Is the Employee Retention Credit Refund Taxable?

The Employee Retention Credit (ERTC), a refundable payroll tax credit, offered financial relief to businesses that retained employees during the COVID-19 pandemic. The ERTC refund itself is not considered taxable income. However, receiving the credit impacts a business’s deductible wage expenses.

Federal Tax Implications

The amount of the ERTC reduces the wage expense deduction for the tax year in which the qualified wages were originally paid. For instance, if a business received an ERTC for wages paid in 2020 or 2021, the deductible wage expense for that specific prior year must be reduced by the credit amount. This adjustment effectively increases the business’s taxable income for the prior year, as a smaller deduction leads to a higher net income.

This reduction in deductible wages is mandated by Internal Revenue Code Section 280C, which prevents businesses from receiving a “double benefit” by both claiming a credit and deducting the same wages.

State Tax Implications

State income tax laws concerning the Employee Retention Credit can vary significantly. Some states may automatically conform to federal tax treatment, meaning they also require a reduction in the wage expense deduction for state income tax purposes. These states often base their tax laws on the Internal Revenue Code, leading to similar treatment of the ERTC.

Other states, however, might have their own specific rules regarding the taxability of ERTC refunds or the adjustment of wage expenses. Some states may allow businesses to deduct wages that the IRS disallows for federal tax purposes, creating differences in tax outcomes. Businesses should consult their specific state’s tax laws or a qualified state tax professional to determine the exact implications for their individual circumstances.

Reporting Requirements

Accounting for the Employee Retention Credit refund requires amending prior income tax returns to adjust the wage expense deduction. Since the ERTC relates to wages paid in 2020 or 2021, businesses must amend the income tax return for the year the wages were originally deducted. This involves reducing the amount of wage expenses claimed on the original return by the amount of the ERTC received.

For corporations, this means filing an amended Form 1120-X, Amended U.S. Corporation Income Tax Return. Partnerships may need to file an amended Form 1065, U.S. Return of Partnership Income, or an Administrative Adjustment Request (AAR). Individual taxpayers or sole proprietors who filed Schedule C, Profit or Loss from Business, with their Form 1040, U.S. Individual Income Tax Return, would use Form 1040-X, Amended U.S. Individual Income Tax Return.

Although the ERTC is initially claimed on Form 941-X, Adjusted Employer’s Quarterly Federal Tax Return or Claim for Refund, to adjust payroll taxes, the corresponding income tax return amendment is necessary to reflect the reduced wage deduction. Maintaining thorough records of the ERTC calculation, qualified wages, and all supporting documentation is important for compliance and potential audits. The IRS has recently provided updated guidance allowing taxpayers, in certain situations, to include the overstated wage expense as gross income in the year the ERTC was received, rather than amending prior-year returns, especially if the statute of limitations has expired for those earlier years.