Is the Employee Retention Credit (ERC) Taxable Income?

The Employee Retention Credit (ERC) was a refundable payroll tax credit designed to help businesses retain employees during the COVID-19 pandemic. Many businesses receiving this credit frequently inquire about its tax implications and how it affects their income tax obligations.

Understanding ERC Taxability

The Employee Retention Credit itself is not directly considered taxable income. Instead, its taxability arises from a required adjustment to the wage expenses a business can deduct on its income tax return. While the credit reduces a business’s payroll tax liability, the corresponding wages used to claim the credit cannot also be fully deducted as an expense for income tax purposes.

For instance, if a business received a $100,000 ERC, it must reduce its deductible wage expenses by that same $100,000. This prevents a double benefit. Internal Revenue Service (IRS) guidance, including Notice 2021-20 and Notice 2021-49, clarifies this required reduction.

How ERC Impacts Income Tax Filings

The ERC’s impact on income tax filings is tied to the tax year in which qualified wages were paid, not when the refund was received. For instance, if a business paid qualifying wages in 2020 or 2021 but received the ERC refund later, the wage expense reduction must still apply to the 2020 or 2021 income tax return. This timing often necessitates reviewing previously filed returns.

The adjustment method varies by business structure. A C corporation, filing Form 1120, reports the reduced wage expense directly. Partnerships, filing Form 1065, reflect the adjustment on their return, flowing through to individual partners via Schedule K-1. Sole proprietors and single-member LLCs, reporting on Schedule C (Form 1040), reduce their wage deduction on that schedule.

Required Wage Expense Adjustments

The required wage expense reduction directly impacts a business’s net income and income tax liability. The mechanism for this adjustment typically involves reporting the ERC on an adjusted employer’s quarterly federal tax return, such as Form 941-X, Adjusted Employer’s Quarterly Federal Tax Return or Claim for Refund. While Form 941-X is used to claim the credit and adjust payroll taxes, the corresponding reduction in wage expense ultimately affects the income tax return filed for that specific year. This reduction is a mandatory accounting adjustment to accurately reflect the business’s taxable income after benefiting from the credit.

Amending Prior Tax Returns

Businesses that claimed the Employee Retention Credit after filing their original income tax returns for the years when qualified wages were paid will generally need to amend those prior returns. This is because the required reduction in wage deductions impacts the taxable income of the original filing year, not the year the ERC was received. For a corporation, this typically involves filing Form 1120-X, Amended U.S. Corporation Income Tax Return. Individuals reporting business income on Schedule C, such as sole proprietors, use Form 1040-X, Amended U.S. Individual Income Tax Return. Partnerships must also amend their Form 1065 to reflect reduced wage deductions, which affects the Schedules K-1 issued to their partners.

Amending returns can be complex, involving recalculating taxable income and potentially additional tax due or a reduced refund. Consulting with a qualified tax professional is often recommended to ensure accurate compliance and navigate specific requirements.