Author: Mark Guirguis, CPA, CMA, Registered Representative | Vice President, Guirguis & Gibbs Inc.
What has now become an unavoidable and all too enticing money grab for small business owners struggling with cash flow problems since the COVID 19 pandemic, the CARES Act of 2021 air dropped a liquidity lifeline that seemed too good to be true. The Federal Government was giving the opportunity for all businesses that retained employees and paid qualified wages to some or all employees after March 12, 2020, and before January 1, 2022 to the tune of $55 billion dollars in refundable credits.
Companies that specialize in helping businesses apply for the ERC, channel their messaging by focusing solely on the maximum amount that each retained employee’s credit could be $26,000. The Employee Retention Credit serves as a lesson to everyone in advertising, taxation and inflation.
Deceptive Advertising
Advertising is the cornerstone of brand visibility, growth and market evolution. It is what a business needs to be able to remain relevant in the eyes of the market they serve by focusing on retaining revenue and bringing in new customers to use their products or services. Under the CARES Act of 2021, the Federal Government earmarked $55 billion dollars disguised as refundable credits and packaged it to offer the appearance of a helping hand. Companies that focus on helping businesses try to obtain these refundable credits then exploit business owners by telling them how much money they could receive. At this point, the intended recipients of these credits don’t care about anything else: logically drowned out by the idea that they could feel some sort of financial relief without having to resort to taking on bank loans or increasing any credit line balances.
As the old cliché goes, the devil is in the details and in this case, the details happen to hold the most important information. The Federal Government’s futile attempt to offer assistance in the form of refundable credits largely went unchallenged as the messaging’s goal was to offer help to struggling businesses. What wasn’t properly disclosed was that this assistance wasn’t in the form of stimulus or Payroll Protection Program loans but in refundable credits. A refundable credit can be used to generate a federal tax refund larger than the amount of tax paid throughout the year, however in the case of already filed quarterly Employer Taxes, the credit was capped at $26,000 per employee. Essentially, the Federal Government knew that businesses would have to reduce the amount reported as payroll expenses by the amount of the credit claimed for the 2020 & 2021 filed tax returns, forcing them to report higher net income and thus, pay taxes.
The companies that are running wild with their advertising and marketing promoting the ERC, are focused on assisting applicants for a fee that is contingent upon the amount of the refund received. Once an applicant gets underway in the process, they begin to learn what is entailed with receiving these credits: a drawn-out application process, a revision of the employer quarterly tax returns and the understanding that the US Treasury most likely wouldn’t be able to provide the applicant with a refund for approximately 8-12 months. Simply put, from the time a business owner engages a company to help with the application process until the time they could tangibly receive a check for the refund amount, a whole year could lapse. It is true that the servicing company’s contingent fee is deductible but only in the year it is paid, not against the years in which the credit is applied, which doesn’t escape the tax implications of the refundable credit (more on that below). For some businesses, this time frame could mean the difference between keeping their doors open or shutting down their operations for good.
Here is the worst part that these companies won’t tell you: if you are audited by the IRS and they deem you as not qualified for receiving the ERC, you will have to pay it all back to them.
Taxation Implications
It seems odd that the Federal Government would offer assistance in the form of refundable tax credits and yet, want to seemingly tax business owners who take the offer in good faith just to keep their businesses afloat. As much of a paradox as this is, it does make perfect sense. The Federal Government does not give anything away without finding an avenue to get something in return.
Refundable credits offer a perfect cover, enabling the Federal Government the appearance of extending an olive branch to businesses in need, only to strike them down with the cold hard reality that this is nothing more than a wolf in sheep’s clothing: the wolf being analogous to taxation and sheep representing a helping hand. As mentioned above, refundable credits can be used to generate a federal tax refund larger than the amount of tax paid throughout a given year. In this case, the refundable credit is used to reduce the amount of payroll expenses in either 2020, 2021 or both years. This reduction in payroll expenses forces the business owner to revise the following: quarterly Employer Tax Returns, business income tax returns and in some cases, individual income tax returns. The contingent fee paid for getting the Credit cannot be applied retroactively, meaning it is only deductible in the year in which it was paid. For some taxpayers, this could mean up to a total of 12 tax returns would need to be revised even before seeing a dime of this refund.
Revising all the tax returns impacted by the refund is non-negotiable and failing to do so will cause the taxpayer to owe penalties and interest. Figuring out exactly how much a taxpayer would owe once the credit refund is factored in is dependent on multiple variables and if you received an ERC, you should be consulting with your accountant or tax professional. What I will say is this: if you received thousands of dollars in ERC money, expect to potentially pay thousands of dollars out in taxes as a result. If this alone does not make you sick to your stomach, then I hope you realize this: the IRS will now begin conducting ERC audits to ensure that all taxpayers have made the proper adjustments in their accounting records, revised all the tax returns correctly and have paid income taxes based on their newly amended tax returns. Be aware that the IRS can knock on your door at any time to conduct this audit, so you need to be prepared.
Inflation Impact
In basic terms, inflation exists because of the rise in prices of goods and services over time. For businesses, this results in higher costs such as wages, raw materials and overhead expenses. However, inflation can also be caused by another factor: an increase in the money supply. Remember how I mentioned earlier that the CARES Act set aside $55 billion dollars for the ERC? This money wasn’t conveniently sitting in some bank account on standby, budgeted to be used for this exact purpose. The Federal Government is printing money and inflating the money supply which is eroding the purchasing power of all the participants in the economy. Fiat money is printed at an alarming rate and not backed by anything, in effect, rendering our ability to pay for goods and services impotent. Since 2020, inflation has spiraled out of control, hitting a 40-year high without signs of breaking and it is estimated that on average, cumulative inflation has been approximately 20%, battering American citizens at a time when they need help the most.
You might be asking yourself, how does inflation factor into the ERC credit? I mentioned earlier that the ERC credit applies to payroll expenses a business paid during 2020 & 2021. If cumulative inflation has caused purchasing power to decrease 20% then the reality is that the money the Federal Government would give you for the ERC is not equivalent to the value of the money you spent keeping people employed during the pandemic. If you factor in inflation for each of those years, then the amount of ERC credit you could receive should be higher to compensate for the loss of purchasing power against those wages that were paid. To make things worse, the ERC only added to the inflation problem we have by pumping $55 billion dollars into an economy that has run out of steam, stuck at the crossroads of stagnation and inflation.
Tying It Altogether
The best way I could illustrate how all three of these individual lessons connect is by the following case scenario:
ABC Company Inc., a California based S Corporation, reported payroll expenses of $400,000, spread out amongst its 10 employees, for each of 2020 & 2021 applied for the Employee Retention Credit. Overnight ERC Inc., a company that has promoted their services on the local radio station reached out to ABC Company Inc. to explain how the process works and offer its services to help them apply for the ERC and in return, they will charge 25% as a contingent fee. The business owner likes what is being said and enthusiastically jumps at this too good to be true opportunity. ABC Company Inc. decides to use their services to apply for the ERC and is approved for $260,000, $130,000 for each year. The business owner is ecstatic as this can help pay overhead expenses, since costs have gone up since the pandemic.
Adjusted for a cumulative inflation rate at 20%, the business owner’s purchasing power in today’s dollars amounts to $210,704.00 for the amount. The business owner must pay the contingency fee for getting the ERC, which is $65,000. The value of the ERC in 2023 dollars, net of the contingency fee paid, is now $145,704.00. This amount now represents around 56% of the $260,000 they were qualified to receive.
Table 1.1
The business owner then goes to their accountant to inform them of the news.
Related Article: A New Client’s Guide To Financial Excellence With Guirguis & Gibbs, Inc.
The accountant informs the business owner that all tax returns (including the quarterly Employer Tax Returns that Overnight ERC Inc. will revise) must be amended to reflect the refund amount and that the business owner is going to have to pay the additional tax as a result. Since the business is structured as an S Corporation, the business owner is personally liable for the taxes on the amended returns. Assuming the business owner is in a 25% individual federal tax bracket, that means an increase in $260,000 of business net income now results in a minimum of $32,500 in federal taxes owed personally for each year.
The scenario above is hypothetical but the circumstances are far too common: a refundable credit advertised to small business owners, a company that will assist in the application process for a contingent fee and the eventual realization that taxes will have to be paid for the amount received.
The ERC has emerged as a tantalizing financial lifeline for small business owners grappling with cash flow challenges in the wake of the COVID 19 pandemic. This crucial provision of the Cares Act of 2021 seemed too good to be true – air dropped support from the Federal Government, offering a mind boggling $55 billion dollars in refundable credits waiting to be claimed. Businesses that seemingly came out of nowhere strategically honed their messaging, emphasizing a significant gain to be had: a maximum credit of up to $26,000 per retained employee. This singular aspect blinded many business owners from realizing the strings that were attached to such an offer. The biggest realization regarding the ERC is understanding how a targeted policy measure and well-crafted economic initiatives can unleash a cascade of effects on businesses and the overall economy.
If you applied for the ERC and are concerned about the potential impacts to your business or yourself, don’t hesitate to call and make an appointment with us.
Guirguis & Gibbs Inc. is located at 27819 Smyth Drive Floor 2. Valencia, CA 91355. Give us a call at (661) 209-3287.
*Mark Guirguis is a Registered Representative of Cetera Financial Specialists LLC, member FINRA/SIPC. Cetera is under separate ownership from any other named entity. For a comprehensive review of your personal situation, always consult your tax and/or legal advisor. Neither Cetera Financial Specialists LLC nor any of its affiliates offer tax or legal services.
