Are Employee Retention Credit Refunds Taxable?

The Employee Retention Credit (ERC) was a refundable tax credit established to encourage businesses to retain employees during the economic disruptions caused by the COVID-19 pandemic. Introduced as part of the CARES Act in March 2020, it provided eligible employers with a credit against certain employment taxes for qualified wages paid between March 12, 2020, and December 31, 2021. This program aimed to support businesses facing government-mandated shutdowns or significant declines in gross receipts.

Taxability of ERTC Refunds

Employee Retention Credit (ERC) refunds are subject to income tax. While the ERC itself is a credit against employment taxes, its impact on a business’s income tax liability stems from the tax benefit rule. This rule dictates that if a deduction taken in a prior year reduced taxable income, any subsequent recovery or benefit related to that deduction must be included in income. For businesses, wages paid to employees are deductible expenses that reduce taxable income.

When a business claims the ERC, it receives a credit based on qualified wages that were also deducted as an expense. The Internal Revenue Service (IRS) guidance clarifies that the amount of the ERC must reduce the deduction for wages. This reduction in deductible wages effectively increases a business’s taxable income, aligning with the principle that a taxpayer cannot receive both a tax credit and a full deduction for the same wage expenses. This is mandated by tax law, specifically IRC Section 280C.

When to Account for the Refund

Determining the timing for recognizing the income tax effect of an Employee Retention Credit (ERC) refund depends on a business’s accounting method. For businesses operating on a cash basis, income is recognized when cash is received. This means the income tax impact of the ERC refund is accounted for in the tax year the refund check is deposited.

For businesses using the accrual basis of accounting, income is recognized when all events have occurred that fix the right to receive the income, and the amount can be determined with reasonable accuracy. Previously, the wage deduction reduction was required in the tax year the qualified wages were paid. However, recent IRS guidance allows taxpayers who received an ERC refund in a later year to include the overstated wage expense amount as gross income on their income tax return for the tax year when the ERC was received.

Effect on Wage Deductions

A crucial aspect of the Employee Retention Credit (ERC) is its direct impact on a business’s wage deductions. Businesses cannot claim a deduction for the portion of wages equal to the ERC amount they receive. This is mandated by tax law, specifically IRC Section 280C, which prevents a “double benefit” of both a credit and a deduction for the same expenses.

The IRS explicitly requires that the amount of the ERC reduces the amount of wage expense reported on the income tax return for the tax year in which the qualified wages were paid. This means that even if a business applies for and receives the ERC refund in a subsequent year, the adjustment to the wage deduction must relate back to the original tax year when those wages were paid. For example, if a business claimed the ERC for wages paid in 2020 but received the refund in 2023, the 2020 wage deduction would need to be reduced.

Reporting ERTC Refunds

Businesses must report the income tax effect of Employee Retention Credit (ERC) refunds on their tax returns. The method of reporting depends on the business entity type and whether previous tax returns were amended. Generally, the ERC refund is not reported as a separate line of income, but rather through an adjustment to the wage expense deduction.

For sole proprietorships, this adjustment affects Schedule C (Form 1040), reducing the reported wage expense for the relevant tax year. Partnerships report this on Form 1065, while S-corporations use Form 1120-S, often adjusting line 13g. C-corporations report on Form 1120, adjusting their wage expense line item. If the original income tax return for the year the qualified wages were paid has already been filed, an amended return (such as Form 1040-X, Form 1065-X, or Form 1120-X) is required to reduce the previously deducted wage expense. However, recent IRS guidance provides an alternative: if a business received an ERC refund in a later year, it can report the ERC amount as gross income in the tax year the refund was received, avoiding the need to amend older returns.