Are ERC Refunds Taxable? A Look at the Tax Implications

The Employee Retention Credit (ERC) was a refundable tax credit established to encourage businesses to retain employees during the COVID-19 pandemic. While the refund itself is not considered taxable income, receiving an ERC refund carries important tax implications that businesses must understand and address to ensure compliance. The credit impacts a business’s deductible wage expenses, which in turn affects its taxable income. Understanding these nuances is crucial for accurate financial reporting and avoiding potential tax issues.

Federal Income Tax Treatment

The Employee Retention Credit itself is not directly taxable as income when a business receives the refund. Instead, its tax impact involves the reduction of wage expenses. The amount of the ERC a business claims must reduce the deductible wage expenses in the tax year the qualified wages were originally paid. This adjustment is necessary to prevent a “double benefit,” where a business could both deduct the wages and receive a credit for those same wages.

For example, if a business claimed the ERC for wages paid in 2020, the wage deduction on its 2020 federal income tax return must be reduced by the credit amount, regardless of when the refund was actually received. This means the business’s taxable income for that prior year will effectively increase due to the lower wage deduction. This treatment aligns with Internal Revenue Code Section 280C, which generally disallows a deduction for expenses to the extent a credit is received for those same expenses.

Reporting Requirements for Different Entity Types

The reduction in wage expenses, which affects taxable income, is reported differently depending on a business’s legal structure. Each entity type has specific forms and methods for reflecting the ERC’s impact.

C-Corporations, which file Form 1120, will see the wage expense reduction directly impact their taxable income reported on this form. This adjustment increases the corporation’s overall taxable income for the year the wages were paid, potentially leading to a higher tax liability.

S-Corporations, filing Form 1120-S, and Partnerships, filing Form 1065, reflect the wage expense reduction at the entity level. For S-corporations, this adjustment affects the calculation of income or loss that flows through to shareholders’ Schedule K-1s. Similarly, for partnerships, the reduction impacts the income or loss passed through to partners on their K-1s. The individual owners then report this adjusted income on their personal tax returns (Form 1040).

Sole Proprietors and single-member LLCs, who typically report their business income and expenses on Schedule C (Form 1040), will reduce their wage expenses directly on this schedule. This reduction will increase the net profit reported on Schedule C, which then flows through to their individual Form 1040, affecting their personal taxable income.

State Tax Considerations

The tax treatment of ERC refunds at the state level can vary significantly from federal rules. While federal guidance requires a reduction in wage expenses, states may adopt different approaches. Some states might conform to the federal treatment, requiring a similar reduction in wage expenses for state income tax purposes.

Other states may choose to treat the ERC refund as taxable income, or they might not tax it at all. It is important for businesses to consult their specific state’s tax laws or seek advice from a state tax professional to understand the applicable rules. Information regarding state-specific treatment can often be found on state department of revenue websites.

Adjusting Prior Year Tax Filings

Since the Employee Retention Credit often applies to wages paid in prior tax years, such as 2020 or 2021, businesses frequently need to amend previously filed income tax returns to reflect the required reduction in wage expenses. This amendment process is distinct from the initial ERC claim, which is typically made using Form 941-X, Adjusted Employer’s Quarterly Federal Tax Return or Claim for Refund.

Amended income tax returns are filed using specific forms:

• C-Corporations: Form 1120-X, Amended U.S. Corporation Income Tax Return
• Partnerships: Form 1065-X, Amended Return or Administrative Adjustment Request (AAR)
• S-Corporations: Form 1120-S (and amended Schedule K-1s if shareholder income is affected)
• Sole Proprietors and single-member LLCs: Form 1040-X, Amended U.S. Individual Income Tax Return (to adjust Schedule C)

The IRS has provided updated guidance. In cases where businesses received an ERC refund but did not amend prior income tax returns to reduce wage expenses, the IRS states taxpayers are not required to amend the prior-year return. Instead, they can include the amount of the overstated wage expense as gross income on their income tax return for the year in which they received the ERC refund. This approach aligns with the “tax benefit rule” and offers a simpler way to correct the income tax impact.