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New IRS Rule on Small Businesses Sends Them to Bizarro World

A new IRS guidance document issued on August 4 may seem dry, but for small business owners it is anything but. By adopting an absurd interpretation of a COVID-related emergency tax credit for small business created by Congress, the IRS would effectively punish small business owners for having immediate family members. Rather than inferring that this was not Congress’s intent, or at least proposing congressional action to address it, the IRS and the Treasury Department instead is moving forward with enforcement — even retroactively on those who have already claimed it.

The Employee Retention Tax Credit (ERTC) was created by the CARES Act in 2020, the law that also created the Paycheck Protection Program (PPP) of forgivable loans for maintaining payroll expenses. ERTC is separate from PPP (initially an alternative but starting in December 2020 employers could take both) that reduces employer payroll tax liabilities for wages and health benefits paid to employees. By the end of 2021, approximately $36 billion will have been claimed under the credit, a majority by businesses with fewer than 100 employees. The ERTC is to expire at the end of 2021, although the infrastructure bill would end it earlier, on September 30.

IRS Notice 2021-49 may upend all that. Using some reductio ad absurdum reasoning, the IRS has concluded that a small business owner cannot claim the ERTC on the wages they pay themselves if they have a brother, sister, parents, or children — whether or not those people are involved in the business in any way. 

Here’s the operative language from pages 28-29: “[A] majority owner of a corporation is a related individual for purposes of the employee retention credit, whose wages are not qualified wages, if the majority owner has a brother or sister (whether by whole or half-blood), ancestor, or lineal descendent.[…] In the event that the majority owner of a corporation has no brother or sister (whether by whole or half-blood), ancestor, or lineal descendent[…,] the wages paid to the majority owner and/or the spouse are qualified wages for purposes of the employee retention credit, assuming the other requirements for qualified wages are satisfied.”

How did the IRS reach this result? The notice explains multiple steps of reasoning. First, the CARES Act did not create new eligibility rules for ERTC but instead incorporated the eligibility rules from the Work Opportunity Tax Credit (WOTC), a tax credit for hiring employees from specific disadvantaged groups. Second, these recycled WOTC rules disallow counting any wages paid to close relatives (children, siblings, parents, nieces and nephews, and aunts and uncles). Third, those rules also disallow any wages paid to any individual that controls more than 50 percent of the business, including by Section 267 of the Internal Revenue Code. Fourth, Section 267 restricts a taxpayer’s ability to shift shares to relatives to avoid being a majority shareholder, by assuming that any share of the company owned by a relative is actually a share owned by the taxpayer. 

The convoluted logic here is that since CARES says to use WOTC rules, and WOTC rules say to use Section 267, and Section 267 says a taxpayer’s relatives are the same as the taxpayer, then any majority owner of a business isn’t really a majority owner if they have relatives. That’s because, the IRS says, the relative is also a majority owner and the taxpayer a relative of them, and the wages of relatives are ineligible to be counted for the credit. Therefore, the IRS concludes that the wages of a majority owner are ineligible for the ERTC if they have any immediate family.

The Notice states (on page 20) that this “clarification” applies to 2020 and 2021, and acknowledges that many taxpayers will have to file “an adjusted or amended return to reflect these clarifications” that will result in additional tax being owed, but promise that “any penalties for failure to timely pay or deposit tax will not apply if the taxpayer can show reasonable cause and not willful neglect for those failures.”

This ridiculous logic might be amusing if it were not about to cause significant and real harms. The ERTC has particularly benefited small businesses where the “majority owner” and their relatives are most of the employees, if not all of them. The IRS is expecting any such business not only to stop taking the ERTC going forward due to its new conclusion, but to repay amounts received in 2020 and so far in 2021. The National Conference of CPA Practitioners estimates that this could cost up to $66,000 for a mom-and-pop small business, “funds [that] may make the difference between closing the doors or enabling those businesses to remain open and continue employing their staff for years to come.”

Needless to say, the IRS and the Treasury Department didn’t need to do this. They could have avoided causing small businesses unnecessary harm by including only direct WOTC rules rather than inferred rules. Even if they were determined to stick to their (misfiring) guns, they could have only applied this new determination going forward rather than retroactively, given how many taxpayers have relied on their guidance until now. They could have flagged the result as clearly unintended and approached Congress for a legislative fix rather than proceeding directly to enforcement. 

Those are all still options, but they would require the IRS and Treasury to act as constructive partners rather than adversaries. Congress created the ERTC to keep small businesses open, and absent legislative intervention, IRS Notice 2021-49 will instead use that law to shut them down.

One last point: Notice 2021-49, like most IRS pronouncements, was issued without the benefit of the notice-and-comment procedures that every federal agency is required to follow when issuing regulations. Instead, the IRS just proclaimed it, posting it to its website. The IRS resists calls from NTUF and others to follow the Administrative Procedure Act (APA), losing 9-0 in the U.S. Supreme Court earlier this year in their attempt to shield their rules from being challenged on that basis. The IRS’s resistance to following APA procedures before issuing binding regulations and interpretations may add legal vulnerability to Notice 2021-49.


Joe Bishop-Henchman is Vice President of Policy & Litigation at National Taxpayers Union Foundation.