How Does IRC 280C Affect the Employee Retention Credit?

The Employee Retention Credit (ERC) is a refundable tax credit to help businesses with the cost of keeping staff employed during the COVID-19 pandemic. While the credit itself is not considered taxable income, Internal Revenue Code (IRC) Section 280C imposes a rule that affects a business’s income taxes and prevents a “double tax benefit.”

This provision requires a business to reduce its deductible wage expenses by the exact amount of the ERC it claims. This means a company cannot take a full tax deduction for wages subsidized by a tax credit. The interaction increases a business’s taxable income, and this adjustment is a required component of claiming the ERC with important implications for tax return preparation.

The Core Rule of Wage Deduction Disallowance

The principle of the wage disallowance rule is that a business is prohibited from using the same dollar of wages to generate both a tax credit and a tax deduction. When a business claims the ERC for qualified wages paid, it must decrease the amount of wage expense it deducts on its income tax return by the amount of the credit. The direct result of this rule is an increase in the business’s net taxable income.

To illustrate this, consider a corporation that paid $100,000 in qualified wages during a quarter in 2021. Based on these wages, the business claims an ERC of $70,000. When preparing its annual income tax return, the business cannot deduct the full $100,000 in wages and must subtract the $70,000 credit, leaving only $30,000 as a deductible business expense.

This reduction has a direct impact on the company’s tax liability. By reducing its deductible expenses by $70,000, the business’s taxable income is $70,000 higher than it would have been. If the corporation is in a 21% federal tax bracket, this disallowed deduction results in an additional $14,700 in income tax.

The rule applies regardless of the business’s accounting method, whether cash or accrual. The focus is on the wages paid or incurred within the taxable year for which the credit is determined.

Determining the Timing of the Deduction Reduction

A point of confusion for many businesses is the timing of the wage deduction disallowance. According to IRS guidance, the reduction to the wage expense deduction must be made on the income tax return for the year in which the qualified wages were paid, not the year the ERC refund is received. This means if a business claims the ERC for wages paid in 2021, the deduction must be reduced on the 2021 income tax return, even if the refund check arrives in 2023.

This timing rule creates a common scenario for many taxpayers. Numerous businesses filed their 2020 and 2021 income tax returns before they realized they were eligible for the ERC. They then filed an amended payroll tax return, Form 941-X, to retroactively claim the credit for a prior year, but their original income tax return for that year had already been filed claiming a full deduction.

This situation results in an overstated wage deduction on the originally filed income tax return. For example, if a business filed its 2021 tax return and then filed a Form 941-X to claim the ERC for 2021, its 2021 income tax return is now incorrect. This discrepancy creates an underpayment of income tax for the 2021 tax year, which must be corrected.

Correcting Previously Filed Income Tax Returns

To correct an overstated wage deduction on a previously filed return, a business must file an amended income tax return for the affected year. For a corporation, this is Form 1120-X, Amended U.S. Corporation Income Tax Return. For a sole proprietor, it is Form 1040-X, Amended U.S. Individual Income Tax Return. The amended return reports the reduced wage deduction, the resulting higher taxable income, and the additional tax owed, plus any applicable interest.

Program Status and Key Deadlines

In September 2023, the IRS announced a moratorium on processing new ERC claims due to concerns about fraudulent applications. While the IRS has resumed processing claims filed before the moratorium, they are subject to increased scrutiny and longer processing times.

The period to file a claim for wages paid in 2020 has passed. The deadline for filing claims related to the 2021 tax year is April 15, 2025.