Is the Employee Retention Credit Refund Taxable?
Learn how your Employee Retention Credit refund impacts your business's taxable income, not as new revenue, but through expense adjustments.
The Employee Retention Credit (ERC) was a refundable payroll tax credit designed to assist businesses that retained employees during the COVID-19 pandemic. This credit provided financial relief by offsetting a portion of qualified wages paid. A common question for businesses receiving this benefit is whether the ERC refund itself is subject to taxation. While the credit directly reduces payroll taxes and is not considered taxable income, its receipt can impact a business’s taxable income because it reduces wage expenses.
Federal Tax Treatment of ERC Refunds
The Employee Retention Credit is not considered taxable income for federal income tax purposes. This means the amount a business receives is not directly added to its gross income. Instead, the credit impacts taxable income because the qualified wages used to calculate the credit are typically deductible business expenses.
When a business claims the ERC, it receives a benefit related to wages for which it would otherwise claim an income tax deduction. To prevent a “double benefit” (both a credit and a full deduction for the same wages), federal tax law requires businesses to reduce their deduction for qualified wages by the amount of the credit. This reduction in deductible expenses increases a business’s taxable income for the year the wages were paid. For example, if a business paid $10,000 in wages and received a $7,000 ERC for those wages, it can only deduct $3,000 of those wages for income tax purposes. This adjustment ensures businesses do not deduct expenses effectively reimbursed by the credit.
Timing for Accounting for the Refund
For most businesses, particularly those operating on an accrual basis, the wage expense deduction must be reduced in the tax year the qualified wages were paid and the credit was earned. This applies even if the actual refund check is received in a subsequent tax year. The reduction aligns the expense with the period in which the related economic activity occurred.
For cash-basis taxpayers, similar principles apply, meaning they typically account for the credit in the year the wages were paid or the credit was claimed, not when the cash is received. However, recent Internal Revenue Service (IRS) guidance provides flexibility for taxpayers who did not amend their prior-year income tax returns to reduce wage expenses. These taxpayers now have the option to include the ERC refund amount as gross income in the tax year the refund is actually received. This updated guidance can simplify compliance by eliminating the need to amend older returns, especially if the statute of limitations for those years has passed.
Reporting the Refund on Tax Forms
Reporting the Employee Retention Credit’s impact on federal tax returns involves specific procedural steps, primarily through amending previously filed forms. Businesses that claimed the ERC generally need to amend their quarterly employment tax returns, Form 941. This amendment is made by filing Form 941-X for each quarter in which the credit was claimed.
The reduction in qualified wage expenses, resulting from the ERC, then flows through to the business’s federal income tax return. For corporations, this adjustment impacts Form 1120. S-corporations report the change on Form 1120-S, and partnerships on Form 1065. Sole proprietors, including those filing Schedule C or F on Form 1040, adjust their wage expense deductions accordingly. The recent IRS guidance also offers an alternative: if a business did not previously amend its income tax return, it can report the ERC amount as income in the year the refund is received.
State Tax Treatment of ERC Refunds
The federal tax treatment of Employee Retention Credit refunds is defined, but the approach at the state level can differ considerably. Some states align their tax laws with the federal treatment, requiring businesses to reduce their deductible wage expenses by the amount of the ERC, thereby increasing state taxable income. This conformity simplifies compliance for businesses operating in those states.
Other states may have their own unique tax rules regarding the ERC. Some states may not require any adjustment to wage expenses, while others may treat the refund differently for state income or franchise tax purposes. Businesses should consult their specific state’s tax laws or seek advice from a state tax professional to understand the implications for their state-level tax obligations.