Is the Employee Retention Credit Taxable?

The Employee Retention Credit (ERC) was a refundable tax credit designed to assist businesses during the economic challenges of the COVID-19 pandemic. This credit encouraged businesses to retain employees on their payroll, offering financial relief for qualified wages paid. While the ERC provided significant support to many employers, understanding its tax implications is important for accurate financial reporting.

The Taxability Rule

The Employee Retention Credit itself is not considered taxable income for federal income tax purposes. Instead, the tax law specifies that businesses must reduce their deduction for qualified wages by the amount of the credit received or expected to be received. This adjustment effectively increases a business’s taxable income, as a smaller deduction leads to a higher net income subject to tax.

This treatment is consistent with guidance issued by the Internal Revenue Service (IRS). Specifically, IRS Notice 2021-20 clarified that employers must reduce their deduction for qualified wages by the amount of the ERC. Further guidance in IRS Notice 2021-49 reinforced this position, stating that the reduction in wage expense applies to the tax year in which the qualified wages were paid, even if the credit is claimed or received in a later tax year.

Impact on Business Income and Deductions

Businesses calculate their taxable income by subtracting eligible deductions, such as wage expenses, from their gross revenue. When a portion of these wages, specifically those covered by the ERC, can no longer be deducted, the total amount of deductible expenses decreases. This reduction in deductions results in a higher reported net income for tax purposes.

For example, if a business paid $100,000 in wages and received a $50,000 ERC, it must reduce its wage deduction by $50,000. This means only $50,000 of the original $100,000 in wages can be deducted, leading to a higher taxable income compared to if the full $100,000 deduction was allowed. This adjustment increases the amount of federal income tax a business may owe.

For pass-through entities, such as partnerships and S corporations, the increase in taxable income flows through to the individual owners’ personal income tax returns. This means the owners of these entities will see an increase in their share of the business’s taxable income, which could result in a higher individual income tax liability. While the credit itself is not income, its interaction with the wage deduction directly influences the tax burden at both the entity and individual owner levels, requiring careful consideration in tax planning and compliance.

Reporting and Amending Tax Returns

Businesses that have not yet filed their income tax returns for the years in which they claimed the Employee Retention Credit should account for the reduced wage expense on their original filings. Corporations typically report their income and deductions on Form 1120, while partnerships use Form 1065. Sole proprietors and single-member LLCs report their business income and expenses on Schedule C or Schedule F, attached to their Form 1040. On these forms, the amount of qualified wages used to determine the ERC should be subtracted from the total wage expense before calculating the deduction.

Businesses that have already filed their original income tax returns for the relevant periods and subsequently claimed or received the ERC must file an amended return. Amending a return is necessary to correctly reflect the reduction in the wage expense deduction for the tax year in which the qualified wages were paid. Corporations typically amend their returns using Form 1120-X, and partnerships use Form 1065-X. Individuals who report business income on Schedule C or F amend their personal tax returns using Form 1040-X.

The general timeline for amending a tax return to claim a refund or make adjustments is typically within three years from the date the original return was filed or two years from the date the tax was paid, whichever is later. When preparing the amended return, businesses should clearly indicate the adjustment to the wage expense deduction and provide an explanation for the change. Accurate and timely amendment ensures compliance with tax regulations and proper reflection of the business’s tax liability.