TCC’s FAQs about the ERC Startup Recovery Business

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IRS Notice 2021-49 was a little vague when explaining the new Recovery Startup Business provision of the Employee Retention Tax Credit. In the absence of FAQs from the IRS, we submit the following attempt:

Question 1: If a new business engaged in certain startup activities before February 15, 2020, can they still receive a credit as a recovery startup business?

Answer 1: The Code has always distinguished between expenses incurred “in connection with a new trade or business” versus expenses incurred “in carrying on a trade or business.” Section 2134(c)(5)(A) of the Code provides that a recovery startup business is an employer that began carrying on a trade or business after February 15, 2020.

This is a facts and circumstances test. What is clear, however, is those businesses that have incurred certain start-up and organizational costs but have not yet attempted to market or sell a product, are not considered to have been carrying on a trade or business. These types of expenses may be deducted or amortized under different sections of the IRC (e.g., section 195).

A business, even if it has taken significant steps to prepare for its business activity but has not yet attempted to market or sell a product or service is not considered to have begun a trade or business. Therefore, as long as no activities for which the business was ultimately organized to engage in have been completed prior to February 15, 2020, the business may be considered a recovery startup business once it begins to engage in those activities after that date.

Example 1: Individual M began making investments to research and develop a product intended for sale on October 1, 2018. Prior to February 15, 2020, Individual M had neither marketed nor sold a product. On March 1, 2020, Individual M launched a website for Startup A and began selling their product. Startup A meets the gross receipts requirement for a recovery startup business. Startup A is a recovery startup business for the third and fourth quarters of 2021 because it began carrying on a trade or business after February 15, 2020.

Example 2: Individual N starts Startup B on July 31, 2021. Startup B hires and pays employees but does not otherwise perform the ultimate activity for which the business was organized. Startup B is not a recovery startup business because they have not begun carrying on a trade or business.

Question 2: Is an employer began carrying on a trade or business in 2021 with a tax year ending on December 31, 2021 that had gross receipts in excess of $1,000,000 in 2021 considered a recovery startup business?

Answer 2: Yes. Section 3134(c)(5) of the Code indicates that the gross receipts should be determined for the period ending with the taxable year which preceded the calendar quarter for which the employer is claiming the employee retention credit. When a business has not completed a single taxable year, the gross receipt limitation will not apply.

Example 1: Employer A begins carrying on a trade or business on January 1, 2021. The first taxable year of Taxpayer A ends on December 31, 2021. Employer A generates $2,000,000 in gross receipts between January 1, 2021 and June 30, 2021. Employer A is a recovery startup business for the third and fourth quarters of 2021 because there is no 3-taxable-year period preceding the calendar quarter for which Employer A is claiming the employee retention credit.

Example 2: Same facts as Example 1, except Employer B elects to have a short tax year ending on June 30, 2021. Employer B is not a recovery startup business for the third or fourth quarters of 2021 because the 3-taxable-year period that ended preceding the first quarter for which the employee retention credit is available Employer B had gross receipts exceeding $1,000,000.

Example 3: Same facts as Example 1, except Employer C elects to have a short tax year ending on October 31, 2021. The determination of whether an employer is a recovery startup business is made separately for each calendar quarter. Employer C is a recovery startup business for the third quarter of 2021 because there is no 3-taxable-year period preceding the calendar quarter for which Employer C is claiming the employee retention credit. Employer C is not a recovery startup business for the fourth quarter of 2021 because the 3-taxable-year period ending before the fourth quarter had gross receipts exceeding $1,000,000.

Question 3: How should the 3-taxable-year average annual gross receipts be calculated for a business that has not been in existence for 3-years?

Answer 3: Section 3134(c)(5) of the Code indicates that the average annual gross receipts of an employer is determined by applying rules similar to the rules in section 448(c)(3) of the Code. Section 448(c)(3)(A) addresses a circumstance in which an entity has not been in existence for 3-years and states that the average gross receipts should be calculated on the basis of the period during which such trade or business was in existence. Section 448(c)(3)(B) addresses a circumstance in which the trade or business had a short taxable year and says that gross receipts for the short year should be annualized “multiplying the gross receipts for the short period by 12 and dividing the result by the number of months in the short period.”

Example 1: Employer D began carrying on a trade or business as of April 1, 2020 with a tax year ending December 31, 2020 during which time Employer D generated $250,000 in gross receipts. To annualize the gross receipts, multiply 250,000 x 12 equaling 3,000,000. Divide 3,000,000 by the number of months in the short period, 9, equaling 333,333. Employer D is a recovery startup business for the third and fourth quarters of 2021 because the gross receipts for the 3-taxable-year period ending with the taxable year preceding the calendar quarter for which the employer is claiming the employee retention credit is less than $1,000,000.

Example 2: Same facts as Example 1, except Employer E generated $600,000 in gross receipts between April 1, 2020 and December 31, 2020. The annualized gross receipts for Employer E are (600,000 x 12)/6 = 1,200,000. Employer E is not a recovery startup business for the third or fourth quarters of 2021 because the 3-taxable-year period that ended preceding the first quarter for which the employee retention credit is available Employer E had gross receipts exceeding $1,000,000.

Question 4: Can a tax-exempt organization be a recovery startup business?

Answer 4: Yes. The Treasury Department and the IRS have determined that it is appropriate for an organization described in section 501(c) and exempt from tax under section 501(a) to be able to be treated as an eligible employer due to being a recovery startup business based on all of its operations and average annual gross receipts determined under section 6033 as defined in section III.E. of Notice 2021-20.

Learn more about the Employee Retention Credit (ERC).

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