Employee Retention Credit or ERC is reevaluating the status of small employee for increasing cash payments. The current cash preference (which does not increase due to ERC) for all small employee is paid in the first three years for earnings up to $40,000, and that cash preference reduces annually until it reaches zero. According to the statute, in the year it reaches zero, the employer receives a credit on that employee’s tax return equal to the employer’s payment in the first three years. This credit reduces the employee’s income tax liability.
Or individuals earning $250,000 or more, the employer’s payment is now subject to tax, as is the amount previously subject to tax. For taxpayers earning $50,000, the ERC reduces the employer’s payments by $3,000 in 2015 and $3,000 in 2016. The ERC payments decline thereafter (by approximately 1 percent for all years), to $1,000 in 2017, $1,500 in 2018, $1,600 in 2019, and $1,500 thereafter. The net ERC credit or reduction is between $1,000 and $1,500 per employee. The net ERC reduction for most small business is $200 to $500 per year.
We propose to reduce the tax preference for small employee from $2,000 to $1,000 per employee, effective for 2015, for each of the following reasons:
- EFC is fully realized in the first three years, so there is no additional cost.
- Additional qualified business income (QBI) is not available to the small employer.
- Small employer remains eligible for a 20 percent deduction for qualified dividends (up to a maximum of $1,000), as well as 20 percent of the employee’s qualified business income.
We propose to raise the cash alternative to the small employer so that it is more favorable than the ERC reduction for qualified dividends.
Reciprocal ERC, ERC Reduction and Minimum Payment
Revenue requirements for the ERC credit have not been fully met. According to the Treasury Department, the amount of employer payments received by the small employer must equal the amount of employee payments received by the small employer. This requirement means that the federal government must be able to identify a small employer if it is making payments. In addition, the Small Business Administration (SBA) must be able to identify a small employer if the employee is a bona fide employee.
Our proposals would eliminate the requirements that the employer be in the business of providing services to the small employer and the requirement that the employer be a bona fide employee, and would add an administrative condition requiring the employer to make the cash alternative payment. The combination of these two requirements results in an approximate $2,000 employer ERC reduction. For example, if we make the cash alternative payment and the total employee payments received by the small employer equals $2,000, the federal government receives $1,500 of employer payments and $1,500 of employee payments. The cost of making this $2,000 payment is offset by the small employer cash preference credit, which decreases by approximately $1,500 per year.
As we have shown in Section 3, we propose to reduce the cash preference for small employee. The proposed changes also mean that the federal government does not receive additional payment of the small employer’s qualified dividends. In addition, the elimination of the requirement to identify a small employer means that no one is obliged to maintain a small employer. A bona fide employee can resign from his or her employer and go to another small employer in the same industry without providing the services to the small employer. The administrative requirement for cash payment represents a small amount of tax compliance.
Final Tax Reform Proposals
Beginning in 2023, we propose to reduce the business income tax rate on nonresidential business income from 35 percent to 28 percent. This rate reduction is offset by reducing the small business ERC and employee ERC from 40 percent to 30 percent for tax years beginning in 2023. The policy basis for the 28 percent rate is intended to provide parity with the effective tax rate on taxable income from domestically based business income.
We propose to increase the cash alternative to the small employer. The cash alternative represents the portion of the employer’s qualified dividends that is not subject to the small business ERC requirement and which is not subject to the small employer cash preference.
Increase the Employee’s Minimum Tax Credit and Removing the Revenue Requirement
Under current law, employees with income over $157,500 have a reduced minimum tax rate. However, it is offset by a cash preference credit that the ERC credit is reduced by for each dollar that the employer withholds from the employees’ pay. Under our proposal, an employee’s reduced minimum tax rate is offset by an employee’s minimum tax credit. Our proposal increases the minimum tax credit for employees with taxable income over $40,000.
In addition, we propose to increase the employee’s minimum tax credit to $3,600 for those who are subject to the individual alternative minimum tax. ERC calculation will be based on modified adjusted gross income (MAGI). We believe this would reduce the income subject to the individual alternative minimum tax.
Reduce the Small Business Effective Tax Rate
Finally, we propose to reduce the small business effective tax rate. A small business ERC and employee ERC are proportionate to taxable income. Therefore, the ERC should be approximately equal to the employee ERC, which means that the small business ERC is the same as the employee ERC. Our proposal reduces the small business ERC from 40 percent to 28 percent.
It is important to note that the proposed policy changes would not have the effect of lowering the amount of income subject to the small business ERC or the employee ERC. For a taxpayer with an AGI of $15,000 or less, the change in the small business ERC or employee ERC is not going to affect the amount of employee ERC or small business ERC that the taxpayer is entitled to receive.
In summary, the reductions in the cash preference and elimination of the small employer ERC requirements that we propose in this column would result in the following:
- Decrease the ERC and minimum tax credit for employee benefits from approximately $22,700 to $3,600.
- Increase the employee ERC to $3,600.
- Allow employees to exclude employer ERC from their taxable income at the employee tax rate (with a credit against their minimum tax credit).
- Reduce the cash preference and elimination of the small employer ERC to 14 percent for taxable years beginning in 2023.
- Reduce the small business effective tax rate from 38 percent to 28 percent.
- Change the small business ERC formula from the base ERC (discussed above) to the eligible ERC (discussed above).
We believe the above proposals would result in the following:
- Reducing the ERC and employee ERC would reduce the tax payable to the IRS from roughly $13,000 to $1,300 for those taxpayers with an AGI of less than $120,000.
- Reducing the small business ERC and eliminating the employee ERC would reduce the tax payable to the IRS from roughly $12,700 to $1,200 for those taxpayers with an AGI of less than $150,000.
- Increasing the employee ERC and increasing the employee ERC credit would reduce the tax payable to the IRS from roughly $22,700 to $3,600 for those taxpayers with an AGI of $120,000 or more.
- Reducing the cash preference and eliminating the small employer ERC would reduce the tax payable to the IRS from roughly $22,700 to $15,000 for those taxpayers with an AGI of less than $150,000.
- Taxpayers with an AGI of $150,000 or more would see their taxable income increase by approximately $6,700.
- Small businesses would have a smaller tax liability and gain tax efficiency in complying with the payroll tax.
- Repealing the small employer ERC and reducing the small business ERC would improve compliance of the small business and improve taxpayer economics.
Why ERC Is Reevaluating For Small Businesses?
ERCs have an important and long-standing role in the tax code. When designing the tax code, Congress has often set aside special provisions for small businesses to simplify or otherwise provide significant tax savings. ERCs are an important part of that basic design.
However, most businesses do not use them in the same way that they are designed for. The definition of a small business in the tax code is pretty clear, but it is not exactly as prescribed by Congress. While most small businesses use ERCs in some form, some small businesses use ERCs in ways that go well beyond the traditional definition of a small business.
Part of the point of this column is to illustrate the importance of the small business ERC and discuss what Congress and policymakers can do to make ERCs easier to use for small businesses and, therefore, more valuable. We do not believe it is good policy for the IRS to continue a separate set of rules for many small businesses and benefit from those rules.
Any efforts that policymakers can make to simplify the tax code for small businesses or make the IRS more effective at collecting ERCs would be good for the taxpayers and small businesses.
Which Should Be Part Of The Consolidated ERCs?
A few important questions arise from our proposal of a unified consolidated ERC for small businesses:
- Should the ERC be taken out of the small business tax rate table and added to the consolidated ERC table?
- Should the maximum ERC be reduced to 14 percent, as we suggest above?
- Or should the consolidated ERC be returned to its original 14 percent level?
- If we use a 14 percent ERC, what should the qualified small business rate be? Should the small business rate be the same as the consolidated small business rate, or should it be a different number?
The Consolidated ERC for Small Businesses
Our suggestion of a consolidated ERC for small businesses is simple. The consolidated ERC for small businesses would equal 14 percent for all employees and would require the EIC and nonqualified EIC to be taken into account.
Thus, this proposal would have the dual benefits of simplification, meaning that the small business ERC would be a simple percentage of wages, and efficiency, because it would eliminate the need to calculate EIC, and NAICS codes. This would ensure that tax planning for the EIC and nonqualified EIC would be more streamlined.
As with our original proposal, for small businesses that use ERCs in a less formal, more complicated way, we would advocate going to the lowest taxable income level, at which the EIC and nonqualified EIC would also be taken into account.
Thus, the lowest taxable income level for a small business would be 15 percent of wages, and the taxable income level at which the EIC and nonqualified EIC would be taken into account would be $186,500.
One extra benefit of the consolidated ERC for small businesses is that the larger amounts of qualified business income would go directly into the personal tax system, rather than all of it being deposited in the small business tax system for the owners to pay.
ERC Simplification is an Active Track
There are several advantages to consolidated ERC. Some people, including some within Congress, have suggested that we should just simplify the small business ERCs and move to the flat 12 percent tax rate. While this is possible, the proposal we have made would remove some complexity. Two other simplification proposals have been discussed, but our proposal is different. One simplification proposal would have the new 12 percent small business ERC put all employees into the small business tax rate. However, it does not make sense to make it so that the 1099 workers are in the tax rate when they are no longer engaged in the performance of services that, with exceptions, would otherwise be taxable under the small business tax code.
For example, the 1099 workers of a leasing company may have taken a 1099 as an independent contractor and are still working for the company. Yet the income earned by the 1099 workers would be taxed at the 12 percent small business rate. The small business rate is often appropriate for sales or rental of equipment, and many of the 1099 workers in the leasing industry have generally earned income, with the exception of some limited capital gain, through sales or rentals of their equipment.
Therefore, our suggestion is to keep ERC for 1099 workers as is, except to allow those who are engaged in so-called common activities to be in the rate where the other employees are in the 12 percent tax bracket. The ERC would not apply to employees who are engaged in common activities. So the EIC and nonqualified EIC would be reduced to 0 percent for all employees. The idea is that the small business EIC could remain the same rate. We would also eliminate the capital gains treatment on small business income earned by the 1099 workers. However, the change would result in larger deductions for the EIC than current law allows, without taxing more capital gains.