Area 51 is that mysterious area in the Nevada desert under the control of the United States Air Force. But it turns out that Area 51 is not the only mysterious 51 related to the United States federal government.  Tax advisers have been exploring their own “area 51,” this time found at IRC Section 51(i)(1) that is cross-referenced for limiting the application of the employee retention credit.

Some parts of this 51 item are relatively clear. We know the employee retention credit (ERC) isn’t allowed for the various relatives of a control owner under CARES Act Section 2301(e) and its later updated versions.  But what has become as obscure to some as Area 51 is whether this provision will work to also eliminate the ability of most shareholders owning more than 50% of the stock of a corporation to obtain the employee retention credit on their own wages.

Tax Area 51 – The Limitation Cross-References for the Employee Retention Credit

CARES Act Section 2301(e) provides that “rules similar to the rules of sections 51(i)(1)” shall apply to the employee retention credit.  And that language has survived unchanged through the two revisions (to date) we’ve been through each time the ERC has been extended and modified.

IRC Section 51 defines the work opportunity tax credit (WOTC) and was around long before the CARES Act and the employee retention credit.  Part of that section looked to limit the ability to claim the WOTC on compensation paid to certain parties related to anyone who directly or indirectly controlled the employer.  That limiting provision is found at IRC §51(i)(1).

IRC §51(i)(1) provides, in part:

No wages shall be taken into account under subsection (a) with respect to an individual who—

(A) bears any of the relationships described in subparagraphs (A) through (G) of section 152(d)(2) to the taxpayer, or, if the taxpayer is a corporation, to an individual who owns, directly or indirectly, more than 50 percent in value of the outstanding stock of the corporation, or, if the taxpayer is an entity other than a corporation, to any individual who owns, directly or indirectly, more than 50 percent of the capital and profits interests in the entity (determined with the application of section 267(c)), …

The key issues that will cause us concern in that paragraph are:

• The reference to IRC §152(d)(2)(A)-(G) for a list of relatives impacted by these rules;

• The reference to directly or, more importantly, indirectly controlling the employer and

• The use of IRC §267(c) to determine that direct or indirect ownership.

Barred Relationships

Before getting into the indirect problem, let’s first look at just who would be the related parties on which claiming the ERC will be barred under this provision.  Any compensation paid to a person holding a relationship listed in §152(d)(2) to any person who directly or indirectly is found to own more than 50% of the stock of the corporation will not be wages on which the ERC can be claimed.

Section 152(d)(2)(A)-(G) gives the list of barred relationships.  Anyone who has the listed relationship to any person with more than 50% control of the corporation could not be paid wages on which the ERC could be claimed:

(2) Relationship

For purposes of paragraph (1)(A), an individual bears a relationship to the taxpayer described in this paragraph if the individual is any of the following with respect to the taxpayer:

(A) A child or a descendant of a child.

(B) A brother, sister, stepbrother, or stepsister.

(C) The father or mother, or an ancestor of either.

(D) A stepfather or stepmother.

(E) A son or daughter of a brother or sister of the taxpayer.

(F) A brother or sister of the father or mother of the taxpayer.

(G) A son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law.

A simple example would hold that if I own 100% of a corporation, wages paid to my son or daughter could not be treated as wages on which the corporation could claim the employee retention credit.  So far this is pretty straight-forward.  While you might argue it’s unfair in many cases, it certainly isn’t unclear.

But in that case the employee is the child of a person who actually is holding the shares in question.  How would we determine if some other employee is going to be taken out of the pool of ERC eligible employees due to holding an impermissible relationship to a party that indirectly owns more than 50% of the corporation?

Indirect Ownership for Purposes of the Employee Retention Credit

Section 51 does give us some guidance on how to determine indirect ownership with the parenthetical reference at the end of IRC §51(i)(1)(A) to IRC §267(c) being applied to determine ownership.

IRC §267(c) defines constructive ownership of stock.  Thus, it would seem, constructive ownership of stock under §267(c) would constitute indirect ownership of stock for purposes of §51 and, going all the way back up the chain, to the various employee retention credits beginning with the first one added in the CARES Act.

IRC §267(c) provides:

(c) Constructive ownership of stock

For purposes of determining, in applying subsection (b), the ownership of stock—

(1) Stock owned, directly or indirectly, by or for a corporation, partnership, estate, or trust shall be considered as being owned proportionately by or for its shareholders, partners, or beneficiaries;

(2) An individual shall be considered as owning the stock owned, directly or indirectly, by or for his family;

(3) An individual owning (otherwise than by the application of paragraph (2)) any stock in a corporation shall be considered as owning the stock owned, directly or indirectly, by or for his partner;

(4) The family of an individual shall include only his brothers and sisters (whether by the whole or half blood), spouse, ancestors, and lineal descendants; and

(5) Stock constructively owned by a person by reason of the application of paragraph (1) shall, for the purpose of applying paragraph (1), (2), or (3), be treated as actually owned by such person, but stock constructively owned by an individual by reason of the application of paragraph (2) or (3) shall not be treated as owned by him for the purpose of again applying either of such paragraphs in order to make another the constructive owner of such stock.

Let’s try a simple example—if I hire my brother’s sister-in-law, my corporation won’t be able to claim the credit on her wages.  While she is not my sister-in-law, my brother under IRC §267(c)(2) is considered to indirecty own 100% of the S corporation and my employee has the impermissible sister-in-law relationship to this indirect owner.

Splash-Back Problem

So far, so good.  But now we get to the crux of the matter.

As we noted earlier, my brother cannot be paid wages and have my corporation claim the credit on those wages since he’s in the list at §152(d)(4).  Again, this much is crystal clear.

But, as just noted as well, my brother is also someone covered by IRC §267(c)(2) and (4), so he is deemed to own indirectly 100% of the stock of the corporation as well since he’s deemed to indirectly own every share I own. 

Well, that now means his brother (meaning me, the 100% shareholder) is now also someone who cannot receive wages for which the ERC credit is claimed by my S corporation since I bear the barred §152(d)(4) relationship to my brother and he indirectly controls the corporation via my stock.

I can repeat that same logic with my parents, children, grandchildren, etc.  So only if I have no one who will be deemed to own my stock indirectly under the family rules of IRC §267(c) could I get the ERC under a literal interpretation of the law.

Joint Committee on Taxation Seemed to Believe This Was Obvious in 2015

This issue has been discussed nonstop since the ERC was opened up to PPP borrowers among a group of tax geeks (myself included) on Twitter.  During one of those conversations, Tony Nitti messaged me to point out one case where the Joint Committee on Taxation appears to have actually discussed the specific issue of whether “splash back” blocks the controlling shareholder from having the corporation claim a credit limited by IRC §51(i)(1).

In the Technical Explanation of The Protecting Americans From Tax Hikes Act of 2015, House Amendment #2 to the Senate Amendment to H.R. 2029 the Joint Committee on Taxation was describing the Work Opportunity Credit which had been extended and modified by the PATH Act.  As part of describing the impact of the Act, the JCT discussed portions of the Act that, while not changed by the Act, need to be understood to understand the impact of passing the bill, as these existing rules would apply to the WOTC as modified.

One part of that document talked about “Other Rules” and stated, in part “The work opportunity tax credit is not allowed for wages paid to a relative or dependent of the taxpayer. No credit is allowed for wages paid to an individual who is a more than fifty-percent owner of the entity.”[1]

As no part of IRC §51 directly states that a more than 50% owner can’t qualify for the credit, presumably this sentence is referring to the overwhelmingly likely possibility that the individual in control will have his/her ownership attributed to a person under IRC §267(c) to which he/she will bear one of the impermissible relationships listed at IRC §152(d)(2)(A)-(G).

Note that the sentence is very matter of fact in its presentation, as if the answer should be clear to anyone reading the law.

So Are Owners Out of Luck?

When you follow the cross-references, it certainly doesn’t look good for claiming the credit on the majority shareholder’s wages based on a literal reading of the IRC provisions in question.

But it does seem like an odd way to arrive at this result.  For instance, the JCT’s statement appears overly broad, even if it would be correct in an overwhelming number of real world cases.  That is, if I had no living direct ancestors, as well as no living brother or sister and no children or other lineal descendants, there would be no indirect owners that would end up causing my wages to not be eligible for the credit in my corporation.

As well, Congress tends to start with such a direct bar on benefits to owners and then expand out when writing such provisions. Barring owners from getting benefits meant to be given only if they benefit the rank and file is not something Congress usually obscures in laws they pass.

But despite all of that, as courts have ruled in the past, Congress can pass absurd laws if that absurdity is caused by the plain language of the statute.  Absurd but unambiguous is fine by the Courts.

Could the IRS Rescue the Credit for Owners?

One possible way the IRS could conclude the credit is available on the wages of majority shareholders would be to focus on the theory that there are to be rules “similar to” those found at IRC §51(i)(1).  That phrase might, if the IRS was feeling particularly generous, be enough ambiguity to allow the agency to write rules allowing for such wages to qualify without necessarily ruling that owners could also qualify for the work opportunity credit.

While the IRS might be stretching their authority if they did that, there’s also the simple fact that it would be hard to conceive of a situation where someone could take the IRS to court to challenge that holding (ignoring the fact that not many would want to do so).

Congressional Action

The simplest way to clear the path for controlling shareholder wages to qualify for the credit would be for Congress to change the law if, in fact, Congressional intent was to allow the credit in such cases.  But there are a couple of complications in that path.

First, Congress has trouble passing virtually any legislation these days due to partisan battling.  Even though the provision in question passed with a bipartisan vote in the CARES Act, that doesn’t mean that the parties would non insist on additional provisions being attached to any bill introduced to obtain this result.

Second, it’s not clear that denying the credit to controlling shareholders is contrary to Congressional intent.  After all, sole proprietors and partners do not qualify for any such subsidy for their needs no matter how you read CARES Act Section 2301 or its successors.

[1] Joint Committee on Taxation, Technical Explanation of The Protecting Americans From Tax Hikes Act of 2015, House Amendment #2 to the Senate Amendment to H.R. 2029, JCX-144-15, December 17, 2015, p. 59