Do You Pay Taxes on the Employee Retention Credit?

The Employee Retention Credit (ERC) was established as a refundable tax credit to support businesses that retained employees during the COVID-19 pandemic. While the ERC provides financial relief, businesses should understand its implications for federal and state income taxes. The credit itself is not considered taxable income; however, claiming the ERC generally affects a business’s taxable income by requiring a reduction in the deductible wage expense.

Federal Income Tax Implications

The Employee Retention Credit is not treated as taxable income directly. Instead, tax law requires businesses to reduce their deduction for qualified wages by the amount of the credit received. This adjustment effectively increases the business’s taxable income, making the ERC “taxable” through an expense reduction.

This requirement stems from Internal Revenue Code Section 280C. This section disallows a deduction for the portion of wages equal to certain credits, including the ERC. This prevents a “double-dipping” scenario where a business benefits from both a tax credit and a full deduction for the same wage expenses. For example, if a business paid $100,000 in qualified wages and received a $50,000 ERC, it can only deduct $50,000 of those wages for income tax purposes.

Reducing the wage expense directly impacts a business’s net income. A lower expense deduction results in higher reported profits, which leads to a higher federal income tax liability. Businesses need to account for this wage expense reduction when calculating their federal income tax.

Timing of ERC Income Recognition

The reduction in wage expense, which increases taxable income, occurs in the tax year when the qualified wages were originally paid, not when the ERC refund is received. For most businesses, these qualified wages were paid during 2020 and 2021. This timing rule applies regardless of whether the business uses the accrual or cash basis method of accounting.

For accrual basis taxpayers, the wage deduction is reduced in the year the wages were incurred. For cash basis taxpayers, the reduction applies to the year the wages were actually paid. The date a business receives the ERC payment from the IRS does not determine the tax year for this wage expense adjustment. This means a business might receive an ERC refund in a current year but needs to adjust its taxable income for a prior year, such as 2020 or 2021.

This timing necessitates revisiting previously filed tax returns. Businesses must account for the reduction in wage expense in the correct historical tax period to accurately reflect their taxable income for those years.

Amending Prior Tax Returns

Since the Employee Retention Credit affects taxable income in the year qualified wages were paid, businesses frequently need to amend their previously filed federal income tax returns for those years, typically 2020 or 2021.

The specific form used for amending federal income tax returns depends on the business entity type. Corporations generally use Form 1120-X, Amended U.S. Corporation Income Tax Return, while individuals and sole proprietors file Form 1040-X, Amended U.S. Individual Income Tax Return. Partnerships typically use Form 1065, U.S. Return of Partnership Income, checking the “Amended Return” box, or in some cases, an Administrative Adjustment Request (AAR) using Form 8082 or Form 1065-X.

The ERC itself was claimed by filing an amended employment tax return, such as Form 941-X, Adjusted Employer’s Quarterly Federal Tax Return or Claim for Refund. However, the income tax implication—the reduction in wage expense—requires a separate amendment to the business’s federal income tax return for the relevant year, increasing taxable income for the year the wages were originally paid.

State Tax Considerations

While the federal treatment of the Employee Retention Credit (ERC) consistently requires a reduction in wage deductions, state income tax laws may vary in how they treat this credit. Some states may automatically conform to the federal tax treatment, requiring businesses to reduce their deductible wage expense by the amount of the ERC.

Other states may have different rules or may not fully conform to federal tax law regarding the ERC’s impact on taxable income. This can lead to situations where a business’s state taxable income is calculated differently than its federal taxable income, even for the same tax year. Businesses should not assume their state tax obligations will mirror their federal adjustments.

Businesses should consult their state’s specific tax guidance or a qualified tax professional. This ensures accurate state income tax reporting and compliance.