Are ERC Funds Taxable? Federal and State Rules
Understand the nuanced federal and state tax implications of Employee Retention Credit (ERC) funds and how they affect your business's taxable income.
The Employee Retention Credit (ERC) was a refundable payroll tax credit designed to help businesses retain employees during the COVID-19 pandemic. Businesses often question whether ERC payments are subject to income tax. Understanding the tax implications of the ERC is important for proper financial reporting and compliance.
Federal Income Tax Treatment of ERC
The Employee Retention Credit itself is not considered taxable income for federal purposes. However, businesses claiming the ERC must reduce their deductible wage expenses by the amount of the credit received. This reduction in deductible expenses effectively increases the business’s taxable income, making the credit indirectly subject to income tax. This rule prevents businesses from receiving a “double benefit” by both claiming the credit and fully deducting the wages for which the credit was received.
The wage expense reduction must occur in the tax year the qualified wages were paid, even if the ERC funds were received later. This often means businesses need to amend prior year tax returns to reflect the reduced wage deduction. The IRS has provided guidance on this, clarifying the application of Internal Revenue Code Section 280C rules to the ERC.
Recent IRS updates in March 2025 offer flexibility if the wage expense was not reduced in the original year. If a business claimed the ERC but did not reduce wage expenses in the year wages were paid, and the ERC was received later, the business can now include the overstated wage expense as gross income in the year the ERC was received. This alternative aligns with the tax benefit rule, which requires including a reimbursement as income if a prior deduction was taken.
This updated guidance provides clarity and can reduce the need for amending prior-year income tax returns. However, the economic benefit from the ERC remains subject to federal income tax, either through reduced wage deductions or increased gross income. Businesses should determine the most appropriate method for addressing the ERC’s impact on their federal income tax liability.
Reporting ERC on Federal Tax Returns
Businesses must accurately reflect the ERC and the corresponding wage expense reduction on their federal income tax filings. The specific forms used depend on the entity type. Corporations typically report this on Form 1120, S-corporations use Form 1120-S, and partnerships use Form 1065.
A common scenario involves filing amended returns for prior tax years. If the ERC relates to wages paid in a previous year but the credit was received later, businesses generally need to amend their income tax returns for that earlier year to reduce the wage deduction. This adjustment is important for compliance, as failing to reduce wage expenses could lead to an understatement of taxable income.
Claiming the ERC often involves filing an amended federal employment tax return, Form 941-X. Businesses file Form 941-X for each applicable quarter in which qualified wages were paid. After filing Form 941-X, businesses must ensure their income tax returns accurately reflect the wage expense reduction.
State Income Tax Treatment of ERC
The state income tax treatment of the Employee Retention Credit can vary significantly due to differences in state tax laws and their conformity to federal tax provisions. Some states automatically conform to the federal rule requiring a reduction in wage deductions by the amount of the ERC. This means that in these states, the ERC indirectly increases state taxable income, similar to the federal treatment.
Other states may have partial or complete non-conformity with the federal ERC rules. This could mean a state does not require the wage expense reduction, effectively making the ERC tax-free at the state level, or it might have its own specific rules for how the credit impacts state income tax. For instance, some states allow businesses to deduct wages and healthcare expenses that the IRS disallows for federal purposes.
Given this variability, businesses must consult their specific state’s tax laws and guidance or seek advice from a state tax professional. Relying solely on federal treatment could lead to incorrect state tax filings and potential penalties. Understanding state-specific conformity rules is important for accurate state income tax reporting related to the ERC.