Is Employee Retention Credit Taxable in California?

The Employee Retention Credit (ERC) was a refundable tax credit designed to encourage businesses to retain employees on their payroll during the economic disruptions caused by the COVID-19 pandemic. This incentive helped eligible employers cover a portion of their qualified wages and certain health plan expenses. The credit aimed to provide financial relief to businesses that faced significant declines in gross receipts or had operations fully or partially suspended due to government orders.

Federal Income Tax Treatment of the Employee Retention Credit

For federal income tax purposes, the Employee Retention Credit itself is not considered taxable income to the business. However, businesses claiming the ERC must adjust their wage expense deductions. The Internal Revenue Service (IRS) clarifies in Notice 2021-20 that the amount of qualified wages, including allocable qualified health plan expenses, used to calculate the ERC cannot be deducted as wage expenses for federal income tax purposes.

This means that even though the credit itself is not income, the business’s taxable income effectively increases because a portion of its otherwise deductible wage expenses becomes non-deductible. The reduction in the wage deduction applies to the tax year in which the qualified wages were paid, regardless of when the ERC was actually received. Employers who claimed the ERC after filing their original income tax returns often need to file amended federal income tax returns to reflect this required reduction in wage deductions.

How California Taxes the Employee Retention Credit

California’s tax treatment of the Employee Retention Credit differs significantly from the federal approach. The state does not conform to the federal requirement that businesses reduce their wage and salary expense deductions by the amount of the ERC received. This means that for California state income tax purposes, businesses can generally deduct the full amount of qualified wages, even if those wages were used to claim the federal ERC. Furthermore, the California Franchise Tax Board (FTB) has clarified that the Employee Retention Credit itself is not required to be included in gross income for California income tax purposes.

Reporting ERC on California State Tax Returns

Given California’s non-conformity, businesses report the ERC differently on their state tax returns than on their federal returns. Since California does not require a reduction in wage deductions, businesses will not need to make this specific adjustment when calculating their taxable income for state purposes. This often results in a difference between the federal adjusted business income and the California business income.

Businesses typically reflect this difference on their California state tax forms, such as Schedule CA (Form 540) for individuals, where adjustments are made to federal income to arrive at California income. For other business entity types, similar adjustments would be made on their respective state tax forms. Businesses that may have previously reduced their wage deductions for California purposes should review their prior returns, as they may be able to file amended state tax returns to claim a refund.