How to Record the ERC Credit on Your Books

The Employee Retention Credit (ERC) was established as a refundable payroll tax credit to help businesses retain employees during the economic challenges of 2020 and 2021. This credit provided financial relief to eligible employers who continued to pay wages during the COVID-19 pandemic. Understanding how to properly record the ERC on a business’s financial books is important for accurate financial reporting and compliance. This guide outlines the accounting treatment for the ERC, from determining the appropriate recognition period to addressing its impact on income tax and specific accounting situations.

Determining the Recognition Period

Businesses operating under the accrual basis of accounting should recognize the Employee Retention Credit in the financial period when the qualified wages were paid and the credit was earned. This approach aligns with the fundamental accounting principle of matching, where revenues and expenses are recognized in the same period they are incurred. The eligibility for the credit is tied directly to the payment of qualifying wages during specific calendar quarters in 2020 and 2021.

The credit should be recorded in the books for the quarter in which the underlying wages were incurred, even if the formal claim on Form 941-X is filed much later. This ensures that the financial statements accurately reflect the economic events of the period. While some small businesses may use the cash basis of accounting, the accrual method is generally used by most businesses and provides a more comprehensive view of financial performance.

Recording the Credit

Recording the Employee Retention Credit on a company’s books involves specific journal entries to properly reflect its impact. When the credit is determined and earned, it should be recognized as a receivable. A common entry involves debiting an “ERC Receivable” account to establish the amount owed to the business.

The corresponding credit can be made to either “Payroll Tax Expense” or “Other Income/Grant Income.” Crediting “Payroll Tax Expense” directly reduces the overall payroll expense for the period, reflecting the ERC’s nature as an offset to employment taxes. Alternatively, crediting “Other Income” or “Grant Income” treats the ERC as a form of government assistance, which may be more appropriate depending on the company’s accounting policies for grants.

Upon receiving the cash refund from the IRS, a separate journal entry is necessary to reflect the cash inflow and clear the receivable. This entry involves debiting the “Cash” account and crediting the “ERC Receivable” account. The ERC effectively reduces the gross payroll tax expense that would otherwise be recorded for the period, providing a financial benefit that impacts the overall profitability shown on the income statement.

General ledger accounts commonly used for these entries include “ERC Receivable,” “Payroll Tax Expense,” and “Other Income” or “Grant Income.” Selecting the appropriate credit account for initial recognition should be based on the business’s consistent accounting policies and how it classifies similar governmental benefits.

Impact on Income Tax

The Employee Retention Credit carries implications for a business’s income tax liability, primarily by affecting the deductibility of wage expenses. While the ERC itself is not considered taxable income, businesses must reduce their deductible wage expenses by the amount of the credit claimed. This adjustment prevents a “double benefit,” where a business would both deduct the wages and receive a credit for them.

The reduction in deductible wages occurs in the tax year the qualified wages were paid or incurred, regardless of when the ERC cash is actually received. Businesses often need to amend prior-year income tax returns to reflect this reduced deduction.

Recent guidance from the IRS offers an alternative approach for situations where the wage expense was not initially reduced. If a business claimed the ERC but did not reduce its wage expense in the year the wages were paid, and the ERC is received in a subsequent year, the business may include the overstated wage expense amount as gross income in the year the ERC is received. There is no direct journal entry in a company’s accounting records to reflect this income tax impact; it is a tax adjustment made when preparing the income tax return.

Addressing Specific Accounting Situations

When the Employee Retention Credit is claimed by amending prior payroll tax returns, the core accounting principles for recognition remain consistent. The credit should be recognized in the financial period when the qualifying wages were originally paid and the credit was earned, not when the amended return is filed.

Businesses that received advance payments of the ERC needed to account for these funds differently. Upon receipt of an advance, a business would debit Cash and credit a “Liability for ERC Advance” account. This liability would then be reduced as the final credit was determined and applied against employment tax liabilities or refunded. The IRS stopped accepting Form 7200 for advance payments after January 31, 2022.

An important consideration involves the interplay between the ERC and Paycheck Protection Program (PPP) loans. Businesses are prohibited from claiming the ERC on wages that were used to obtain forgiveness for a PPP loan. When recording the ERC, businesses must ensure that the qualified wages used for the credit calculation do not overlap with wages for which PPP loan forgiveness was granted. Proper documentation is necessary to demonstrate that the wages claimed for ERC are distinct from those covered by PPP forgiveness.