Is ERTC Income Taxable? How the Credit Affects Your Taxes
Unpack the tax implications of the ERTC. Understand how this credit affects your business's deductible expenses and federal tax obligations.
The Employee Retention Tax Credit (ERTC) provided relief for businesses during the COVID-19 pandemic. This refundable tax credit incentivized eligible employers to retain employees, even when operations faced suspension or a decline in gross receipts. A common question arose regarding its tax implications: is the ERTC considered taxable income? Understanding the federal and state tax treatment of the ERTC is important for accurate financial reporting.
Understanding ERTC Taxability
While the Employee Retention Tax Credit itself is not considered taxable income, it impacts a business’s taxable profits by reducing deductible wage expenses. The wages used to calculate the ERTC cannot also be fully deducted for federal income tax purposes. This prevents a “double benefit” where a business would both receive a credit for wages paid and fully deduct those same wages.
The ERTC amount reduces the deduction for qualified wages paid. This adjustment applies to the tax year in which the qualified wages were paid, regardless of when the credit was claimed or received. For instance, if qualified wages were paid in 2021, the wage deduction for 2021 must be reduced by the ERTC amount, even if the credit payment was received in 2024. This adjustment increases the business’s taxable income for the year the wages were paid.
The Internal Revenue Service (IRS) provided guidance on this matter. IRS Notice 2021-20 clarified that employers do not include the ERTC in gross income but must reduce their wage expense deduction by the credit amount. This position was reiterated in IRS Notice 2021-49, stating the reduction must occur in the same tax year the ERTC is claimed.
Reporting ERTC on Federal Tax Returns
Businesses must adjust their wage expense deductions on their federal income tax returns to account for the Employee Retention Tax Credit. This adjustment is necessary because the wages forming the basis of the ERTC are no longer fully deductible. The specific forms used depend on the business entity type.
Corporations, including C-corporations and S-corporations, make this adjustment on Form 1120 or Form 1120-S. Partnerships report it on Form 1065. Sole proprietors and single-member LLCs reporting business income and expenses on personal tax returns use Schedule C (Form 1040).
If a business claimed the ERTC after filing its original income tax return for the year qualified wages were paid, an amended return is required. Corporations file Form 1120-X, partnerships Form 1065-X, and individuals Form 1040-X. This ensures the wage deduction is correctly reduced for the relevant tax year. However, recent guidance from March 2025 indicates that if wage expenses were not reduced in the original filing year, businesses may now include the ERTC amount as gross income in the year the credit is received, rather than amending prior-year returns.
Considering State Income Tax Rules
The state income tax treatment of the Employee Retention Tax Credit can differ from federal rules. Businesses must understand their specific state’s regulations. While federal guidance dictates a reduction in deductible wages equal to the ERTC amount, states may adopt various approaches. Some states conform to the federal treatment, requiring a similar wage deduction reduction for state income tax purposes.
Other states may have independent rules, meaning they do not recognize the ERTC for state income tax purposes or treat it differently. This variation can lead to situations where the ERTC is not taxable federally but influences state taxable income. Businesses should consult their state’s tax laws or seek advice from a state tax professional to determine their state income tax obligations related to the ERTC.