Is the Employee Retention Credit (ERC) Taxable Income?

The Employee Retention Credit (ERC) was a refundable tax credit established to assist businesses that maintained employees on their payroll during the COVID-19 pandemic. This credit provided financial relief to eligible employers, encouraging them to retain their workforce. A key question for businesses receiving this credit is how it impacts their tax obligations, specifically whether the ERC is considered taxable income.

Tax Treatment of the Employee Retention Credit

The Employee Retention Credit is not directly included in a business’s gross income for federal income tax purposes. However, it affects a business’s taxable income by requiring a reduction in deductible wage expenses. While the credit amount is not added to revenue, it reduces the payroll costs that can be claimed as a deduction, effectively increasing the business’s taxable profit.

The Internal Revenue Service (IRS) mandates this reduction to prevent businesses from receiving a “double benefit.” This means businesses cannot claim both a tax credit and a full deduction for the same wages. IRS guidance clarifies that the amount of the ERC reduces the employer’s deduction for qualified wages. Businesses must therefore adjust their payroll expense deduction by the amount of the ERC claimed.

Timing of Income Recognition

Businesses are required to reduce their deductible wage expenses in the tax year the qualified wages were paid or incurred, regardless of when the ERC is received. For instance, if qualified wages were paid in 2020 or 2021, the wage expense reduction applies to those respective tax years.

If a business claimed the ERC after filing its original income tax return, it historically needed to file an amended income tax return to reflect the reduced wage deduction. However, recent IRS guidance offers an alternative. If a business did not reduce its wage expense on its original return and received the ERC in a later year, it may now include the overstated wage expense amount as gross income in the year the ERC was received. This new approach aims to simplify compliance and may eliminate the need to amend prior-year returns in some cases.

Impact on Wage Deductions

Receiving the Employee Retention Credit results in a reduction in the amount of qualified wages a business can deduct on its federal income tax return. This reduction applies specifically to the wages used to calculate the ERC. For example, if a business paid $100,000 in qualified wages and received a $50,000 ERC related to those wages, only $50,000 can be deducted as wage expense for tax purposes.

This adjustment directly influences a business’s overall taxable income. By reducing the available wage deduction, the business’s net income for tax calculation purposes will increase, which can lead to a higher tax liability. The IRS requires this to ensure that businesses do not benefit twice from the same economic outlay, once through a credit and again through a deduction. Businesses must account for this wage expense reduction to ensure accurate tax reporting.