November 3, 2020
1. What is the ERC?
The CARES Act Employee Retention Credit is a fully-refundable tax credit for employers, equal to up to 50 percent of qualified wages (including allocable qualified health plan expenses) that “Eligible Employers” pay their employees after March 12, 2020 and before January 1, 2021. Qualified wages are compensation provided to an employee for time the employee is not providing services. The maximum credit for an eligible employer for qualified wages to any employee is $5,000. The tax credit offsets all withheld federal employment taxes including federal income tax withholding, Employer FICA and Medicare.
The Employee Retention Credit should be considered for most companies within a PE firm’s portfolio. Additionally, an acquisition target that had previously claimed ERC may be eligible for more than the seller had already claimed. Its worth taking a deeper dive into eligibility and qualified wages , as the credit potential for middle market companies can easily climb into the millions of dollars.
2. How is the ERC impacted by Paycheck Protection Program (PPP) Loans?
Companies and controlled groups of companies that received a PPP loan are not eligible to claim the ERC.
Section 2301(j) of the CARES Act states that if an employer receives a loan under section 1102 of this Act (PPP loan), such employer shall not be eligible for the ERC. Sections 52 of the Internal Revenue Code, as well as Section 414 affiliation rules apply. If an entity owns more than 50% of the ownership of a company, the companies in aggregate are part of a controlled group. Ownership is defined as 50% or more of either the voting rights or the value (total stock or equity) of the owned entity.
If the portfolio does not include any companies that took PPP, then eligibility is straightforward. Alternatively, if any of the companies within a specified fund vehicle received a PPP loan, the sponsor should further analyze the structure of that fund vehicle. In common general partner / limited partner (GP/LP) fund structures, the controlled group is siloed within each fund vehicle, and does not cross over into other funds. Generally speaking, GPs cannot unilaterally comingle assets interfund.
If any portfolio company received a PPP loan, a fund should first determine which fund vehicle owns that company. Using the definition of control above, a fund needs to determine if the specified fund vehicle controls the company that received the PPP loan. Take this fictional example of Vested Capital Partners having deployed capital from Fund IV into RRR Retail Services. RRR received a PPP loan. Vested Capital owns 75% of the stock of RRR. There are twelve other companies in Vested Capital’s Fund IV, and none of the others received a PPP loan. For purposes of the ERC, Fund IV should be considered a controlled group, and none of the other portfolio companies would be eligible for PPP. Now let’s say that Vested Capital has three other active funds, Fund V, VI and VII. Assuming no companies in any of those funds received a PPP loan, the companies within those funds would be potential candidates for ERC.
3. How should a sponsor determine ERC eligibility for each portfolio company?
The Cares Act provides two ways that a company can test for ERC eligibility.
- The Gross Receipts test – A 50% or greater quarterly decline in Gross Receipts in any quarter in 2020, vs. that same quarter in 2019; or
- The Suspension test – A full or partial suspension of normal business operations as a result of a governmental order
Funds should apply these tests at the controlled group level. The IRS has confirmed in its FAQs 37 and 43 that (i) if the operations of a trade or business of one member of an aggregated group are suspended by a governmental order, the operations of that trade or business of the other members of the aggregated group are considered to be fully or partially suspended for purposes of the Employee Retention Credit and (ii) the decline in gross receipts test is determined based on the entire group. Example: XYZ Partners operates two funds (Fund X and XI), with two portfolio companies in each fund
- Scenario A: A company in Fund X experienced a partial suspension due to a Covid-19-related Order. The entirety of Fund X should be eligible for ERC throughout the period covered by the Order
- Scenario B: Neither of the companies in Fund XI experienced a partial suspension. However, aggregating quarterly gross receipts of both companies in Fund XI results in a greater than 50% decline in gross receipts in Q2 2020 vs Q2 2019. The companies in Fund XI should both be eligible for ERC
4. Can this tax position be insured?
Despite its complexity, the CARES Act was passed in a matter of days. The credit potential can run into the tens of millions of dollars for some companies. As with any tax position, there is a possibility of an IRS challenge in the future. Depending on the facts and circumstances, there may be some great options to mitigate that risk. For a nominal premium, it may be possible to insure an ERC position with a top tier insurance carrier. Some points to consider:
- The position is covered through the expiration of the statute of limitations
- The premium is ‘one-time’ payable upon binding the policy
- The policy covers the position, audit defense and penalties
- Coverage may eliminate the need to book a reserve, and the potential credit could in theory immediately lift net income
- The premium can range from 2.5% to 5.0% of the maximum loss (e.g., a $10m position can be insured for between $250k and $500k)
5. Should a sponsor review ERC as part of buyside due diligence?
Like any tax positions, the seller’s position on ERC can present an opportunity or a liability. In situations where the target claimed the credit, the buyer should understand whether the target made the proper assertions with respect to eligibility and qualified wages. Conversely, if the target was eligible though did not claim the ERC, its possible that this may present a significant source of cash for the new equity holders post-closing.
Adam Taplinger is TCC’s Sponsor Solutions Director. With over 20 years of investment banking and operating experience, he has extensive knowledge with respect to P&L optimization of sponsor backed entities, including identifying and maximizing tax credits and other incentives.