Your Tax Matters Partner is pleased to introduce a new contributor Dan Chodan CPA of Trout CPA in Lancaster PA.

On Feb. 25, 2021, the AICPA published a letter to the IRS making several recommendations for the employee retention credit (ERC). Among these recommendations was a request for clarity as to whether wages paid to S corporation owners and their spouses can qualify for ERC. The letter refers to a substantial amount of confusion among AICPA members on the issue. This confusion is understandable given the complexity of underlying regulations and the number of Code sections referenced.

Related parties do not qualify

The Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136, states that rules similar to Sec. 51(i)(1) apply for the ERC, causing certain related individuals’ wages to be ineligible under the relationships listed at Sec. 152(d)(2). These rules were reiterated in the guidance for 2020 ERCs in Notice 2021-20 but without any additional commentary. The related individuals disqualified are listed in
the IRS’s frequently asked question No. 59 for ERC (the same as they appear at Sec. 152(d)(2)). Relationships disqualified include the following:

• A child or a descendant of a child;
• A brother, sister, stepbrother, or stepsister;
•  The father or mother, or an ancestor of either;
•  A stepfather or stepmother;
•  A niece or nephew;
•  An aunt or uncle; and
•  A son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law.

Each of the relationships listed is disqualified for ERC if the person is related to a greater-than-50% owner. The confusion begins with this list. Owners and spouses themselves are not listed as disqualified relationships. This has led some to believe owner and spouse wages are allowed for ERC benefits, but further reading will show why they are not.

Analysis

The key issue is the definition of a more-than-50% owner under Sec. 51(i)(1). The IRS’s FAQ No. 59 indicates it is an individual owning “directly or indirectly” more than 50% of the value of stock in a corporation or of the capital and profits interests in the entity. The term “directly or indirectly” under Sec.51(i)(1) is defined as being determined with the application of Sec. 267(c). The attribution rules of Sec. 267(c) include entity-to-member attribution, family attribution, partner-to-partner attribution, and limits on reattribution. While all of these rules do apply to the determination of a more-than-50% owner for ERC, let’s just focus on the family attribution rules for the purpose of this article.

Family attribution of ownership under Sec. 267(c) occurs between the direct owner and the owner’s brothers and sisters (whether by whole or half blood), spouse, ancestors, and lineal descendants. This attribution of ownership occurs regardless of whether the family member owns any portion of the business under Regs. Sec. 1.267(c)-1. As a result, family attribution rules create many indirect owners of
a business because they are related to the direct owners of a business. Family attribution also may cause an owner with only a small portion of direct ownership to have a larger portion of direct and indirect ownership.

Examples

A common example is a S corporation owned 100% by a father with the only employees being the father and his son. The son’s wages are clearly disqualified for ERC as he is a disqualified relationship to a greater-than-50% owner (the father). The father’s wages are not as clear because owners themselves are not listed as disqualified relationships. However, when we apply the family attribution of ownership rules, we determine there is more than one owner. The father’s 100% ownership attributes to his son, leaving both the father and the son as 100% owners directly and indirectly. Because the father now has a disqualified relationship to a greater-than-50% owner, the father’s wages are also ineligible for ERC. The same result would occur whether or not the son was employed by the S corporation or had any direct ownership himself.

Another common example is an S corporation owned 50%/50% by two brothers with the only employees being the two brothers. Since there is no greater-than-50% owner, it may at first seem there are no related-party wages disqualified for ERC. However, when we apply the family attribution of ownership rules, the ownership of each brother attributes to the other and leaves both as 100% owners directly and
indirectly. Because each brother now has a disqualified relationship to a greater-than-50% owner, the wages of both owners are ineligible for ERC.

A final example is an S corporation owned 50%/50% by two cousins with the only employees being the two cousins. The cousins’ ownership does not attribute to each other by the family attribution rules. So each cousin is only a 50% owner directly and indirectly. However, the cousins’ ownership does attribute to ancestors, including their shared grandmother. The grandmother is considered a 100% owner of the S corporation because she is attributed the ownership of both of her grandchildren (the cousins). Because each cousin now has a disqualified relationship to a greater-than-50% owner, the wages of both owners are ineligible for ERC.

Full evaluation of ownership and related parties is necessary

Advisers should achieve a full understanding of the direct ownership of a business, the related individuals employed by the business, and the owner family tree(s) for ownership attribution purposes. The first step is determining who the direct and indirect owners of the business are according to family attribution rules of Sec. 267(c). The second step is applying the disqualified relationships of Sec. 51(i)(1) as they relate to any direct and indirect owners of greater than 50%. Further attribution complexities can arise when owners are also partners in another enterprise, when multiple layers of ownership exist, or when reattribution is limited, but these topics are beyond the scope of this article.

Family attribution of ownership produces unfavorable results by generally disqualifying more wages for the purposes of the ERC. Advisers and taxpayers should take a close look at these rules before claiming the recently expanded benefits of ERC.

Dan Chodan, CPA is a partner at Trout CPA in Lancaster, PA.