Are ERC Credits Taxable? How They Affect Your Taxes

The Employee Retention Credit (ERC) provided financial relief to businesses that retained employees during the COVID-19 pandemic. While the ERC itself is a refundable payroll tax credit and is not considered taxable income, its receipt does impact a business’s tax liability. This impact stems from the requirement to adjust the amount of wage expenses that can be deducted for income tax purposes. Understanding this indirect effect helps businesses ensure accurate tax reporting.

How ERC Credits Affect Taxable Income

Businesses deduct wages paid to employees as an expense when calculating their taxable income. The Employee Retention Credit is directly tied to those same qualified wages. The Internal Revenue Service (IRS) requires businesses to reduce their deductible wage expenses by the amount of the ERC claimed. This is because the ERC functions as a subsidy or reimbursement for a portion of those wages, and tax law prevents taxpayers from receiving a double benefit for the same expense.

This adjustment means that while the ERC refund itself is not added to a business’s gross income, the reduction in deductible wage expenses effectively increases the business’s net taxable income. For example, if a business paid $100,000 in qualifying wages and received a $20,000 ERC based on those wages, only $80,000 of those wages can be deducted for income tax calculations. This change in deductible expenses leads to a higher taxable profit, which in turn can result in a greater income tax liability for the business. The effect is indirect but alters the overall tax picture by modifying the expense side of the income statement.

Timing of the Tax Impact

A common point of confusion for businesses centers on the timing of this wage expense reduction. The reduction in deductible wage expenses must be applied in the tax year in which the qualified wages were originally paid or incurred, not in the year when the ERC refund is actually received. This distinction is important because many businesses filed their income tax returns before they applied for or received their ERC refunds. Consequently, their originally filed income tax returns likely included the full wage deduction without the required reduction.

For instance, if a business paid qualified wages in 2020 but did not receive the ERC refund until 2023, the wage expense reduction must still be accounted for in the 2020 tax year. This often necessitates amending prior year income tax returns to reflect the correct wage expense deduction. The IRS has provided alternative guidance for situations where the ERC was received in a subsequent year and the prior year’s return was not amended. Under this guidance, taxpayers might be able to include the overstated wage expense as gross income in the year the ERC was received, rather than amending the prior year’s return. This offers a simplified approach, especially for those cases where the statute of limitations for amending a prior return might be approaching.

Reporting and Adjusting for the Credit

Businesses that claimed the Employee Retention Credit must take specific steps to report the necessary wage expense adjustments. The initial claim for the ERC is typically made on an amended employment tax return, such as Form 941-X, Adjusted Employer’s Quarterly Federal Tax Return or Claim for Refund. When filing Form 941-X to claim the ERC, businesses are reminded that they must reduce their deduction for wages by the amount of the credit for that same tax period.

Beyond the payroll tax adjustment, businesses must also address the impact on their income tax returns. This involves amending the income tax return for the year in which the qualified wages were paid. For corporations, this means amending Form 1120; for partnerships, Form 1065; and for sole proprietors, Schedule C of Form 1040. The specific lines or sections affected will depend on the business entity type and the form used. Given the complexities involved, especially with multiple tax years or new guidance, consulting with a qualified tax professional is advisable to ensure accurate reporting and compliance. Non-compliance or incorrect adjustments can lead to penalties.