Aggregation Rules May Prevent
Private Equity Portfolio Companies From Taking Full Advantage of the New Employee Retention Credit Under the CARES Act

Section 2301 of the recent Coronavirus Aid, Relief, and Economic Security (CARES) Act (the Act) provides “eligible employers” with a refundable credit against the employer’s share of Social Security taxes in an amount equal to 50% of “qualified wages” with respect to each of its employees, subject to an aggregate wage limitation of $10,000 per employee.^[1] The provision covers wages paid after March 12, 2020, and before Jan. 1, 2021, but only with respect to eligible employers that do not take a small business interruption loan authorized elsewhere under the Act (a paycheck protection loan).^[2] The employee retention credit is one of the principal business-related relief provisions under the Act.

An eligible employer is one that was carrying on a trade or business during 2020 and, with respect to any calendar quarter, (i) the operation of such trade or business is partially or fully suspended as a result of a governmental order due to the COVID-19 pandemic (a Covered Business Suspension) or (ii) the employer suffers a significant decline in gross receipts (a Significant Decline). A Significant Decline period commences with the first calendar quarter beginning after Dec. 31, 2019, during which the employer realizes less than 50% of gross receipts as for the same calendar quarter during the prior year; it ends with the calendar quarter beginning after the first quarter during which such employer’s gross receipts are greater than 80% of gross receipts for the same calendar quarter during the prior year.

The amount of qualified wages varies significantly depending upon whether the employer is considered a large employer for purposes of the credit. For employers whose average number of full-time employees during 2019 exceeded 100 (Large Employers), qualified wages are only those wages paid to employees who are not performing services for such employer due to a Covered Business Suspension or a Significant Decline (and even then, only those wages paid during the relevant period). For eligible employers whose average number of full-time employees during 2019 was not greater than 100, qualified wages are (i) any wages paid by such employer to an employee during a Covered Business Suspension (without regard to whether such employee is still performing any services for the employer) or (ii) wages paid to an employee during a Significant Decline period.

Section 2301(d) of the Act provides that all persons treated as a single employer under Section 52(a) or (b) (or pursuant to sections 414(m) or (o) relating to, among other things, members of an affiliated service group) of the Internal Revenue Code of 1986, as amended (the Code), are treated as one employer for purposes of the credit, including in determining whether an employer is a Large Employer and whether the Significant Decline test is met (the Aggregation Rule).^[3] Broadly speaking, the Aggregation Rule provides that all members of a group of entities (whether corporations, partnerships, sole proprietorships, trusts or estates) under common control are treated as a single employer in determining eligibility for the credit.^[4]

Section 52(a) of the Code treats all employees of a “controlled group of corporations,” as defined in Code Section 1563(a) with certain modifications, as employed by a single employer. Such a group is any group of one or more chains of corporations connected through stock ownership with a common parent corporation if (i) more than 50% (by vote or value) of the stock of each corporation, except the common parent, is owned (directly or constructively through the application of certain broad attribution rules) by one or more of the other corporations and (ii) the common parent corporation owns (directly and constructively through the application of such broad attribution rules) more than 50% (by vote or value) of the stock of at least one of the other corporations (excluding, for purposes of such computation, stock owned directly by such other corporations).

Section 52(b) of the Code authorizes the Secretary of the Treasury to prescribe regulations treating all employees of trades or businesses (whether or not incorporated) that are under common control as employed by a single employer, based on principles similar to the principles set forth under Section 52(a).

Treasury Regulation § 1.52-1(b) provides in relevant part that the term “trades or businesses under common control” means any group of trades or businesses that includes, inter alia, a “parent-subsidiary group under common control.” Such a group consists of one or more chains of “organizations” (defined to include a sole proprietorship, a partnership, a trust, an estate or a corporation) conducting trades or businesses that are connected through ownership of a “controlling interest” with a common parent organization if (i) a controlling interest in each of the organizations is owned (directly and constructively through option attribution) by one or more of the other organizations and (ii) the common parent owns (directly and constructively through option attribution) a controlling interest in at least one of the other organizations (excluding, for purposes of such computation, any direct ownership interest held by the other organizations). A “controlling interest” is defined for this purpose as, among other things, ownership of more than 50% (by vote or value) of a corporation’s stock and, in the case of a partnership, ownership of more than 50% of the profits or capital interests of the partnership.

These broad common control rules can result in disparate companies controlled by a single private equity sponsor being aggregated for purposes of determining eligibility for the credit and the amount of the credit to which such companies may be entitled.

For example, assume a private equity sponsor has a single fund that owns more than 50% of two portfolio companies, A and B, each with 60 employees in 2019 and comparable 2019 gross receipts. The two portfolio companies share no employees and are in separate lines of business. Portfolio company A is subject to a Covered Business Suspension while portfolio company B is not. Under the Aggregation Rule, A and B appear to be part of a single employer with the fund and thus a Large Employer for purposes of the credit. As a result, while A and B are both treated as subject to a Covered Business Suspension (as a partial suspension), each is entitled only to the credit with respect to wages paid to employees who are not providing services (or are providing limited services) as a result of the Covered Business Suspension.^[5]

Similarly, assume that neither A nor B is subject to a Covered Business Suspension. However, A’s gross receipts in the second quarter of 2020 decline by 60% as compared to the second quarter of 2019. B’s gross receipts for such quarter, on the other hand, decline by only 30%. Because one presumably aggregates the gross receipts of both A and B in testing whether the group has suffered a Significant Decline, neither A nor B would suffer a Significant Decline. Thus, neither A nor B is entitled to the credit.

The above results would be different if A and B were not under common control. That can be the case, for example, if the private equity sponsor has two funds, such as side-by-side offshore and domestic funds in a non-feeder structure, and neither fund owns more than 50% of both portfolio companies under the Aggregation Rule. In that scenario, A would be entitled to the credit in both examples above and would not be treated as a Large Employer, while B would not be entitled to any credits. On the other hand, if the domestic and offshore funds were feeder funds that together owned a master fund, then A and B would again be a single employer.

Given that the purpose of the credit is to incentivize employers to continue paying their employees, it is hard to see the policy rationale for depriving A of credits solely because of a common fund sponsor with B, when they share no employees and are in disparate businesses. Moreover, it is not clear why the result should hinge on the sponsor’s fund structure or on the percentage in either portfolio company that is owned by management and/or co-investors. In addition, if the fund had sold one of the portfolio companies at the end of 2019 to another private equity fund, then the Aggregation Rules would not apply to treat A and B as a single employer.

Treasury has issued guidance on the credit in the form of Frequently Asked Questions, but it does not address the Aggregation Rule in this context. Hopefully Treasury will provide further guidance that narrows the Aggregation Rule’s broad scope, though it may feel constrained by the words of the Act.  

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If you have any questions about the issues addressed in this alert or would like copies of any of the materials mentioned, please contact any of the authors.

^{[1]  For our earlier discussion of the credit and other tax-related provisions in the Act, see “Tax-Related Provisions of the CARES Act.”}

^{[2]  For a more complete discussion of the paycheck protection loan program, see “SBA Paycheck Protection Loan Program and Additional Financial Assistance Programs.”}

^{[3]  When two or more entities are treated as a single employer under the Aggregation Rule, in calculating gross receipts one presumably must take into account the gross receipts of all such entities, and not just of the business(es) conducted by a single member of the group.}

^{[4]  Potential borrowers seeking paycheck protection loans authorized under the Act are also subject to affiliation rules in determining whether they exceed the maximum number of employees permitted under the program. The affiliation rules for purposes of that program differ from the Aggregation Rule and are subject to waiver in limited circumstances. Employers can choose to apply for a paycheck protection loan or can choose to take the employee retention credits, if eligible, but cannot choose both. Private equity funds and their portfolio companies are likely to fall under the paycheck protection loan affiliation rules, thereby precluding their participation under the program. If, as described below, such funds and their portfolio companies are also subject to the Aggregation Rule, preventing their eligibility for, or limiting their ability to utilize the maximum amount of, the employee retention credit, they will suffer a double whammy that Congress may not have contemplated.}

^{[5]  Recently issued FAQs by both the Senate Finance Committee and the Internal Revenue Service suggest that some portion of the credit may be taken by Large Employers in the case of employees who may be performing some services, to the extent wages are paid to such employees in excess of the amount the employer would have paid for the services actually rendered to the employer. Further guidance in this area is expected.}