Now May Be the Perfect Time to Address Compliance
in Order to Maximize the Benefits of the
Paycheck Protection Program and the Employee Retention Credit
Whether mandated by the government or as a result of economic factors, many businesses have been forced to either shut down or significantly limit operations as a result of COVID-19. Businesses everywhere are looking for financial assistance in order to survive and many are concerned about retaining their most valuable asset, their employees. Recent government initiatives created by the CARES Act, such as the Paycheck Protection Program (“the PPP”) and Employee Retention Credit (“Retention Credit”), are viable options for smaller labor-intensive businesses facing these issues. Unfortunately, since these incentives are predicated on the magnitude of “payroll,” businesses historically categorizing their workers as either independent contractors or nonemployees will miss out. It is not too late to proactively address these classifications to qualify for additional benefits from these initiatives. These changes may not only improve the prospect for government assistance, but they can also mitigate potentially significant taxes and penalties resulting from misclassification.
COVID-19 Assistance: Paycheck Protection Program and Employee Retention Credit
The PPP and Retention Credit were instituted by the federal government in response to COVID-19. These were designed to incentivize employers to retain employees and, in turn, reduce the effect of the shutdown on the economy and minimize the administrative strain that will face unemployment insurance programs. The PPP achieves this goal by quickly funding SBA-backed loans to employers. Employers can receive loans of up to 250% of their monthly payroll. Although the PPP offers other incentives, its main attraction is the ability to have the entire balance of the loan forgiven if the proceeds are spent upon “payroll” and other qualified expenses within the 8-week period after origination. The PPP has been so popular that it already exhausted authorized funds within a matter of days. Separately, the Retention Credit allows employers not obtaining financial assistance through the PPP to obtain payroll tax credits for retaining workers. These credits are refundable and are based upon 50% of up to $10,000 in qualifying wages paid per employee. Both of these programs can provide a real shot in the arm for small businesses.
The Problem: Businesses Misclassify Workers and Cannot Qualify for Maximum Benefits
While there is a clear need, many businesses cannot qualify for much, if any, benefit because they treat their workers as “independent contractors” or “nonemployees” for tax purposes. For the PPP, the maximum amount of the loan to be provided to a business is based upon 250% of monthly “payroll costs.” Payroll costs generally include salary, wages, commissions, and similar compensation paid to employees – but it does not generally include payments made to independent contractors. (Under the PPP, independent contractors are treated as separate businesses that are permitted to separately seek benefits.) Lenders may request payroll records, including Forms 941, Forms 940, and Forms W-2, to verify the maximum loan authorized under the PPP. Further, in order to qualify for loan forgiveness, the amount of the loan proceeds used to pay “payroll costs” will be verified by Forms 941, Forms 940, and Forms W-2. If workers are treated as independent contractors, they will not be reported by the business on any of these forms (if anything, the worker may receive a Form 1099) and so the business will not be able to prove qualification for either the loan or for forgiveness.
Similarly, eligibility for the Retention Credit is based upon “wages” paid to an “employee.” While not explicit, these definitions will be interpreted in a similar manner as generally applied by the Internal Revenue Service. In other words, independent contractors and payments made to them do not qualify for the Retention Credit. Furthermore, the Retention Credit is administered through offsets and refunds with respect to Forms 941 (quarterly employment tax returns) filed by an employer. If a business consistently treated workers as independent contractors and did not (and does not) report payments on a Form 941, there will be no basis for the credit.
Oftentimes, businesses misclassify workers because they are unfamiliar with the differentiation between an employee and independent contractor. Other times, either the employer or the worker is attempting to reduce its payroll taxes or to avoid further government regulation. And other times, the decision is based upon competition and other business considerations. Whatever the reason and without considering other compliance risks, the PPP and Retention Credit have reversed, at least in the short term, the incentives for worker classification. It now behooves many businesses to classify workers as employees rather than independent contractors.
The Potential Solution: Reclassifying Workers Proactively
If workers have been misclassified, all is not lost; however, immediate action may be necessary. When evaluating most applicants for the PPP, lenders should analyze the average payroll costs of the employer during 2019 or the rolling year ending on the date of application. Lenders will request payroll information and tax documentation for verification. For those applicants that misclassified workers, they will not necessarily be able to certify that payments to independent contractors should be included and will not be able to produce verification. To address this, employers considering the PPP may want to consider retroactively or, at least, prospectively, reclassifying worker as employees.
For employers that have not yet submitted their application for the PPP, retroactive reclassification may be helpful. To do this, employers may consider filing amended quarterly employment tax returns for 2019 (Forms 941-X) and/or issuing wage statements (Forms W-2). (The employer may file original returns for these periods if none have yet been filed.) Before any delinquent returns are filed, consideration should be given to the additional employment taxes that may arise. As an alternative, employers may consider applying for the Voluntary Classification Settlement Program (“VCSP”). While there are significant eligibility limitations for the VCSP (e.g., workers must have consistently been issued Forms 1099), those employers qualifying will be able to credibly certify that amounts paid to workers, as reported on Forms 1099, should be treated as payroll costs. Moreover, a VCSP applicant is able to eliminate potential liabilities relating to these workers for periods prior to 2019 and will end up paying a small fraction of the liability generally applicable. In sum, employers intending to apply for the PPP may want to consider taking immediate action to address payroll tax exposure for 2019 and to maximize the amount of the loan offered.
For employers that have already had their application for the PPP processed (and loan proceeds disbursed based on the classification of payments to independent contractors as “payroll costs), consideration should be given to prospective reclassification as well. This can be accomplished through the VCSP or simply by filing future Forms 941 and Forms W-2 (for 2020) with workers treated as employees. Since an employer is required to provide documentation to confirm the amount of loan forgiveness based upon payroll costs incurred, reporting of payments on a Form 941 or on similar employment tax filings is likely a must. Without it, an employer may not be able to have any such payments included in the forgiveness amount, rendering the process much less helpful. Even though employers will be required to incur additional employment tax costs for that quarter (and likely on a going forward basis), those costs are more than covered by the benefit of the loan forgiveness.
For those that are not eligible for or are not pursuing a loan through the PPP, a similar analysis should be performed with respect to benefits offered through the Retention Credit. Unlike the PPP, the amount of the Retention Credit is not limited based upon the treatment of workers in 2019. Accordingly, businesses may consider treating previously classified independent contractors as employees in 2020. Still, as with the analysis for PPP applicants, those seeking the Retention Credit should evaluate whether the VCSP may prove useful in limiting exposure to tax, penalties, and interest relating to periods prior to 2020.
In either event, and particularly for those employers with low-paid workers, the benefits of the Retention Credit far exceed the related increase in employment taxes, at least in the short-term. For example, if an employee is paid $20,000/year ($5,000 quarter), an employer may be eligible to receive the full credit of $5,000 across the first two quarters of 2020. When compared to the related annual increase in employer-paid employment taxes (roughly $1,500), the financial benefit of the reclassification is apparent. For those businesses impaired by the impact of COVID-19, making the change in classification now (versus next year) may provide current financial benefits.
The Time to Act Is Now, Not Later
The proper classification of workers is very fact-intensive. Although most businesses try to get it right, many businesses incorrectly classify workers as independent contractors instead of employees. For businesses falling in that category, they face potentially significant enforcement actions and – as an immediate issue – the inability to qualify for substantial incentives created by the CARES Act. Given the magnitude of these incentives, now is the perfect time for many businesses to address these lingering issues, come into compliance, and reap meaningful government subsidies.
These descriptions are intended for informational purposes only and should not be taken as legal advice on any particular set of facts or circumstances. Rosenberg Martin Greenberg, LLP is experienced in all aspects of federal and state tax laws, legislative developments concerning the CARES Act, addressing prior compliance issues, white collar criminal litigation, and more. For more information, please contact Brandon Mourges at 410.951.1149 or firstname.lastname@example.org.
 For instance, if a worker is paid $60,000/year, they are paid $5,000 in potentially qualifying wages. Under the PPP, the employer may qualify for $12,500 in forgivable loan proceeds with respect to that worker. On the flip side, by amending employment tax returns for 2019 to treat this worker as employee, the employer will incur an addition amount of employment tax, interest, and penalties. Not including potential liability for unemployment insurance, income tax withholdings, and other costs, the additional employment tax obligation of the employer for that year would be roughly $4,600. This would be a recurring annual cost.
 While those using the VCSP are required to pay all employment taxes on a prospective basis, the settlement payment is generally limited to 10% of the employment tax that would have been due for the prior year. Looking to the example in FN 1, if the VCSP was used, the employer’s liability for prior periods would be limited to roughly $200.
 Employers have an obligation to correctly classify their workers. Such a classification should not be based on financial incentives but should take into consideration the relationship between the parties. The Internal Revenue Service has developed a 20-factor test in making this determination and has an administrative mechanism to aid in this process.
This calculus does not detail the non-tax costs and benefits associated with the change in classification from an independent contractor to an employee. These considerations include, but are not limited to, healthcare requirements, potential enforcement actions, unemployment insurance, etc.