanation

• Step A: Employers begin by identifying whether they have hired employees from a designated targeted group (for WOTC) or if they meet the requisite shutdown/receipts decline test (for ERC).
• Step B: Employers gather all documentation, including state workforce agency certifications, payroll records, and government shutdown orders.
• Step C: Calculate wages that qualify for the respective credit.
• Step D: For WOTC, the employer must obtain certification from the state agency confirming the employee’s eligibility; for ERC, the employer must verify if it meets the mandated criteria each quarter.
• Step E: The credit is typically claimed on specific IRS forms—for instance, Form 5884 for the WOTC (and carried to business returns), or Form 941 (Employer’s Quarterly Federal Tax Return) for the ERC.
• Step F: Employers must maintain working papers to support their credit claims in the event of an IRS examination.

Common Pitfalls and Best Practices

1. Overlapping Credits

Employers must be vigilant not to claim the same wage expense for multiple credits (e.g., WOTC and ERC on the same payroll dollars). Proper classification, documentation, and thorough tracking in payroll systems help mitigate this risk.

2. Filing Deadlines and Certification Obstacles

For WOTC, forgetting to submit the pre-screening Form 8850 within 28 days of the new hire can disqualify the employer from claiming the credit. For the ERC, incorrectly identifying qualifying quarters or missing relevant changes in legislation can lead to over- or under-claiming.

3. Documentation Requirements

The IRS remains cautious with both WOTC and ERC claims. Employers who fail to maintain robust support (certifications, gross receipts calculations, etc.) risk having their credit disallowed upon audit.

4. Tracking Legislative Updates

The ERC has seen multiple changes over its lifetime. Paying close attention to legislative details—especially effective dates—is crucial for correct calculation and reporting.

5. Understanding Aggregation Rules

Businesses under common ownership can be required to aggregate employees, gross receipts, or wages. Overlooking these rules often triggers accidental noncompliance or miscalculation of total credit eligibility.

Case Study: Combining WOTC and ERC

XYZ Enterprises hired 10 new employees during Q4 2020, 2 of whom qualified as ex-felons under the WOTC rules. Additionally, XYZ faced partial shutdown orders in October 2020. Let’s examine how the employer manages compliance:

1. WOTC Certification
   • XYZ submits Form 8850 on behalf of the ex-felon hires within 28 days of each new employee’s start date.
   • Each ex-felon employee works over 120 hours, potentially qualifying for 25% of wages up to $6,000 each, or 40% if they work beyond 400 hours.

2. ERC Qualification
   • For Q4 2020, the employer sees a 60% decrease in gross receipts compared to Q4 2019, meeting the CARES Act requirement (≥50%).
   • XYZ can claim the ERC of 50% of the first $10,000 in qualified wages per employee for the entire quarter.

3. Separate Wages
   • Any wages used toward WOTC cannot be doubly counted for the ERC. XYZ carefully segregates the portion of wages used for WOTC from the portion used for the ERC to comply with the “no double dipping” rule.
   • By reconciling payroll records monthly, XYZ ensures that the same payroll costs are not allocated to both credits.

4. Claiming the Credits
   • WOTC is claimed on Form 5884, eventually carried over to the business income tax return.
   • ERC is claimed by reducing the payroll tax deposits on Form 941 or filing an amended Form 941-X if needed.

This example shows that while employers can employ multiple credits concurrently, careful documentation and tracking are key.

Strategies for Exam Success

1. Memorize Thresholds and Rates
   • Knowing WOTC’s standard 25%/40% thresholds for 120/400 hours, and the ERC’s changing percentages (50% vs. 70%) helps you quickly solve short-answer or multiple-choice questions.

2. Be Aware of Aggregation Rules
   • On the exam, you might be presented with a scenario involving commonly owned firms. Familiarity with controlled group rules can be critical when calculating credit eligibility.

3. Stay Current
   • The exam tests your ability to apply current law. Even hypothetical future legislative changes might not appear, but ensure you know the final structure of the ERC for 2020, 2021, and any relevant guidance.

4. Practice Detailed Calculations
   • Use practice questions to gain confidence in computing partial wage thresholds, netting out wages used for other credits, and applying maximum credit limitations.

5. Cross Reference with Payroll Tax Filings
   • Understanding how each credit flows onto specific forms (e.g., claiming the ERC on Form 941) is essential to linking theory with real-world reporting.

Additional Tables & Quick Reference

Quick WOTC Reference

Quick ERC 2020 vs. 2021 Reference

References and Further Exploration

• IRS Publication 15 (Circular E): Employer’s Tax Guide
• IRC §51: Work Opportunity Tax Credit Guidance
• IRS FAQ on Employee Retention Credit (periodically updated): https://www.irs.gov
• “Coronavirus Aid, Relief, and Economic Security Act” (CARES) and subsequent amendments
• Chapter 20: “Recent Legislative Developments & Sunset Provisions” from this text for additional coverage of COVID-era legislation

Quiz: Employment Credits Mastery

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