How Does Employee Retention Credit Affect Your Tax Return?
Understand how the Employee Retention Credit impacts your tax return, including payroll adjustments, refunds, and key recordkeeping requirements.
The Employee Retention Credit (ERC) was introduced to help businesses retain employees during difficult times. It provides a refundable tax credit based on qualified wages, affecting how businesses file taxes and claim refunds.
Understanding the ERC’s impact on tax filings is essential to ensure compliance with IRS regulations and avoid errors.
Determining Eligible Wages
To calculate the ERC, businesses must identify which wages qualify. Eligibility depends on employer size, when wages were paid, and whether employees were actively working. Companies with 500 or fewer full-time employees can claim the credit for all wages paid during eligible periods, while larger employers can only claim wages paid to employees who were not working due to COVID-19-related disruptions.
The ERC covers wages paid between March 13, 2020, and September 30, 2021, for most businesses. Recovery startup businesses—those that began operations after February 15, 2020, with annual gross receipts under $1 million—could claim the credit through December 31, 2021. Wages paid outside these periods do not qualify.
Employers cannot claim the ERC for wages already used to claim other tax credits, such as the Work Opportunity Tax Credit or the Families First Coronavirus Response Act paid leave credits. Wages paid to majority owners or their relatives are also generally ineligible due to IRS attribution rules.
Qualified wages include direct salary payments and employer-paid health insurance costs. If an employee was furloughed but continued receiving health benefits, those costs can be included in the credit calculation.
Adjustments to Payroll Filings
Businesses that did not initially claim the ERC must amend their payroll tax filings using IRS Form 941-X, the Adjusted Employer’s Quarterly Federal Tax Return or Claim for Refund. This allows them to retroactively claim the credit and adjust payroll tax liabilities.
Amending payroll filings requires careful reconciliation with financial records to prevent discrepancies that could trigger IRS scrutiny. Since the ERC reduces payroll tax liability, businesses must also adjust their income tax returns. Wages used to claim the credit cannot be deducted as a business expense, meaning companies that previously deducted the full amount must file amended income tax returns, such as Form 1120X for corporations or Form 1040-X for sole proprietors and partnerships.
The IRS generally allows businesses to amend payroll tax filings within three years of the original filing date. For example, a Form 941 filed for the second quarter of 2021 can typically be corrected until July 2024. Missing the deadline results in losing the ability to claim the credit. Additionally, interest may accrue on refunds, affecting financial planning.
Annual Return Considerations
Businesses that claimed the ERC must account for its impact when preparing annual tax returns, as it affects taxable income. Since the credit reduces deductible wages, companies may report higher taxable income than expected, potentially increasing their tax liability.
For businesses following Generally Accepted Accounting Principles (GAAP), the ERC is recorded as a reduction to payroll expenses in the period when the wages were originally paid, not when the credit was received. Misreporting the timing can lead to errors in financial statements, increasing audit risk or requiring restatements.
Tax planning strategies should be adjusted to reflect the ERC’s effect on deductions. Businesses that expected lower taxable income due to fully deducting wages may need to reassess estimated tax payments. Pass-through entities, such as S corporations and partnerships, must ensure the ERC’s effect on income is correctly reported on K-1 forms, as it increases taxable income for shareholders or partners.
Refund and Overclaim Handling
Receiving an ERC refund can take months due to IRS processing delays. Employers awaiting refunds should monitor IRS updates and ensure banking details are accurate to avoid further delays. If a refund check is lost or not received, businesses can request a payment trace using IRS Form 3911. Companies relying on these funds for cash flow should consider alternative financing options while waiting.
Incorrectly claiming the ERC—whether due to miscalculations or misunderstanding eligibility rules—can result in repayment demands and penalties. The IRS has increased enforcement efforts, particularly targeting businesses that improperly claimed the credit based on misleading advice from third-party firms. Employers who realize they overclaimed should promptly file a corrected Form 941-X to amend the error and minimize penalties. Interest accrues on overclaimed amounts, so addressing mistakes quickly reduces financial exposure.
Recordkeeping Essentials
Proper documentation is necessary to support ERC claims, as the IRS may request records to verify eligibility and calculations. Businesses should maintain payroll records, financial statements, and documentation demonstrating the economic impact that qualified them for the credit. This includes proof of revenue declines, government-mandated shutdown orders, and records of wages paid during eligible periods. Without sufficient documentation, businesses risk claim denials or penalties if audited.
Employers should retain copies of all filed Forms 941 and 941-X, along with any correspondence related to ERC claims. Since tax authorities can audit payroll filings for up to five years, businesses should keep these records for at least that long. Digital storage solutions can help ensure documents remain accessible. If a third-party payroll provider or tax advisor assisted with ERC claims, businesses should obtain copies of all filings and supporting calculations to maintain independent records.