Timing of Deductions Related to Payroll Tax Deferral

November 23, 2020

The Coronavirus Aid, Relief, and Economic Security (CARES) Act allows employers to defer payment on the employer’s share of Social Security taxes (6.2% of eligible wages) that would have otherwise been due between March 27, 2020 and December 31, 2020. Employers must pay 50% of the amount of these deferred payroll taxes by December 31, 2021 and the remaining 50% by December 31, 2022. The result of deferring the tax payments may push the expense recognition to 2021 or 2022. The result is a loss of the payroll tax deduction in 2020 and an increase in income taxes for the tax year. For accrual method businesses, there may be opportunities to deduct the deferred portion of the payroll tax paid in 2021 on their 2020 tax returns. Cash and accrual method employers should take time to plan and assess their liquidity and decide the most beneficial way to use their cash.

Cash Basis Taxpayers

For employers that are cash basis taxpayers, tracing deductions is a straightforward exercise–if cash was paid for the expense in 2020, the deduction will be allowable for the 2020 tax year. Payments must be made in 2020 in order to obtain the deduction for the 2020 tax year. Employers that project a decrease in taxable income or losses in 2021 and 2022 may benefit from an early payment of the payroll taxes that have been deferred during calendar year 2020.

Accrual Basis Taxpayers

While cash method employers need to pay their tax in the payment year to claim the payroll tax deduction, the same is not necessarily true for accrual method employers. Timing rules for accrual method taxpayers may be beneficial and allow the taxpayer to claim a deduction in 2020 while deferring payment until 2021.

Accrual method taxpayers are generally allowed an income tax deduction in the taxable year when the “all-events” test is met, and economic performance occurs. If the all-events test is met, a payroll tax deduction is allowable in the tax year when all of the following occur:

  1. The fact of the liability has been established;

  2. The amount of liability can be determined with reasonable accuracy; and

  3. Economic performance has been completed by the last day of the tax year 

The first two requirements are met when applying the all-events test to payroll tax because the liability and the amount of the liability are both established by law. However, the third requirement will not generally be met until the tax liability has been paid. Payroll taxes, including the employer’s share of Social Security taxes, is considered to have met the Economic Performance test on payment. Unless an exception to the all-events test applies, the deferral of the payment of the employer’s portion of Social Security taxes to 2021 will prevent the employer from taking the deduction for those deferred amounts in the 2020 tax year.

Recurring Item Exception

Regulation Section 1.461-5 provides that a taxpayer may deduct an accrued liability even where economic performance has not yet occurred under the “recurring item exception.” Under this exception, a taxpayer may deduct an accrued liability if the first two requirements of the all-events test are met, and economic performance occurs before the earlier of:

  1. 8 ½ months after year-end, or

  2. filing of the tax return

Employers that have adopted the recurring item exception for payroll taxes may defer the payment of the employer portion of Social Security taxes to 2021 and still claim the deduction in 2020. However, the payment of the deferred amount by calendar-year taxpayers must be made by the earlier of the date the return is filed or September 15, 2021. For employers that have not adopted the recurring item exception, the business must file a Form 3115 either before or at the time the income tax return is filed.

Other Considerations

As originally enacted, the CARES Act prevented employers that received a Paycheck Protection Program (PPP) loan from deferring the Social Security tax after receiving notification of loan forgiveness. However, the PPP Flexibility Act was enacted and made changes to the CARES Act to allow employers to continue to defer Social Security tax deposits after the PPP loan is forgiven, which greatly expands the amount of Social Security taxes PPP loan recipients are permitted to defer.

The Employee Retention Credit is a refundable tax credit against certain employment taxes equal to 50 percent of the qualified wages an eligible employer pays to employees after March 12, 2020, and before January 1, 2021. Eligible employers can get immediate access to the credit by reducing employment tax deposits they are otherwise required to make. Also, if the employer's employment tax deposits are not sufficient to cover the credit, the employer may get an advance payment from the IRS. An employer is permitted to defer the deposit of the employer’s share of Social Security taxes before it applies the employee retention credit. The paid leave credits and the employee retention credit are applied after taking into consideration the deferred employer share of Social Security taxes. This is a favorable aspect of the IRS guidance because it allows employers to layer the benefit of payroll tax deferral on top of these other provisions. For more information, please refer to the “Deferral of employment tax deposits and payments through December 31, 2020” FAQs.

Marks Paneth will continue to monitor developments and will provide updates as they become available. Contact your Marks Paneth advisor if you need additional information or assistance or email responseteam@markspaneth.com.

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