Is the Employee Retention Credit Taxable?

The Employee Retention Credit (ERC) was a significant federal program designed to help businesses retain employees during the economic disruption caused by COVID-19. This refundable tax credit provided financial relief to eligible employers who continued to pay wages while their operations were fully or partially suspended due to government orders, or who experienced a substantial decline in gross receipts. While the ERC offered a welcome financial lifeline, its interaction with federal income tax rules has created complexities for many businesses navigating their tax obligations.

Understanding ERC Taxability

The Employee Retention Credit itself is not considered taxable income for federal income tax purposes. The American Rescue Plan Act of 2021, which expanded and extended the ERC, clarified that the credit amount does not need to be included in a business’s gross income. This means that when a business receives an ERC refund, the ERC refund is not added to its revenue for income tax calculation.

The ERC functions as a credit against employment taxes, rather than an addition to gross income. This distinction is important because it means the credit directly offsets certain payroll tax liabilities. While the credit itself is not income, its receipt has an indirect effect on a business’s taxable income, which arises from the treatment of the wages used to calculate the credit.

Adjusting Wage Expense Deductions

While the ERC itself is not includible in gross income, businesses must adjust their wage expense deductions for federal income tax purposes by the amount of the credit received. This adjustment is mandated by Section 2301(e) of the CARES Act. This provision prevents a “double benefit” where an employer would both receive a credit for qualified wages and also deduct those same wages as a business expense.

The rule requires that the amount of qualified wages, including certain health plan expenses, for which the ERC is claimed cannot also be deducted as a business expense. For instance, if a business paid $100,000 in qualified wages and received a $50,000 ERC based on those wages, only $50,000 of those wages would be deductible for income tax purposes. This reduction in deductible wage expense effectively increases the business’s taxable income.

Timing Taxable Impact

The timing of this wage expense deduction adjustment depends on the taxpayer’s accounting method and the year the ERC was received. For accrual basis taxpayers, the wage deduction disallowance generally applies in the tax year the qualified wages were paid or incurred. This often necessitates amending prior year income tax returns to reduce the wage deduction for the year the wages were originally paid.

For cash basis taxpayers, the wage deduction disallowance traditionally applied in the tax year the ERC was received. However, recent IRS guidance provides flexibility. If a taxpayer claimed the ERC but did not reduce wage expenses in the year the wages were paid, and the ERC was received in a subsequent year, they are generally not required to amend the prior year’s return. Instead, they can include the overstated wage expense amount as gross income on their income tax return for the tax year in which the ERC was received. This alternative aims to simplify compliance.

Reporting on Tax Returns

The reduction in deductible wage expense due to the ERC is reported on the business’s federal income tax return. For corporations, this reduction is reflected on Form 1120 (U.S. Corporation Income Tax Return) or Form 1120-S (U.S. Income Tax Return for an S Corporation) by adjusting the wages or salaries line item. Partnerships report this adjustment on Form 1065 (U.S. Return of Partnership Income), and sole proprietors on Schedule C (Form 1040), Profit or Loss from Business.

When the timing rules necessitate amending a prior year’s income tax return, businesses typically use specific amended return forms. Corporations use Form 1120-X (Amended U.S. Corporation Income Tax Return), individuals and sole proprietors use Form 1040-X (Amended U.S. Individual Income Tax Return), and partnerships use Form 1065-X (Amended Return or Administrative Adjustment Request (AAR)). The reduction in the wage deduction is reflected on the relevant income tax return to account for the credit’s impact.