Since the Employee Retention Credit (ERC) was enacted in March 2020, the guidance available for taxpayers has been limited, and for nonprofits, even more so.
Although ERC-specific guidance for nonprofits is lacking, ASC Topic 958-605 dates back to 2018 and provides general guidance on how nonprofits should account for contributions (i.e., grants, credits, etc.) they receive. Within this accounting standard, there is the concept of a Limited Discretion Indicator in determining whether an agreement or other accession to an economic benefit contains a “barrier to entitlement” (to such contribution). In short, a “barrier to entitlement” generally means some type of limitation, restriction, and/or risk of forfeiting an economic benefit. Said differently, these are factors that need to be met before an NPO can recognize the economic benefit for accounting purposes.
Paragraph 958-605-25-5D states that “depending on the facts and circumstances, some indicators may be more significant than others, and no single indicator shall be determinative.” Under this guidance, the unique facts and circumstances of each “contribution agreement” (i.e., ERC claim with the Internal Revenue Service, or “IRS”) must be analyzed within the context of the “indicators” to conclude whether a barrier to entitlement exists and ultimately, whether (and when) an NPO can recognize the benefit.
For the ERC, the concept of a barrier to entitlement equates to the measurable, but often subjective, performance-related barriers to qualifying for the credit, which include the following:
In addition, the NPO must generally have had 100 or fewer full-time W-2 employees in 2019 to qualify for the 2020 credit, or 500 or fewer full-time W-2 employees in 2019 to qualify for the 2021 credit. For such purposes, a given NPO may also be aggregated with another commonly controlled NPO.
According to the revenue recognition standard under ASC Topic 958-605, an organization can recognize income when they meet all program requirements and incur eligible wages. In effect, meeting requirements constitutes satisfying the “contribution agreement” with the IRS. Given the ERC relates to historical payroll tax periods in 2020 and 2021, the barriers of entitlement (i.e., eligibility requirements and eligible wage incurrence) also reside in these years. Therefore, it is apparent that NPOs that are eligible for ERC and file a Form 941-X to claim the ERC are doing so retroactively and are applying under the assumption that both: (i) eligibility is met; and (ii) qualified wages have been incurred. Notwithstanding, where there is sufficient uncertainty as to the sustainability of eligibility positions (most likely, full or partial suspension eligibility), an NPO may have some level of doubt on whether they have sufficiently overcome the barriers to entitlement.
If we assume that an NPO duly overcomes the barriers to entitlement and applies for the ERC, they should determine the appropriate accounting treatment for the claim. ASC Subtopic 958-605 requires that when the requisite conditions are met, an NPO is required to record the income as revenue in the year the claim is submitted and does not permit the NPO any netting of such revenue against related expenses to obtain the contribution. Said differently, the ERC should be treated by NPOs akin to grant revenue and not a reduction in wage expense (which we note is contrary to the tax treatment of for-profit entities, who are required to reduce wage expense in 2020 and 2021 by the amount of ERC, as addressed in IRS Notice 2021-20).
Although the IRS Notices do not address this treatment specifically for NPOs, since Form 990 is reported on the same method of accounting as the books and records of the organization, it is reasonable to record the grant revenue in the same fiscal year that the credit is reported in the organization’s financial statements.
Just as with for-profit entities, it is of paramount importance for NPOs to have adequate documentation on the ERC and eligibility, and more so, to take care in choosing a third-party ERC advisor. The rise in ERC noncompliance is largely a result of the proliferation of “ERC Mills” that have aggressive positions on eligibility and assert false claims that every business (including NPOs) is eligible for ERC without a real accounting or legal function available to support their analysis. Learn more about the dangers of and how to identify ERC Mills, by reading this recent article.
To avoid audit risk and general noncompliance, we recommend that NPOs perform a thorough assessment and maintain adequate documentation surrounding eligibility and the calculation of the ERC. NPOs should be prepared for their auditors, and potentially the IRS, to examine such information. If auditors determine that your business failed to meet the eligibility requirements, there may be a potential material misstatement issued in your financials. In addition, noncompliance identified by the IRS may lead to penalties, interest, and having to repay amounts received. NPOs that receive the ERC should begin discussions with their management team and financial auditors early in the process to ensure all parties agree with the treatment of the ERC.
Lastly, Sagemont Tax is proud to offer qualifying clients a Tax Refund Guarantee as an optional “add-on service” in order to provide financial protection (in the form of a guaranty or third-party insurance policy) for their ERC claims. This process entails an evaluation of a client’s industry, potential or actual ERC amount, and the availability and sufficiency of certain source documentation to determine whether a particular client may qualify for the Tax Refund Guarantee. Should the IRS assess an unfavorable “Adjustment Amount”, the Tax Refund Guarantee allows a client to still receive and/or maintain their ERC claim. This not only gives our clients peace of mind with regard to their ERC but can also strengthen the position of an NPO’s ERC Claim, by substantiating in great detail the performance-related barriers to entitlement.
For any questions related to the ERC, your nonprofit organization’s eligibility, or our Tax Refund Guarantee offering, please reach out to our team of industry experts or fill out a form to qualify.
Written by Maxwell Burns, CPA, Managing Director, Sagemont Tax
For the avoidance of doubt, the above information is intended to be general guidance on the accounting treatment of the ERC by NPOs and is not intended to be a primary source of reliance for an NPO’s accounting position on the same. The facts and circumstances of each NPO should be discussed with their financial auditor and/or tax advisor.