Are ERC Credits Taxable? A Look at the Tax Implications

The Employee Retention Credit (ERC) was a refundable tax credit established to assist businesses that continued to pay employees while experiencing disruptions due to the COVID-19 pandemic. While the ERC provided significant financial relief, its tax implications are often misunderstood. The credit itself is not considered taxable income, meaning businesses do not directly pay income tax on the credit amount received. However, receiving the ERC does affect a business’s taxable income indirectly through adjustments to its deductible wage expenses. Understanding this distinction is essential for accurate tax reporting and compliance.

Is the ERC Taxable Income?

The Employee Retention Credit (ERC) is not treated as taxable income or gross receipts for federal income tax purposes; businesses do not include the ERC amount in their gross income. Instead, the tax impact of the ERC arises from a required reduction in the deduction for qualified wages, including qualified health plan expenses, by the amount of the credit. This adjustment prevents businesses from receiving a “double benefit” by both claiming the credit and deducting the full amount of wages used to calculate the credit.

The Internal Revenue Service (IRS) has issued guidance clarifying this treatment, including IRS Notice 2021-20, IRS Notice 2021-49, and Revenue Procedure 2021-33. This guidance consistently emphasizes that while the credit itself is not income, it necessitates an adjustment to wage deductions.

Impact on Wage Expense Deduction

The mechanics of the ERC’s effect on a business’s taxable income involve a mandatory reduction in deductible wage expenses. When a business claims the ERC, qualified wages (including qualified health plan expenses) must be reduced by the credit amount for income tax deduction purposes. This adjustment prevents a business from benefiting twice from the same wages. For example, if a business paid $100,000 in qualified wages and received an ERC of $50,000 based on those wages, its deductible wage expense for tax purposes would be limited to $50,000.

This reduction directly impacts the business’s taxable income. A lower wage expense deduction means a higher taxable income, which can result in an increased tax liability for the business. The principle is that the ERC effectively reimburses a portion of the wages, and therefore, those reimbursed wages cannot also be claimed as a tax deduction.

Timing of Wage Expense Reduction

The timing of this wage expense reduction for tax purposes is important. The general rule is that the reduction in deductible wages occurs in the tax year in which the qualified wages were paid or incurred. This applies even if the ERC is claimed or received in a later tax year. For instance, if a business paid qualified wages in 2020 that generated an ERC, the wage expense deduction for its 2020 tax return must be reduced, regardless of when the ERC was actually received.

For both accrual and cash basis taxpayers, the reduction generally applies in the year the wages were paid. This timing rule often necessitates amending prior year income tax returns if the ERC claim was filed after the original income tax return for the wage-payment year.

Amending Prior Year Tax Returns

Many businesses claimed the Employee Retention Credit for prior tax years, such as 2020 or 2021, often after their original income tax returns for those years had already been filed. In such cases, businesses typically need to amend their prior year income tax returns to reflect the required reduction in wage expenses. This process involves filing an amended return, such as Form 1120-X, Form 1040-X, or Form 1065-X for partnerships.

Amending these returns may result in an increase in taxable income for those prior years, potentially leading to additional tax due. If the ERC was received in a subsequent year and the wage expense was not reduced on the original return, recent IRS guidance provides an option to include the overstated wage expense as gross income in the year the ERC was received, rather than amending the prior year return. However, businesses must ensure timely and accurate adjustments to avoid penalties and interest.