Do You Have to Pay Taxes on an ERC Refund?

The Employee Retention Credit (ERC) was a refundable tax credit established to assist businesses that retained employees during the COVID-19 pandemic, specifically for qualified wages paid between March 13, 2020, and September 30, 2021. This credit encouraged employers to keep workers on their payrolls despite economic disruptions or government-mandated shutdowns. Businesses qualified if they experienced a decline in gross receipts or had operations fully or partially suspended due to government orders. The ERC provided financial relief, with eligible employers receiving up to $5,000 per employee in 2020 and up to $21,000 per employee in 2021.

Taxability of ERC Refunds

While the Employee Retention Credit itself is not considered taxable income for federal income tax purposes, the refund does impact a business’s taxable income. The Internal Revenue Service (IRS) views the ERC as a reduction in the wage expense deduction taken in the tax year the qualified wages were originally paid. This means businesses cannot deduct wages used to calculate the ERC from their gross income, preventing a “double-dipping” benefit.

This principle is outlined in IRS guidance, including Notice 2021-20, stating that employers should reduce their deduction for wages by the amount of the credit. Notice 2021-49 also confirmed that wages used for ERC cannot also be deducted.

Timing of Income Recognition

Understanding when the ERC refund affects a business’s taxable income depends on the accounting method used: accrual or cash basis. For taxpayers using the accrual method of accounting, the reduction in deductible wage expenses must be reflected in the tax year the qualified wages were paid. This applies even if the ERC refund was received in a subsequent tax year. For example, a business that paid qualifying wages in 2020 but received the ERC refund in 2023 needs to adjust their 2020 income tax return.

Conversely, for cash basis taxpayers, the wage expense reduction is recognized in the year the ERC refund is received. However, the IRS prefers that the ERC impact be removed from the year it originated. Most businesses that claimed the Employee Retention Credit were on the accrual basis for 2020 and 2021, making the prior-year adjustment the standard approach.

Recent IRS guidance issued in March 2025 offers an option for businesses that received an ERC refund in a later year without having previously reduced their wage expense: they may now report the ERC refund as gross income in the year it is received, instead of amending the prior return. This alternative is relevant if the statute of limitations for amending the original return has expired. This guidance aligns with the tax benefit rule, which requires including a previously deducted amount in income if the original deduction was overstated.

Reporting ERC on Federal Tax Returns

Businesses that received an Employee Retention Credit refund need to adjust their federal tax returns to reflect the reduced wage expense. This process involves amending both payroll tax returns and income tax returns. For payroll tax adjustments, businesses file Form 941-X, Adjusted Employer’s Quarterly Federal Tax Return or Claim for Refund. This form is used to correct errors on a previously filed Form 941.

Following the adjustment on Form 941-X, an amendment to the business’s income tax return is required. Corporations file Form 1120-X, Amended U.S. Corporation Income Tax Return, to correct a previously filed Form 1120. Sole proprietors and individuals reporting business income on Schedule C amend their personal income tax return using Form 1040-X, Amended U.S. Individual Income Tax Return. Partnerships, including LLCs treated as partnerships, amend their partnership returns (Form 1065) and issue corrected Schedule K-1s to partners, who then amend their individual returns.

The wage expense reduction should be reflected on the appropriate line items of the amended income tax return. For example, on Schedule C, the reduction impacts the wage deduction line. For corporate returns (Form 1120 or 1120-S), the wage expense line is adjusted. These amended returns are submitted via mail to the IRS.

State Tax Considerations

The tax treatment of Employee Retention Credit refunds at the state level can vary. While many states conform to federal tax law regarding the reduction of wage expenses, some states have different rules that impact how the ERC is treated. For instance, some states might allow the full wage deduction even if it was reduced for federal purposes, while others strictly follow the federal disallowance.

Due to this variability, state tax laws may not align with federal guidance, leading to different outcomes for state income tax liabilities. Businesses should consult their state’s tax authority or a tax professional to understand their obligations concerning the ERC refund. This ensures compliance with state tax regulations and avoids issues.