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ESOP repurchase obligations―Planning for future pay ups

By:

Benjamin Schwartz is a Staff Auditor in BerryDunn’s Commercial Group. Benjamin works primarily with construction and professional service firms that have Employee Stock Ownership Plans. Prior to joining BerryDunn, Benjamin’s career ranged from M&A analysis and hedge fund strategy development to serving as a U.S. Peace Corps Community Economic Development Volunteer in Benin, West Africa. His broad experience offers unique perspective for clients.

Benjamin Schwartz
11.19.20

Read this if you are a financial manager of an ESOP.

Employee Stock Ownership Plans (ESOPs) must generally buy back, or repurchase, participants’ shares when they leave the plan or want to diversify holdings. If the ESOP does not purchase the stock the company is required to purchase the shares from the participant under the “put option” described in Internal Revenue Code (IRS) Section 409(h).These rules require the company to either provide enough cash to the ESOP to fund stock repurchases, if adequate other assets are not available within the ESOP, or to fund the repurchase of shares outside of the ESOP. Anticipating the amount and timing of these repurchases requires a lot of number crunching and assumptions to arrive at an estimated “Repurchase Obligation” at a point in time. In most cases, ESOPs enlist the help of valuation specialists, actuaries, or outsider vendors to prepare a study.

All this is done as a component of ESOP cash flow planning but also begs the question, what do you need to record or disclose in your company’s financial statements related to this obligation?

The Financial Accounting Standards Board’s guidance on the subject is contained in Accounting Standards Codification (ASC) Topic 718, Compensation - Stock Compensation. More specifically, ASC Section 718-40-50 clearly outlines the terms, allocated share and fair value information, compensation and other related disclosure requirements for ESOPs in paragraphs 1a through g. One of these requirements—paragraph f—requires disclosure of “the existence and nature of any repurchase obligation...” While the existence of a potential repurchase obligation is undeniable due to the requirements of IRC Section 409(h), disclosure of the nature of the obligation may require judgement and a careful reread of the plan documents.

Existence of the obligation

What private companies record for redemptions is straightforward. They are required to accrue obligations related to redemption events initiated on or before the balance sheet date and disclose share and obligation balance information related to those transactions of material.

Disclosures must include the number of allocated shares and the fair value of those shares as of the balance sheet date. This sounds like a general disclosure of terms, but the intention is to communicate maximum repurchase obligation exposure. If redemptions subsequent to the balance sheet date require material and imminent use of cash, the company should consider whether it is required to disclose them as a subsequent event (including amounts) under ASC Topic 855, Subsequent Events.

Nature of the obligation

So, what do you need to disclose specific to the nature of your company’s ESOP shares repurchase obligation?

Put options against the ESOP trust (i.e., rights afforded under the ESOP requiring the trust to purchase outstanding stock at given prices within specific time horizons). Plan terms allowing redemption payments in excess of a certain threshold to be made over a defined period of time (e.g., retiring employees with vested balances greater than $5,000 may receive their payments in equal installments over a five-year period, while those with lower balances may receive their benefit in a lump sum).

If your company’s ownership has an ESOP component or you are considering an ESOP as part of your exit strategy, please reach out to Linda Roberts and Estera Ciparyte-McDonald. They can help you better understand the myriad considerations to be taken into account, and the required and potential financial statement impact and disclosures.

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Read this if you are an employer with employees on COBRA. There are tax credits available to you. 

The American Rescue Plan Act of 2021 (ARP) creates a requirement that employers treat the total payment for Consolidated Omnibus Budget Reconciliation Act (COBRA) continuation coverage due from certain eligible individuals as being “paid in full” for April 1 through September 30, 2021 (Subsidy Period). The eligible individuals with COBRA coverage will not receive the subsidy directly from the government; rather, they will have a premium holiday during which time the employer pays 100% of the applicable COBRA premium. The employer will be reimbursed in full through refundable payroll tax credits.

The ARP provisions do not apply to all COBRA-eligible individuals; eligibility is limited to employees who lost health care benefits due to an involuntary termination or reduction in hours. While the loss of coverage event can be linked to COVID-19, it is not required to be. A loss of coverage event could have occurred as far back as November 1, 2019, since the law requires an employer to offer a continuation of COBRA coverage for 18 months after an involuntary termination (18 months from November 1, 2019 is April 30, 2021). Eligible individuals who opted not to pay for COBRA coverage will be given another opportunity to elect the free coverage.

Employers and COBRA administrators should prepare to distribute new COBRA election and subsidy notices and to make operational changes soon after further guidance is released. Eligible individuals not already on COBRA will need to act quickly after receiving the notice to elect subsidized COBRA coverage. Failing to timely elect COBRA coverage could result in forfeiting this valuable benefit.

It is expected many people will rush to take advantage of this opportunity, which can provide up to six months of health insurance at no cost. However, employers should keep in mind that the subsidy is available only for certain limited situations.

Which employers are eligible for the new subsidy?

Employers subject to federal COBRA provisions or to a state program that provides comparable group health care continuation coverage are not allowed to charge eligible individuals for COBRA coverage during the Subsidy Period. The subsidy applies to workers in every industry, most tax-exempt employers (except churches who are exempt from COBRA) and union, governmental, and Indian tribal government workers. The federal COBRA provisions generally apply to all private-sector group health plans maintained by employers that had at least 20 employees on more than 50% of its typical business days in the previous calendar year. Both full- and part-time employees are counted to determine whether a plan is subject to federal COBRA coverage. Many states have “mini-COBRA” laws that apply to employers who have fewer than 20 employees. The subsidy is mandatory for all employer-sponsored group health plans (i.e., all employers must offer the subsidy, regardless of whether the plan is fully or partially insured, or self-insured).

During the Subsidy Period, generally, the federal government will reimburse COBRA costs to employers by allowing credits against employers' Medicare (not Social Security or income) taxes (but for union plans, the plan would receive the subsidy and for insured, state “mini-COBRA” plans, the insurer would receive the subsidy). Guidance is needed to clarify how the flow of funds for the subsidy would work. The full cost of COBRA continuation coverage (including up to a 2% administrative fee) at any coverage level (e.g., single, “single-plus-one”, or family coverage) for employees and former employees and their spouses and dependents is eligible for the subsidy via the payroll tax credit. The subsidy applies to health, prescription drug, dental and vision plans, but does not apply to health flexible spending accounts (FSAs), health savings accounts (HSAs), or long-term care plans (further guidance is needed to clarify the scope of the subsidy).  

Due to the fact that most individuals who elect COBRA group health care continuation coverage usually pay 100% of those premiums (and in many cases they must also pay up to a 2% administrative fee), the new subsidy via the employment tax credit keeps the free COBRA coverage at zero cost to the employer. While the employment tax credit is taxable income, it will be offset by the employer’s deductible payment of the healthcare premiums.

Impact on eligible individuals

An eligible individual with an existing or new COBRA election will be provided tax-free health care coverage (both the premium and any administrative charge) at no charge for their remaining COBRA period that overlaps with the Subsidy Period.   

The free COBRA provided during the Subsidy Period would be “affordable” coverage under the Affordable Care Act (ACA). But it is not clear how this “affordable” coverage affects an individual who has purchased coverage on the exchange before they had an offer of affordable coverage.

A recipient of the free health care coverage must notify the employer or plan administrator when they become eligible for Medicare or another group health plan—other than coverage under an excepted benefit, an FSA or a qualified small employer health reimbursement arrangement (QSEHRA). Individuals who fail to promptly give this notice could be subject to a $250 fine and other penalties.

Who is eligible?

Generally, individuals are eligible for free COBRA coverage if (1) they are involuntarily terminated or have a reduction in hours that qualifies them for federal or state COBRA coverage and (2) the Subsidy Period overlaps with their COBRA coverage period.

The new COBRA premium assistance is not available to the following individuals:

  • Employees who are terminated for gross misconduct.
  • Employees who voluntarily terminated their employment or who retired.
  • Individuals who are eligible for COBRA due to other reasons, like divorce, death, or loss of dependency status.
  • Individuals who are eligible for other group health care coverage (such as from a new employer) or Medicare.
  • Individuals who are beyond their normal COBRA coverage period connected to the original qualifying event (i.e., the employee’s involuntary termination or reduction in hours that caused a loss of group health plan coverage).
  • Domestic partners who are not federal income tax dependents of the employee.

What’s the coverage?

Generally, the COBRA coverage will be the same as the coverage elected just prior to the involuntary termination or reduction in hours. However, employers can (but are not required to) allow individuals who are eligible for premium assistance to change their coverage provided it does not result in an increased premium cost. Further guidance is needed regarding the scope of who can change to a lower cost health plan as a result of the new law.

Eligible individuals who lost health care coverage after October 31, 2019 but do not have COBRA coverage on April 1, 2021 due to nonelection or lapse of payment will have a new, 60-day opportunity to elect COBRA coverage. If timely elected, the COBRA covered period will begin on the date of the individual’s qualifying event, but it appears that no payment is due for months prior to April 2021 and no claims can be filed prior to April 1, 2021. For the months remaining in the COBRA period that coincide with April 1 through September 30, 2021, the employee makes no payment but will have claims paid in accordance with the plan’s provisions. To have continued coverage after September 30, 2021, the employee must make the payments required under the plan. If the individual finds this unaffordable, they can simply drop the coverage.

What notices are needed?

The federal government is expected to issue model required notices addressing the existence of the subsidy, the availability of the 60-day election period and advance notice of when the Subsidy Period will be ending. In the meantime, employers should prepare for the following new notice requirements.

  • Group health plans must modify their COBRA election notices for individuals who become eligible for federal or state COBRA during the Subsidy Period to notify them of the premium assistance (and, if applicable, the option to enroll in a lower priced plan).
  • By May 31, 2021, individuals who previously rejected (or terminated) COBRA coverage and to whom a new election period must be offered, must be notified of their new election period and the availability of the premium assistance. This essentially creates a special COBRA enrollment period for such individuals.
  • Between August 17 and September 15, 2021, group health plans must provide a notice to individuals receiving the premium assistance stating that the subsidy will expire on September 30, 2021, and that they may be eligible for COBRA coverage without the subsidy. But if the subsidy would end earlier for any individual, the plan must provide a notice that the subsidy is expiring no earlier than 45 days and no later than 15 days before the subsidy expiration date.

It is not clear how these required notices must be delivered (sending paper mail to former employees may be needed).

How does the subsidy work?

Individuals who are eligible for COBRA premium assistance do not receive a payment from the federal government, group health plan, employer, or insurer. Rather, their COBRA costs are waived during the Subsidy Period.

Employers that sponsor a fully insured plan would continue paying the full premium to the insurer for the assistance eligible participants. Employers that sponsor a self-insured plan would pay the claims incurred by the assistance eligible participants. In both cases, the employer would receive no payment from the eligible individual during the Subsidy Period but would instead recover its COBRA costs (102% of the COBRA premium) for the assistance-eligible individuals by claiming a refundable federal tax credit against the employer’s Medicare taxes.

The COBRA subsidy is prospective only and cannot begin before April 1, 2021.

Although the law does not require employers to pay for any COBRA coverage, some employers pay for some or all of COBRA coverage (for example, as part of a severance package). Such employers can cease those contributions during the Subsidy Period and the federal government will provide the subsidy for 6 months. And although the subsidy is tax-free to employees, employers who take the COBRA premium tax credit must increase their gross income by the amount of such credit for the taxable year which includes the last day of any calendar quarter with respect to which such credit is allowed.
 
Also, under a “no double dipping” rule, employers cannot take the COBRA premium tax credit for any amount which is taken into account as qualified wages for the employee retention credit (ERC) under the Coronavirus Aid, Relief, and Economic Security Act (CARES) and Consolidated Appropriations Act, 2021 (CAA), or as qualified health plan expenses for the Families First Coronavirus Response Act (FFCRA), as amended by CAA and ARP. Likewise, amounts attributable to the COBRA premium tax credit would not be eligible payroll costs under the Paycheck Protection Program (PPP).

Guidance from the Internal Revenue Service (IRS) is needed to clarify how exactly employers would claim the tax credit, but it appears that employers would claim the credit on their quarterly IRS Form 941 or in advance on IRS Form 7200 if the actual or estimated amount of the credit exceeds the employer's Medicare taxes for any calendar quarter. Further guidance is also needed regarding the mechanics of the subsidy for employers that have insured state COBRA coverage, since under Section 9501(b) of the ARP the tax credits reimbursements would go to the insurer, not the employer.

Other considerations

For past COVID-19 relief tax credits, such as the ERC and FFCRA, IRS guidance allowed employers to dip into withheld income and Social Security taxes as a source of claiming those refundable tax credits. But the IRS has not yet authorized such actions for the ARP COBRA subsidy tax credit. Social Security taxes may not be available as a source for the new COBRA tax credits, since the ARP was enacted under budget reconciliation rules which prohibit any changes to Social Security.

Employers are not allowed to voluntarily expand the group of people who are eligible for the special COBRA premium subsidy, because the federal government is paying the full COBRA premium for the designated class of assistance-eligible individuals.

We expect the IRS to issue FAQs on the new COBRA Medicare tax credits, similar to the FAQs that the IRS issued on the ERC and FFCRA payroll tax credits.

This new COBRA subsidy may be economically more valuable than using qualified health care expenses for the ERC, because ERC nets 70% on the dollar whereas the COBRA subsidy is 102% (premium plus administrative charge).

What should employers do now?

Employers should immediately identify all employees who lost group health plan coverage after October 31, 2019 due to an involuntary termination or reduction in hours, without regard to their COBRA elections, because such event would have entitled the individual to 18 months of COBRA coverage (i.e., through April 30, 2021). Guidance is needed on whether notices must be given to individuals in this group that declined COBRA due to eligibility in another employer’s plan or Medicare. Employers will need to notify individuals who have an unexpired COBRA period that premium assistance is available, and they have a right to reconsider their original COBRA election.  

Employers will also need to review and perhaps modify any existing, automatic processes that might otherwise terminate COBRA coverage when premiums are not received during the Subsidy Period.

Year-end reporting on health benefits should also be reviewed to ensure these increased COBRA participants receive the appropriate Form 1095-B or C for 2021.

Employers should develop a procedure to identify COBRA recipients who are eligible for the premium assistance and those who do not qualify (for example, employers will need to distinguish a voluntary quit from an involuntary termination of employment and whether the employee was fired for gross misconduct). For premium-assistance eligible individuals, employers must refund within 60 days any premiums paid during the Subsidy Period. Not all COBRA participants will qualify for the subsidy, so the plan administrator will still need to handle some premium payments from non-eligible individuals.

Vendor outreach

Many employers use outside service providers for their COBRA administration, so employers should reach out to their vendors as soon as possible to coordinate their response to the ARP changes to current COBRA rules, especially the special election period for certain assistance-eligible individuals.

Keep in mind that, separate from the ARP COBRA subsidy, many employees (and their family members) may currently have extended COBRA election rights due to COVID-19 deadline extensions. For example, ERISA Disaster Relief Notice 2021-1 issued on February 26, 2021, announced an individualized one-year deadline extension for COBRA elections, which begins on the date the clock for the particular deadline would have started running (i.e., the one-year extension is applied on a rolling basis to each deadline for each affected individual). But individuals electing retroactive COBRA coverage under those extended deadlines will generally have to pay the full COBRA premiums for such periods. Guidance is needed on how the deadline extension coordinates with the new COBRA subsidy.

Employers may recall that in February 2009, under the American Recovery and Reinvestment Act of 2009 (ARRA), the federal government subsidized 65% of COBRA premiums for certain individuals who were terminated or laid off between September 1, 2008 and March 31, 2010 due to the financial crisis linked to the bursting of the home mortgage lending bubble. The ARRA subsidy was extended through May 31, 2010, so perhaps with Democrats currently controlling both Congress and the White House, the ARP COBRA subsidy may be extended beyond September 30, 2021. Also, the ARRA may be a model for how the flow of funds will work for the ARP premium tax credits for insured state COBRA coverage.

If you have specific questions about your situation, please contact our Employee Benefits consulting team. We’re here to help. 

Article
"Free" COBRA for some employees: Employers may benefit, too

Read this if you are an employer with basic knowledge of benefit plans and want to learn more. 

This article is the third in a series to help employee benefit plan fiduciaries better understand their responsibilities and manage the risks of non-compliance with Employee Retirement Income Security Act (ERISA) requirements. Our first article covers the background of ERISA, while our second article covers the definitions and rules of parties-in-interest and prohibited transactions.

Form 5500 is an informational return filed annually with the US Department of Labor (DOL). The purpose of Form 5500 is to report information concerning the operation, funding, assets, and investments of pension and other employee benefit plans to the Internal Revenue Service (IRS) and DOL. All pension benefit plans covered by the Employee Retirement Income Security Act (ERISA), and, generally, health and welfare plans covering 100 or more participants are subject to filing Form 5500. Any retirement plan covering less than 100 participants at the beginning of the plan year may be able to file Form 5500-SF, Short Form Annual Return/Report of Small Employee Benefit Plan. Read on for important filing requirements, as noncompliance can result in substantial penalties assessed by both the DOL and IRS. 

Who has to file, and which Form 5500 is required?

Pension plans

The most common types of pension benefit plan filers include:

  • Retirement plans qualified under Internal Revenue Code (IRC) § 401(a)
  • Tax sheltered annuity plans under IRC § 403(b)(1) and 403(b)(7)
  • SIMPLE 401(k) Plan under IRC § 401(k)(11)
  • Direct Filing Entity (DFE)

Which Form 5500 you should file depends on the type of plan. Small plans covering less than 100 participants as of the beginning of the plan year will normally file a Form 5500-SF. Conversely, large plans, mainly those plans covering 100 or more participants as of the beginning of the plan year, will file Form 5500 as a general rule. 

Participants include all current employees eligible for the plan, former employees still covered, and deceased employees who have one or more beneficiaries eligible for or receiving benefits under the plan.

Welfare plans

Generally, all welfare benefit plans covered by ERISA are required to file a Form 5500. Common types of welfare benefit plans include but are not limited to medical, dental, life insurance, severance pay, disability, and scholarship funds.

Similar to pension plans, the required Form 5500 to be filed typically depends on whether the plan is a small plan with less than 100 participants at the beginning of the year, or a large plan with 100 or more participants at the beginning of the plan year. However, certain welfare benefit plans are not required to file an annual Form 5500, including, but not limited to:

  • Plans with fewer than 100 participants at the beginning of the plan year and that are unfunded, fully insured, or a combination of the two
  • Governmental plans 
  • Employee benefit plans maintained only to comply with workers’ compensation, unemployment compensation, or disability insurance laws

Participants for welfare benefit plans include current employees covered by the plan, former employees still covered, and deceased employees who have one or more beneficiaries receiving or entitled to receive benefits under the plan (e.g., COBRA). 

Required financial schedules for Form 5500

Small plans that do not file Form 5500-SF require the following schedules to be filed along with the Form 5500:

  • Schedule A—Insurance information
  • Schedule D—DFE/Participating plan information
  • Schedule I—Financial information for a small plan

Large plans require the following schedules in addition to small plan schedules:

  • Plan Audit (Accountant’s Opinion)
  • Schedule C—Service provider information
  • Schedule G—Financial transaction schedules
  • Schedule H—Financial information (instead of Schedule I)

Welfare plans with 100 or more participants that are unfunded, fully insured or a combination of the two are not required to attach Schedule H or an Accountant’s Opinion. Also, pension plans will attach Schedule SB or MB reporting actuarial information, if required, along with Schedule R reporting retirement plan information.

When to File

Form 5500 must be filed electronically by the last day of the seventh calendar month after the end of the plan year. However, a two and one-half months’ extension of time to file can be requested. Penalties may be assessed by both the IRS and the DOL for failure to file an annual Form 5500-series return. For 2020, the IRS penalty for late filing is $250 per day, up to a maximum of $150,000 (applies only to retirement plans), and the DOL penalty can run up to $2,233 per day, with no maximum. Therefore, it is very important to track participant counts and ensure compliance with filing deadlines.

If you have questions about your specific situation, please contact our employee benefit consulting team. We’re here to help.

Article
Form 5500: An overview

Read this if you are an employer that provides educational assistance to employees.

Under Section 127 of the Internal Revenue Code (IRC), employers are allowed to provide tax-free payments of up to $5,250 per year to eligible employees for qualified educational expenses. To be considered qualified, payments must be made in accordance with an employer’s written educational assistance plan. 

The Coronavirus Aid, Relief and Economic Security (CARES) Act amended Section 127 to include student loan repayment assistance as a qualified educational expense. The expansion of Section 127 allows employers to make payments for student loans without the employee incurring taxable income and the payment is a deductible expense for the employer, resulting in tax advantages to both parties.  

Originally, the CARES Act was a temporary measure allowing tax-free principal or interest payments made between March 27, 2020 and December 31, 2020.  Due to the difficulties in adopting a formal education assistance plan, many employers were unable to take advantage of the temporary incentive. As a result, the Consolidated Appropriations Act, signed into law on December 27th, 2020 extended the provision for five years through December 31, 2025.  

Employer requirements

For payments to qualify as tax-free under Section 127, you (the employer) must meet the following requirements: 

  • The employer must have a written educational assistance plan
  • The plan must not offer other taxable benefits or remuneration that can be chosen instead of educational assistance (cash or noncash)
  • The plan must not discriminate in favor of highly compensated employees
  • An employee may not receive more than $5,250 from all employers combined
  • Assistance to shareholders or owners must not exceed 5% of total amounts paid
  • Eligible employees must be reasonably notified of the plan

Eligible employees include current and laid-off employees, retired employees, disabled employees, and certain self-employed individuals. Spouses or dependents of employees are not eligible. Payments of principal or interest can be made directly to employees as reimbursement for amounts already paid (support for student loan payments should be provided by the employee) or payments can be made directly to the lender. Other educational expenses that qualify under Section 127 include:

  • Tuition for graduate or undergraduate level programs, which do not have to be job-related
  • Books, supplies, and necessary equipment, not including meals, lodging, transportation, or supplies that employees may keep after the course is completed

The five-year extension of this student loan repayment assistance can provide tax savings to both employers (employer portion of FICA) and employees (federal and state withholding, and FICA). Additionally, offering a qualified educational assistance program may help strengthen an employers’ recruitment and retention efforts. 

If you have more questions, or have a specific question about your situation, please call us. We’re here to help.

Article
CARES Act expansion of Section 127 of the IRC: Tax savings for employers

Read this if you are an employer looking for more information on the Employee Retention Credit (ERC).

As we previously wrote, the Consolidated Appropriations Act, 2021 expanded, retroactively to March 12th, 2020, the Employee Retention Credit (ERC) to include those otherwise eligible employers who also received Paycheck Protection Program (PPP) loans. For those employers, wages qualifying for the ERC include wages that were not paid for with proceeds from a forgiven PPP loan. 

IRS guidance released

Recently, the Internal Revenue Service (IRS) released guidance under Notice 2021-20 (the Notice) clarifying how eligible employers who also received a PPP loan during 2020 can retroactively claim the ERC. The Notice also formalizes and expands on prior IRS responses to FAQs and addresses changes made since the enactment of the Act; it contains 71 FAQs. The IRS has stated it will address calendar quarters in 2021 in later guidance.

Under the 2020 ERC rules, an eligible employer may receive a refundable credit equal to 50% of qualified wages and healthcare expenses (up to $10,000 of wages/health care expenses per employee in 2020) paid by a business or not-for-profit organization that experienced a full or partial suspension of their operations or a significant decline in gross receipts. For employers that received a PPP loan, Q&A 49 of the Notice outlines the IRS’ position on the interaction with the ERC for 2020. 

An eligible employer can elect which wages are used to calculate the ERC and which wages are used for PPP loan forgiveness. The Notice provides for a deemed election for any qualified wages  included in the amount reported as payroll costs on the PPP Loan Forgiveness Application, unless the included payroll costs exceed the amount needed for full forgiveness when considering only the entries on the application. The text of Q&A 49 appears to treat the minimum amount of payroll costs required for PPP loan forgiveness (i.e., 60%) as being the deemed election as long as there are other eligible non-payroll expenses reported on the application to account for the other 40% of loan forgiveness expenses.

Payroll costs reported on the PPP Loan Forgiveness Application: Examples

The examples make it clear the payroll costs reported on the PPP Loan Forgiveness Application and needed for loan forgiveness are generally excluded from the ERC calculations. The qualified wages included on the PPP Loan Forgiveness Application that may be included in the ERC calculations are partially impacted by the documented non-payroll expenses included in the PPP Loan Forgiveness Application. Following are a few examples from the Notice. Each example outlines the interaction between payroll costs reported on the PPP Loan Forgiveness Application and the qualified wages for the ERC.

Example #1: An employer received a PPP loan of $100,000 and has both payroll and non-payroll costs that far exceed the borrowed amount. The employer only reports payroll costs of $100,000 on the PPP Loan Forgiveness application to simplify the forgiveness process. The employer cannot use any of the $100,000 of payroll costs to claim the ERC. This is notwithstanding the fact that 100% forgiveness may have been achieved by reporting only $60,000 of payroll costs and the remaining $40,000 from non-payroll costs.   

Example #2: An employer received a PPP loan of $200,000. The employer submitted a PPP Loan Forgiveness Application and reported $250,000 of qualified wages as payroll costs in support of forgiveness of the entire PPP loan. The employer is deemed to have made an election not to take into account $200,000 of the qualified wages for purposes of the ERC, which was the amount of qualified wages included in the payroll costs reported on the PPP Loan Forgiveness Application up to (but not exceeding) the minimum amount of payroll costs. The employer is not treated as making a deemed election with respect to $50,000 of the qualified wages ($250,000 reported on the PPP Loan Forgiveness Application, minus the $200,000 PPP loan amount forgiven), and it may treat that amount as qualified wages for purposes of the ERC.

Example #3: An employer received a PPP loan of $200,000. The employer is an eligible employer and paid $200,000 of qualified wages that would qualify for the employee retention credit during the second and third quarters of 2020. The employer also paid other eligible expenses of $70,000. The employer submitted a PPP Loan Forgiveness Application and reported the $200,000 of qualified wages as payroll costs, as well as the $70,000 of other eligible expenses, in support of forgiveness of the entire PPP loan. In this case, the employer is deemed to have made an election not to take into account $130,000 of qualified wages for purposes of the ERC, which was the amount of qualified wages included in the payroll costs reported on the PPP Loan Forgiveness Application up to (but not exceeding) the minimum amount of payroll costs, together with the $70,000 of other eligible expenses reported on the PPP Loan Forgiveness Application, sufficient to support the amount of the PPP loan that was forgiven. As a result, $70,000 of the qualified wages reported as payroll costs may be treated as qualified wages for purposes of the ERC.

Key takeaway:

For purposes of PPP loan forgiveness, an employer must generally submit payroll expenses equal to at least 60% of the loan amount to maximize loan forgiveness and to maximize the available wages for the ERC. If an employer does not report non-payroll costs (or limits the amount it reports) on the PPP Loan Forgiveness Application then doing so will have a direct impact on the wages available for the ERC. 

An employer must also consider the payroll costs reported on the PPP Loan Forgiveness Application and the payroll costs necessary to maximize the ERC. For example, if an employer does not qualify for the ERC until the third quarter of 2020, it should consider limiting the amount of wages reported on the PPP Loan Forgiveness Application that are attributable to the third quarter in order to maximize the wages available for the ERC.

How to claim the Employee Retention Credit

An eligible employer that received a PPP loan and did not claim the ERC may file a Form 941-X, Adjusted Employer’s Quarterly Federal Tax Return for the relevant calendar quarters in which the employer paid qualified wages, but only for qualified wages for which no deemed election was made. 

Form 941-X may also be used by eligible employers who did not receive a PPP loan for 2020, but subsequently decide to claim any ERC to which they are entitled for 2020. 

The deadline for filing Form 941-X is generally within three years of the date Form 941 was filed or two years from the date you paid the tax reported on Form 941, whichever is later.

For more information

If you have more questions, or have a specific question about your situation, please call us. We’re here to help.

Article
IRS guidance: Retroactively claiming the 2020 ERC

Read this if you are a community bank.

The Federal Deposit Insurance Corporation (FDIC) recently issued its fourth quarter 2020 Quarterly Banking Profile. The report provides financial information based on call reports filed by 5,001 FDIC-insured commercial banks and savings institutions. The report also contains a section specific to community bank performance. In fourth quarter 2020, this includes the financial information of 4,559 FDIC-insured community banks. Here are our key takeaways from the community bank section of the report:

  • There was a $1.3 billion increase in quarterly net income from a year prior despite a 38.1% increase in provision expense and continued net interest margin (NIM) compression. This increase was mainly due to loan sales, which were up 159.2% from 2019. Year-over-year, net income is up 3.6%. However, the percentage of unprofitable community banks rose from 3.7% in 2019 to 4.4% in 2020.
  • Provision expense for the year increased $4.1 billion (a 141.6% increase) from 2019.
  • Year-over-year NIM declined 27 basis points to 3.39%. The average yield on earning assets fell 61 basis points to 4.00%.
  • Net operating revenue increased by $3.4 billion from fourth quarter 2019, a 14.5% increase. This increase is attributable to higher revenue from loan sales (increased $1.8 billion, or 159.2%) and an increase in net interest income.
  • Non-interest expenses increased 10.4% from fourth quarter 2019. This increase was mainly attributable to salary and benefit expenses, which saw an increase of $1.1 billion (12.6%). That being said, average assets per employee increased 16% from fourth quarter 2019.
  • Trends in loans and leases showed a moderate contraction from third quarter 2020, decreasing by 1.6%. This contraction was mainly seen in the C&I loan category, which was driven by a reduction in Paycheck Protection Program (PPP) loan balances. However, total loans and leases increased by 10.3% from fourth quarter 2019. Although all major loan categories expanded in 2020, the majority of growth was seen in C&I loans, which accounted for approximately two-thirds of the year-over-year increase in loans and leases. However, keep in mind, C&I loans include PPP loans that were originated in the first half of 2020.
  • Nearly all community banks reported an increase in deposit volume during the year. Growth in deposits above the insurance limit drove the annual increase while alternative funding sources, such as brokered deposits, declined.
  • Average funding costs fell 33 basis points to 61 basis points for 2020.
  • Noncurrent loans (loans 90 days or more past due or in nonaccrual status) increased $1.5 billion (12.8%) from fourth quarter 2019 as noncurrent balances in all major loan categories grew. However, the noncurrent rate remained relatively stable compared to fourth quarter 2019 at 77 basis points, partly due to strong year-over-year loan growth.
  • Net charge-offs decreased 4 basis points from fourth quarter 2019 to 15 basis points. The net charge-off rate for C&I loans declined most among major loan categories having decreased 24 basis points.
  • The average community bank leverage ratio (CBLR) for the 1,844 banks that elected to use the CBLR framework was 11.2%.
  • The number of community banks declined by 31 to 4,559 from third quarter 2020. This change includes two new community banks, four banks transitioning from non-community to community banks, three banks transitioning from community to non-community banks, 30 community bank mergers or consolidations, two community bank self-liquidations, and two community bank failures.

2020 was a strong year for community banks, as evidenced by the increase in year-over-year net income of 3.6%. However, tightening NIMs will force community banks to either find creative ways to increase their NIM, grow their earning asset bases, or find ways to continue to increase non-interest income to maintain current net income levels. Some community banks have already started dedicating more time to non-traditional income streams, as evidenced by the 40.1% year-over-year increase in non-interest income.

Furthermore, much uncertainty still exists. For instance, although significant charge-offs have not yet materialized, the financial picture for many borrowers remains uncertain. And payment deferrals have made some credit quality indicators, such as past due status, less reliable. The ability of community banks to maintain relationships with their borrowers and remain apprised of the results of their borrowers’ operations has never been more important.

As always, please don’t hesitate to reach out to BerryDunn’s Financial Services team if you have any questions. We're here to help.
 

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FDIC issues its fourth quarter 2020 Quarterly Banking Profile

Read this if you are an employee benefit plan fiduciary.

This article is the second in a series to help employee benefit plan fiduciaries better understand their responsibilities and manage the risks of non-compliance with Employee Retirement Income Security Act (ERISA) requirements. In our last article, we looked into the background of ERISA, which established important standards for the sound operation of employee benefit plans, as well as who is and isn’t a plan fiduciary, and what their responsibilities are. 

One important ERISA provision, found in Section 406(a), covers the types of transactions a plan fiduciary can and can’t engage in. ERISA terms the latter prohibited transactions, and they’re a lot like traffic lights—when it comes to avoiding conflicts of interest in business dealings, they’re your guide for when to stop and when to go. By knowing and abiding by these rules of the road, plan fiduciaries can steer clear of tickets, fines, and other damaging mishaps. 

Parties-in-interest—keep them out of the passenger seat 

Much like driver’s ed., fiduciary responsibility boils down to knowing the rules—plan fiduciaries need to have a strong working knowledge of what constitutes a prohibited transaction in order to ensure their compliance with ERISA. The full criteria are too detailed for this article, but one sure sign is the presence of a party-in-interest.

ERISA’s definition of a party-in-interest

The definition includes any plan fiduciary, the plan sponsor, its affiliates, employees, and paid and unpaid plan service providers, and 50%-or-more owners of stock in the plan sponsor. If you’d like to take a deeper dive into ERISA’s definition of parties-in-interest, see “ERISA's definition of parties-in-interest" at right.

Prohibited transactions—red lights on fiduciary road 

Now that we know who fiduciaries shouldn’t transact with, let’s look at what they shouldn’t transact on. ERISA’s definition of a prohibited transaction includes: 

  • Sale, exchange, and lease of property 
  • Lending money and extending credit 
  • Furnishing goods, services, and facilities 
  • Transferring plan assets 
  • Acquiring certain securities and real property using plan assets to benefit the plan fiduciary 
  • Transacting on behalf of any party whose interests are adverse to the plan’s or its participants’ 

Transacting in any of the above is akin to running a red light—serious penalties are unlikely, but there are other consequences you want to avoid. Offenders are subject to a 15% IRS-imposed excise tax that applies for as long as the prohibited transaction remains uncorrected. That tax applies regardless of the transaction’s intent and even if found to have benefited the plan. 

The IRS provides a 14-day period for plan fiduciaries to correct prohibited transactions and avoid associated penalties. 

Much like owning a car, regular preventative maintenance can help you avoid the need for costly repairs. Plan fiduciaries should periodically refresh their understanding of ERISA requirements and re-evaluate their current and future business activities on an ongoing basis. Need help navigating the fiduciary road? Reach out to the BerryDunn employee benefit consulting team today. 
 

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Prohibited transactions: Rules of the road for benefit plan fiduciaries

Read this if you are a residential living facility.

At the end of last year, Congress and the IRS brought about changes to the application of the business interest expense deduction limitation rules with regard to taxpayers that wish to make a real property trade or business (RPTOB) election. This change may benefit owners and operators of qualified residential living facilities. Here’s what we know.

Background

Section 163(j) generally limits the amount of a taxpayer’s business interest expense that can be deducted each year. The term “business interest” means any interest that is properly allocable to a “trade or business,” which could include an electing RPTOB. The term “trade or business” has not been separately defined for purposes of Section 163(j), however, it has been defined for purposes of the passive activity loss rules under Section 469(c)(7)(C) as any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business.

In general, a taxpayer engaged in a trade or business that manages or operates a “qualified residential living facility” may elect to be treated as an RPTOB solely for the purpose of applying the interest expense rules under Section 163(j). Taxpayers that make an RPTOB election to avoid being subject to the business interest deduction limitation under Section 163(j) must use the alternative depreciation system (ADS) to compute depreciation expense for property described in Section 168(g)(8), which includes residential rental property.

In Notice 2020-59, issued on July 28, 2020, the IRS and Treasury proposed a revenue procedure providing a safe harbor for purposes of determining whether a taxpayer meets the definition of a qualified residential living facility and is therefore eligible to make the RPTOB election. Following review of comments submitted in response to Notice 2020-59, the Treasury Department and IRS published Revenue Procedure 2021-9 (Rev. Proc. 2021-9) on December 29, 2020. Rev. Proc. 2021-9 modifies the proposed safe harbor under Notice 2020-59 to make it more broadly applicable and less administratively burdensome. 

Additionally, the emergency coronavirus relief package signed into law on December 27, 2020 contains a taxpayer-favorable provision that modifies the recovery period applicable to residential rental property (including retirement care facilities) placed in service before January 1, 2018 for taxpayers making the RPTOB election.

Modifications to the RPTOB safe harbor under Rev. Proc. 2021

Under Rev. Proc. 2021-9, a residential living facility will be eligible to make the RPTOB election providing the facility:

  1. Consists of multiple rental dwelling units within one or more buildings or structures that generally serve as primary residences on a permanent or semi-permanent basis to individual customers or patients;
  2. Provides supplemental assistive, nursing, or other routine medical services; and
  3. Has an average period of customer or patient use of individual rental dwelling units of 30 days or more.

Alternatively, if the residential living facility qualifies as residential rental property under Section 168(e)(2)(A), it will be treated as an RPTOB for purposes of the revenue procedure. Thus in response to comments submitted to the Treasury Department and the IRS, Rev. Proc. 2021-9 modified the proposed safe harbor published in Notice 2020-59 in several important ways, including the following:

  • The definition of a qualified residential living facility has been modified to reduce the required average period of customer or patient use from 90 to 30 days. Further, the average period of use may be determined by reference to either the number of days paid for by Medicare or Medicaid, or the number of days under a formal contract or other written agreement.

This modification is a welcome change from the proposed safe harbor contained in Notice 2020-59. Medicare and Medicaid frequently cover patient stays of less than 90 days. Consequently, reducing the required number of days of use and allowing for determination with reference to days paid by Medicare or Medicaid should allow a greater number of facilities to qualify under the safe harbor.

  • Rev. Proc. 2021-9 provides an alternative test for purposes of determining whether a taxpayer meets certain requirements of the definition of a qualified residential living facility. Under this alternative test, if a taxpayer operates or manages residential living facilities that qualify as residential rental property for depreciation purposes, then the facility will be considered a qualified residential living facility for purposes of Section 163(j).

The administrative burden on taxpayers should be significantly reduced by allowing reliance on separate determinations made for depreciation purposes. Taxpayers will not be required to consider two distinct tests.

  • Rev. Proc. 2021-9 clarifies that the determination of whether a facility meets the definition of a qualified residential living facility must be determined on an annual basis. 

Under general rules, once a taxpayer makes the RPTOB election, the election remains in effect for subsequent years. Taxpayers relying on this safe harbor cannot depart from these rules as there is a continuing requirement to evaluate qualification on an annual basis. To the extent a taxpayer fails to meet the safe harbor requirements, it may become subject to the business interest deduction limitations under Section 163(j). Unless otherwise provided in future guidance, this would not appear to constitute an accounting method change.

Important Considerations to apply the safe harbor under Rev. Proc. 2021-9

Qualifying taxpayers may rely on the safe harbor contained in Rev. Proc. 2021-9 for tax years beginning after December 31, 2017. Further, if a taxpayer relies on the safe harbor, the taxpayer must use the ADS of Section 168(g) to depreciate the property described in Section 168(g)(8), as discussed above.

The changes under Rev. Proc. 2021-9 could open the door for taxpayers who qualify in a previous year (i.e., 2018 and 2019) as a result of the new rules to amend prior returns (for example, taxpayers that now qualify for the RPTOB election using the 30-day threshold average use instead of the 90-day average).

For purposes of applying the safe harbor, for any taxable year subsequent to the taxable year in which a taxpayer relies on the safe harbor to make the RPTOB election in which a taxpayer does not satisfy the safe harbor requirements, the taxpayer is deemed to have ceased to engage in the electing RPTOB (i.e., the taxpayer will likely be subject to the business interest expense limitations of Section 163(j)). However, for any subsequent taxable year in which a taxpayer satisfies the safe harbor requirements after a deemed cessation of the electing trade or business, the taxpayer’s initial election will be automatically reinstated.

To rely on this safe harbor, a taxpayer must retain books and records to substantiate that all of the above requirements are met each year. Taxpayers are not eligible to rely on the safe harbor in this revenue procedure if a principal purpose of an arrangement or transaction is to avoid Section 163(j) and its regulations in its entirety, and in a manner that is contrary to the purpose of Rev. Proc. 2021-9.

If you have specific questions about your facility or tax situation, please contact Jason Favreau or Matthew Litz. We’re here to help.

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Taxpayer-friendly changes for qualified residential living facilities