Are ERC Payments Taxable? The Impact on Wage Deductions

The Employee Retention Credit (ERC) provided businesses with financial relief during the COVID-19 pandemic, offering a refundable tax credit for retaining employees. While this credit offered a significant lifeline, its tax treatment has introduced complexities for many employers. Understanding whether the ERC payments themselves are taxable, and how they interact with other tax deductions, is a common source of confusion. This article aims to clarify the federal and state income tax implications of receiving ERC payments, helping businesses navigate these nuanced tax considerations.

Federal Income Tax Treatment of the Employee Retention Credit

The Employee Retention Credit (ERC) is not considered taxable income for federal income tax purposes; the amount of the credit or refund received is not added to gross income. The ERC operates as a credit against payroll taxes, and while its refundable nature can result in a direct payment, this payment is not subject to income tax.

The primary tax implication of the ERC arises from its impact on deductible wage expenses. Businesses claiming the ERC must reduce their deduction for qualified wages by the credit amount. This prevents a “double benefit” where the same wages generate both a tax credit and a tax deduction. This adjustment applies to the tax year in which the qualified wages were paid or incurred, regardless of when the credit was received.

Consider a business that paid $100,000 in qualified wages in 2021 and received a $70,000 ERC for those wages. While the $70,000 credit itself is not income, the business must reduce its deductible wage expense for 2021 by $70,000. This means that instead of deducting the full $100,000 in wages, the business can only deduct $30,000 ($100,000 – $70,000). This reduction in deductible expenses leads to an increase in the business’s taxable income for the year the wages were paid. Consequently, while the credit provides cash flow, the reduced deduction can result in a higher tax liability for the relevant year.

The timing of this wage expense reduction can be influenced by a business’s accounting method. For ERC purposes, the IRS has clarified that the wage expense reduction relates to the year the qualified wages were paid or incurred, irrespective of the accounting method.

Recent IRS guidance offers a simplified approach for correcting overstated wage expenses. If a business claimed the ERC but did not reduce its wage expense in the year wages were incurred, and received the ERC in a subsequent year, it may include the overstated wage expense as gross income in the year the ERC was received. This approach, based on the tax benefit rule, is useful if the statute of limitations for amending the prior year’s income tax return has expired. This guidance applies whether the ERC claim was allowed and paid, or disallowed, allowing businesses to adjust their wage expense in the year of final determination.

Amending Prior Income Tax Returns

Because the wage expense reduction for the Employee Retention Credit applies to the tax year in which qualified wages were paid, many businesses found it necessary to amend previously filed income tax returns. The need to amend arises to accurately reflect the reduced wage deduction and its impact on taxable income.

The specific form used to amend an income tax return depends on the business entity type. Individuals reporting business income on Schedule C (Form 1040) use Form 1040-X. Corporations, including S-corporations, typically use Form 1120-X. Partnerships generally amend their returns by filing an amended Form 1065, often accompanied by Form 1065-X.

To complete an amended return, a business needs its original tax return for the year being amended, along with any new documentation supporting the changes. The amended form requires detailing the original reported amounts, the corrected amounts, and the difference between them. A clear explanation of the reasons for the changes, specifically referencing the ERC and the wage expense reduction, must also be provided.

The IRS has expanded electronic filing options, and Form 1040-X can now be e-filed for certain tax periods using tax software. Electronic filing of amended corporate and partnership returns is also becoming more prevalent, though paper filing remains an option. After submission, processing time for amended returns can vary significantly, typically ranging from 16 to 20 weeks. Taxpayers can generally track the status of their amended individual returns using the “Where’s My Amended Return?” tool on the IRS website.

State Income Tax Implications of the Credit

The state income tax implications of the Employee Retention Credit present a more varied landscape compared to federal treatment. Each state has its own tax laws, and their approach to the ERC and the associated wage expense deduction can differ. This variability means that a business’s state tax liability may be affected differently than its federal liability.

Many states adopt what is known as “conformity” with federal tax law, meaning they largely follow federal rules, including the treatment of the ERC. In such states, the ERC would generally not be considered taxable income, and the wage expense deduction would be reduced similar to federal guidelines. Other states, however, “decouple” from federal rules, choosing to establish their own specific tax treatment for certain items. Decoupled states might have different rules regarding the taxability of the credit or the deductibility of wages, potentially not requiring a reduction in wage expenses at the state level.

For example, some states may allow businesses to deduct the full amount of wages, even if those wages were used to claim the federal ERC, effectively providing a state-level deduction that is disallowed federally. Conversely, other states might conform to the federal disallowance, meaning the wage deduction is also reduced for state income tax purposes. It is important to note that a state’s conformity or decoupling stance can impact a business’s overall state tax burden.

Given the diverse approaches across jurisdictions, businesses should consult their state’s specific tax authority or a qualified state tax professional. Relying solely on federal guidance for state income tax matters can lead to inaccurate tax filings and potential penalties. Understanding the precise implications in each relevant state is necessary to ensure compliance and accurately determine the total tax impact of the ERC.