Are Employee Retention Credits Taxable?

The Employee Retention Credit (ERC) was established as a refundable payroll tax credit to support businesses that retained employees during the COVID-19 pandemic. This credit provided significant financial relief, prompting many recipients to question its implications for income tax purposes. This article aims to clarify the federal and state tax treatment of the ERC.

Federal Income Tax Treatment of the Credit

The Employee Retention Credit itself is not taxable income. However, receiving the ERC does impact a business’s federal income tax liability through an adjustment to deductible wage expenses. Specifically, the amount of qualified wages for which the ERC is claimed must be reduced by the credit amount for federal income tax purposes. This prevents businesses from receiving a double benefit by both deducting wages and claiming a credit for the same wages.

The wage expense reduction occurs in the tax year in which the qualified wages were paid or incurred, regardless of when the actual ERC refund is received. This timing is crucial for accurate tax reporting. IRS guidance, including Notice 2021-20 and Notice 2021-49, clarifies this requirement, stating that taxpayers must reduce their wage deduction in the year the wages were paid.

C Corporations

For C Corporations, the reduced wage deduction directly increases the corporation’s taxable income. This adjustment on Form 1120, typically on the “Salaries and wages” line, can lead to a higher federal income tax obligation for the applicable year.

S Corporations and Partnerships

S Corporations and Partnerships, as pass-through entities, experience the impact differently. The reduction in wage deductions increases the entity’s ordinary business income, which is passed through to the owners. This increased income is reported on Schedule K-1 for each shareholder or partner, increasing their individual taxable income.

Sole Proprietors and Single-Member LLCs

Sole Proprietors and Single-Member LLCs, which report business income on Schedule C (Form 1040), also face a direct impact. The amount of wages deductible on Schedule C is reduced by the ERC amount. This adjustment increases the net profit from the business, leading to higher self-employment and income tax for the individual owner.

State Income Tax Considerations

The state income tax treatment of the Employee Retention Credit can vary significantly from the federal approach. Businesses must understand their specific state’s tax laws, as there is no uniform rule across all states.

Some states automatically conform to federal tax law, including Internal Revenue Code Section 280C, which mandates the reduction of wage deductions for the ERC. In these conforming states, the ERC’s impact on taxable income would generally mirror the federal treatment, requiring a similar wage expense adjustment. This conformity simplifies compliance for businesses operating in such states.

Other states may “decouple” from federal rules or have specific legislation addressing the ERC. These states might not require the wage deduction reduction, or they could have unique add-back or subtraction provisions that alter the tax outcome.

Several states do not levy a state income tax on individuals or corporations, including Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming.

Reporting the Credit on Tax Forms

The wage expense reduction due to the Employee Retention Credit involves specific forms and lines on federal income tax returns. Businesses must accurately reflect this adjustment. The reduction is applied directly to the wage expense line item on the relevant income tax return.

For C Corporations, the adjustment is made on Form 1120, U.S. Corporation Income Tax Return, by reducing the amount reported as salaries and wages. Similarly, S Corporations report the reduction on Form 1120-S, U.S. Income Tax Return for an S Corporation, and Partnerships on Form 1065, U.S. Return of Partnership Income.

Sole Proprietors and Single-Member LLCs report this adjustment on Schedule C (Form 1040), Profit or Loss from Business. The amount of deductible wages on Line 26 of Schedule C should be reduced by the ERC amount.

If the Employee Retention Credit was claimed for a prior tax year and the original income tax return did not reflect the required wage deduction reduction, an amended income tax return is necessary. C Corporations file Form 1120-X, Amended U.S. Corporation Income Tax Return, while individuals (including sole proprietors) file Form 1040-X, Amended U.S. Individual Income Tax Return. Partnerships file Form 1065-X, Amended Return or Administrative Adjustment Request (AAR).