How to Report an ERC Refund on Your Tax Return

The Employee Retention Credit (ERC) provided financial support to businesses that retained employees during the COVID-19 pandemic. Understanding how to report an ERC refund on a tax return is important for recipients to ensure compliance with tax regulations. Accurate reporting helps businesses avoid potential issues with the Internal Revenue Service (IRS).

Taxability of the ERC Refund

The ERC itself is not considered taxable income for federal income tax purposes. However, the ERC refund does impact a business’s taxable income indirectly by reducing the amount of deductible wage expenses. This adjustment is necessary to prevent a “double benefit” where a business would both claim the credit for wages and deduct those same wages as an expense.

The reduction in wage expenses applies to the tax year in which the qualified wages were paid or incurred, not necessarily the year the ERC refund was received. This principle stems from Internal Revenue Code Section 280C, which generally disallows a deduction for expenses to the extent a credit is claimed for those same expenses. Consequently, the ERC effectively increases a business’s taxable income for the year the wages were originally paid by reducing the corresponding wage expense deduction.

Recent IRS guidance provides flexibility for taxpayers who did not reduce their wage expenses in the original tax year the qualified wages were paid. If the wage expense adjustment was not made in the year the wages were incurred, taxpayers can include the amount of the overstated wage expense as gross income in the tax year the ERC funds were actually received. This alternative reporting method applies particularly to businesses that received refunds long after the original tax years. The interest paid by the IRS on delayed ERC refunds is considered taxable income and must be reported accordingly.

Reporting the Refund on Your Current Tax Return

For businesses opting to report the impact of the ERC in the year the refund is received, the amount corresponding to the previously overstated wage expense should be included as income on the current year’s tax return. This approach applies when the original wage expense deduction was not reduced in the prior year’s filing. The specific line item for reporting this income varies by entity type, generally falling under “other income” or as an adjustment to gross receipts.

Sole proprietors and single-member LLCs, who typically file Schedule C (Form 1040), would report this amount on Line 6, designated for “Other income.” For partnerships, which file Form 1065, the amount should be reported on Line 7, “Other income.” S-corporations, filing Form 1120-S, would include this income on Line 5, “Other income (loss).” C-corporations, which file Form 1120, would report this amount on Line 10, “Other income.” Regardless of the entity type, maintaining clear documentation explaining the nature of this income as an ERC-related adjustment is advisable.

Impact on Wage Expense Deductions

The core tax implication of the ERC is the required reduction of wage expense deductions. Businesses cannot claim a deduction for the same qualified wages for which they received the ERC. This adjustment applies to the tax year in which the wages were originally paid or incurred, aligning the deduction with the period the credit was earned.

To implement this, businesses must reduce their wage expense deduction by the amount of the ERC received for that specific period. For instance, if a business received an ERC for qualified wages paid in 2020, the wage expense deduction on its 2020 income tax return must be reduced by that credit amount. This adjustment directly impacts the business’s taxable income for that prior year, potentially increasing it. The reduction applies to the gross wages reported on relevant tax forms.

For a sole proprietorship filing Schedule C, the wage expense reduction would occur within Part II, “Expenses,” on the line item for “Salaries and wages.” Similarly, partnerships filing Form 1065 would adjust their “Salaries and wages” on Line 9 in the Deductions section. S-corporations and C-corporations, using Form 1120-S and Form 1120 respectively, would also decrease their “Salaries and wages” or “Compensation of officers” lines to reflect the ERC.

Amending Previously Filed Returns

In many instances, receiving an ERC refund necessitates amending previously filed tax returns, particularly if the wage expense reduction was not accounted for in the original filing. This is often the case for ERCs claimed for qualified wages paid in 2020 or 2021, where the refund might have been received in a subsequent year. Amending ensures the wage expense deduction for those prior years accurately reflects the impact of the credit.

The specific amended form depends on the business entity. Individuals and sole proprietors, including those who file Schedule C, typically use Form 1040-X, Amended U.S. Individual Income Tax Return. C-corporations amend their returns using Form 1120-X, Amended U.S. Corporation Income Tax Return. Partnerships and S-corporations do not have a specific “X” form but must file an amended Form 1065 or Form 1120-S, respectively, checking the “Amended Return” box at the top of the form.

When completing an amended return, taxpayers must clearly indicate the changes made and provide an explanation for the adjustments. For example, on Form 1040-X, Part III, “Explanation of Changes,” should detail that the amendment is to reduce wage expenses due to the ERC received. The amended forms are generally mailed to the IRS, rather than e-filed. Taxpayers should ensure they retain copies of all amended returns and supporting documentation for their records.