How to Account for Employee Retention Credit

The Employee Retention Credit (ERC) is a refundable payroll tax credit established by the CARES Act to support businesses that retained employees during the COVID-19 pandemic. It provides financial relief by offsetting a portion of payroll costs. Understanding the proper accounting treatment of the ERC is important for businesses to accurately reflect its impact on their financial position and operational results, including recognizing the credit, recording it in financial statements, and addressing income tax implications.

Understanding the Accounting Framework for ERC

The Employee Retention Credit is a refundable payroll tax credit, distinct from an income tax credit or a loan. No specific U.S. Generally Accepted Accounting Principles (GAAP) guidance directly addresses such government assistance for for-profit entities. Therefore, businesses account for the ERC by analogizing to existing accounting standards. Commonly applied frameworks include International Accounting Standard (IAS) 20, “Accounting for Government Grants and Disclosure of Government Assistance,” or the guidance for conditional contributions under Accounting Standards Codification (ASC) 958-605, “Not-for-Profit Entities – Revenue Recognition.” Another approach is treating it as a gain contingency under ASC 450, “Contingencies.” The credit should be recognized when eligibility conditions are met and receipt is reasonably assured. This means the credit is recognized in the period the qualifying wages were paid, even if the cash refund is received later.

Recording the Employee Retention Credit

Recording the Employee Retention Credit involves specific journal entries to accurately reflect its impact on a company’s financial records. Upon determining eligibility and having reasonable assurance of receiving the credit, a business recognizes a receivable. This involves a debit to an “ERC Receivable” or “Refundable Payroll Tax Receivable” account. The corresponding credit can either reduce payroll wage expense or go to an “Other Income” account. The common method is to reduce the related wage expense, as the credit directly relates to wages paid.

For example, if a business qualifies for a $50,000 ERC for prior period wages, the initial entry is: Debit ERC Receivable $50,000; Credit Wage Expense $50,000. This entry reflects the reduction in the cost of wages. If recognized as other income, the entry is: Debit ERC Receivable $50,000; Credit Other Income (or Government Grant Income) $50,000.

When the credit is applied against current payroll tax liabilities, the employer debits “Payroll Tax Liability” for the credit amount, with the corresponding credit to wage expense or other income. This reduces immediate cash outflow for payroll taxes. If the credit exceeds the current payroll tax liability, the excess becomes a receivable.

Upon receiving the cash refund from the IRS, a separate entry is required. This involves debiting “Cash” and crediting “ERC Receivable” to clear the outstanding balance. For instance, if the $50,000 ERC is received, the entry is: Debit Cash $50,000; Credit ERC Receivable $50,000. This final entry records the receipt of funds and removes the asset from the balance sheet.

The wages used to claim the ERC are not deductible for federal income tax purposes to the extent of the credit. This tax adjustment impacts taxable income. Businesses make an adjustment to their wage expense accounts to reflect this non-deductible portion for tax purposes. This ensures financial statements reflect accounting treatment, while tax records are adjusted for compliance.

Financial Statement Presentation

The Employee Retention Credit impacts a company’s financial statements, primarily the income statement and the balance sheet. On the income statement, the credit is commonly presented as a reduction of wage expense. This method reflects the economic substance of the credit, effectively lowering the cost of retaining employees. Presenting the ERC this way can improve profitability metrics, as it reduces an operating expense.

Alternatively, some entities may present the ERC as “other income” or “government grant income” on the income statement. While this approach increases net income, it separates the credit from direct operating expenses. Regardless of the chosen presentation, clear disclosure in the financial statement notes is important. These notes should explain the nature of the ERC, the accounting policy applied, and where the amounts are recognized.

On the balance sheet, before the cash refund is received, the ERC is presented as a “refundable payroll tax receivable” or “ERC receivable.” This asset represents the amount the business is entitled to receive from the government. Once the cash refund is received, the receivable is reduced, and the company’s cash balance increases, improving liquidity. Disclosures should clearly articulate the specific line items affected and the amounts. This transparency helps financial statement users understand the non-recurring nature of the credit and its impact on the company’s financial performance and position.

Tax Impact and Reporting

The Employee Retention Credit carries specific implications for a business’s federal income tax reporting, separate from its accounting treatment. The wages used to determine the ERC are not deductible for federal income tax purposes to the extent of the credit received. This rule, stemming from Internal Revenue Code Section 280C, prevents a “double benefit” of both a tax credit and a full wage deduction for the same amount.

This non-deductibility means a business’s taxable income will increase by the ERC amount claimed. For example, if a business claims a $100,000 ERC, its deductible wage expense for income tax purposes is reduced by $100,000, leading to higher taxable income. This adjustment must be made for the tax year in which the qualified wages were paid or incurred, not necessarily when the credit is received.

Businesses that filed income tax returns before claiming the ERC, or before accounting for the wage disallowance, may need to file an amended income tax return. This involves forms such as Form 1120-X for corporations, Form 1065-X for partnerships, or Form 1040-X for sole proprietors, depending on the entity structure. The IRS states that if Form 941-X is filed to claim the ERC, the deduction for wages must be reduced by the credit amount for that same tax period.

The form used to claim the ERC is Form 941-X, “Adjusted Employer’s Quarterly Federal Tax Return or Claim for Refund,” for quarterly filers. Agricultural employers use Form 943-X, and annual filers use Form 944-X. These forms adjust previously filed employment tax returns. Businesses should be aware of the statute of limitations for amending these forms: three years from the date the original Form 941 was filed or two years from the date the tax was paid, whichever is later. For example, 2020 ERC claims had a deadline of April 15, 2024, and 2021 claims have a deadline of April 15, 2025.

Handling Prior Period Adjustments

Many businesses claimed the Employee Retention Credit retroactively, often for periods in 2020 and 2021, after their financial statements had been issued. In such cases, accounting for the ERC may require a prior period adjustment. A prior period adjustment corrects a material error in previously issued financial statements. This differs from a change in accounting estimate, as it rectifies an oversight or misapplication of facts that existed when original statements were prepared.

The process involves restating financial statements for affected prior periods. This means presenting financial results as if the error never occurred, by adjusting the carrying amounts of impacted assets or liabilities as of the beginning of the earliest period presented. The corresponding offset for these adjustments is made to the beginning retained earnings balance in that same accounting period. For example, if an ERC receivable was not recorded in a prior year, the restatement would increase the ERC receivable and retained earnings for that period.

When restating financial statements, businesses must provide disclosures in the notes. These disclosures should detail the nature of the error, the reason for the restatement, and the financial impact on each affected line item for each prior period presented. This includes the effect on net income, earnings per share (if applicable), and retained earnings. Transparency in these disclosures helps inform users about the changes and their origins. For material errors, restatement is the appropriate GAAP treatment to ensure financial statements are free from material misstatement.