Is the Employee Retention Credit Refund Taxable?

The Employee Retention Credit (ERC) was a significant relief measure for businesses during the COVID-19 pandemic, designed to encourage employers to retain their workforce. It provided a refundable tax credit against certain employment taxes based on qualified wages paid. This article clarifies how ERC refunds are treated for tax purposes, offering insights into federal and state considerations and reporting requirements.

Federal Tax Treatment of the ERC

The Employee Retention Credit (ERC) is not considered taxable income for federal purposes. This means the amount of the credit received does not directly increase a business’s gross income. However, receiving the ERC indirectly affects a business’s taxable income.

The Internal Revenue Service (IRS) mandates that qualified wages for which the ERC is claimed must reduce the corresponding wage expense deduction on the business’s federal income tax return. This reduction in deductible wage expenses effectively increases the business’s taxable income. This rule prevents a “double benefit” where a business could both receive a credit for wages and deduct those same wages as an expense. IRS guidance, such as Notice 2021-20 and Notice 2021-49, clarifies this requirement, applying rules similar to Internal Revenue Code Section 280C.

For instance, if a business paid $10,000 in qualified wages and received a $7,000 ERC, the business must reduce its wage expense deduction by $7,000. This means only $3,000 of those wages are deductible for income tax purposes.

This mechanism ensures that while the credit itself is not taxed, the overall taxable profit of the business increases due to the reduced deduction. This adjustment applies to the tax year in which the qualified wages were paid, not necessarily the year the credit was received.

Determining the Tax Year for Reporting

The timing of the wage expense reduction is crucial for reporting the Employee Retention Credit. The IRS requires the wage expense reduction to apply to the tax year in which the qualified wages were paid. This means the income tax return for the original year the wages were paid must reflect the reduced deduction, even if the ERC was claimed or received later via an amended payroll tax return (Form 941-X).

Businesses that claimed the ERC on an original income tax return would have already accounted for this reduction. However, many businesses claimed the ERC retroactively by filing amended employment tax returns, often long after their original income tax returns for those years were filed.

In such cases, the business typically needs to amend its income tax return for the year the qualified wages were paid to reflect the decreased wage deduction. Recent IRS guidance has provided some flexibility for taxpayers who received an ERC refund in a subsequent year and did not reduce their wage expense earlier.

Under this guidance, taxpayers may include the overstated wage expense as gross income on their income tax return for the year they received the ERC refund. This alternative approach, based on the tax benefit rule, can simplify compliance for businesses that received refunds years after the relevant payroll period.

State Tax Considerations

The tax implications of the Employee Retention Credit can vary at the state level. While federal treatment dictates a reduction in wage expenses, state tax laws may not always align with this federal approach. Some states automatically conform to federal treatment, requiring a reduction in deductible wage expenses, which could increase state taxable income.

Other states may have different rules. Some might not require a corresponding reduction in wage expenses, or they might treat the ERC differently for state income tax purposes. For example, some states may allow businesses to deduct the full amount of wages, even if those wages were used to claim the ERC federally. Conversely, some states might conform to the federal disallowance of the wage deduction, even if the state does not offer a similar credit.

Given the variation in state tax laws, businesses should consult their specific state’s tax authority or a qualified state tax professional. This ensures compliance with local regulations and accurate reporting of the ERC’s impact on state income tax filings. Understanding these differences is necessary to avoid potential penalties or overpayments.

How to Report the ERC on Tax Filings

Reporting the Employee Retention Credit’s impact on tax filings involves adjusting the wage expense deduction. The core action is to reduce the wage expense reported on the applicable business income tax return by the ERC amount claimed. This adjustment ensures the business does not receive a double tax benefit from the same wages.

The adjustment is made on specific forms depending on the business structure:
Corporations: Form 1120
Partnerships: Form 1065 (with partner shares on Schedule K-1)
Sole proprietorships and single-member LLCs: Schedule C of Form 1040
S-corporations: Form 1120-S (Line 13g), with shareholder shares on Schedule K-1

The specific wage expense line item on these forms must be reduced. Businesses that claimed the ERC after filing their original income tax returns for the relevant years often need to amend those prior-year returns. This amendment aligns the income tax deduction with the ERC received for the qualified wages.