Do You Have to Pay Taxes on ERC Credit?

The Employee Retention Credit (ERC) was a refundable tax credit designed to support businesses during the COVID-19 pandemic. Its purpose was to encourage employers to retain employees on their payrolls despite economic disruptions caused by government orders or a decline in gross receipts. It offset certain employment taxes. Understanding the tax implications of receiving the ERC is important, as the credit interacts with income tax reporting requirements.

Taxability of the Employee Retention Credit

The Employee Retention Credit itself is not considered taxable income for federal income tax purposes. Instead, the ERC functions as a refundable credit against specific employment taxes, such as the employer’s share of Social Security and Medicare taxes.

While the credit amount is not directly added to a business’s revenue, receiving the ERC does have an indirect effect on a business’s income tax liability. This impact stems from a required adjustment to deductible wage expenses.

Adjusting Deductible Wage Expenses

Businesses are required to reduce their deductible wage expenses by the amount of the ERC received. This adjustment is mandated by the Internal Revenue Code Section 280C, which prevents a “double benefit.” A business cannot both claim a tax credit for wages and simultaneously deduct those same wages as an expense for income tax purposes.

This reduction in deductible wages directly affects a business’s taxable income. By decreasing the amount of expenses that can be deducted, the business’s net income, for tax purposes, effectively increases. This outcome means the economic benefit derived from the ERC is indirectly subject to income tax, as it reduces an otherwise allowable deduction.

The timing of this wage expense reduction is important, especially for businesses that claimed the ERC retroactively. The reduction generally applies to the tax year in which the qualified wages, upon which the ERC was calculated, were paid or incurred. Even if a business received the ERC payment in a later year, the wage expense adjustment relates back to the year the wages were originally paid.

For situations where the wage expense was not reduced in the original year, and the ERC payment was received in a subsequent year, recent IRS guidance offers an alternative. Instead of amending the prior year’s income tax return, a business can include the amount of the overstated wage expense as gross income in the tax year the ERC was received. Similarly, if a business reduced its wage expenses anticipating an ERC, but the claim was later disallowed, the business may increase its wage expense in the year the disallowance becomes final.

Reporting the Credit on Tax Forms

Businesses initially claim the Employee Retention Credit by filing or amending their employment tax returns, typically using Form 941-X, Adjusted Employer’s Quarterly Federal Tax Return or Claim for Refund. However, the impact of the ERC on deductible wage expenses must also be reflected on the business’s federal income tax return.

For corporations, the wage expense reduction is reported on Form 1120, U.S. Corporation Income Tax Return. S-corporations generally report the ERC adjustment on Form 1120-S, U.S. Income Tax Return for an S Corporation, often on Line 13g, “Other Credits,” or on Schedule K, Line 13f, “Credits.” Shareholders of S-corporations then report their share of these adjustments on their individual Schedule K-1.

Partnerships, including many limited liability companies (LLCs) taxed as partnerships, report the ERC impact on Form 1065, U.S. Return of Partnership Income. The adjustment is typically reflected on Schedule K, often on Line 10, “Other Income.” Each partner’s share of the adjustment is then reported on their respective Schedule K-1.

Sole proprietorships, which report their business income and expenses on Schedule C, Profit or Loss From Business, must reduce their wage expenses on this schedule. This adjustment then flows through to their individual income tax return, Form 1040. Recent IRS guidance provides options to address these adjustments on current year returns.