Is the Employee Retention Credit Taxable?

The Employee Retention Credit (ERC) was a refundable tax credit designed to encourage businesses to retain employees during the COVID-19 pandemic. While the ERC itself is not considered taxable income, it significantly impacts a business’s deductible wage expenses, effectively increasing its taxable income. Understanding this distinction is important for accurate tax reporting and compliance.

Federal Income Tax Treatment

The Employee Retention Credit is not treated as gross income for federal tax purposes. Instead, the ERC affects federal income taxes by requiring a reduction in the wage deduction claimed by the business. This reduction applies to the qualified wages used to calculate the credit. The IRS mandates that the ERC reduces the deductible wage expense for the tax year in which those qualified wages were paid or incurred.

This timing rule applies even if the ERC was claimed or received in a later tax year. For instance, if a business paid qualified wages in 2020 or 2021 that generated an ERC, the wage deduction for that specific year must be reduced by the credit amount. This effectively increases the business’s taxable income for the relevant year. The IRS clarifies this treatment in guidance, explaining that rules similar to Internal Revenue Code Section 280C apply, which generally disallows a deduction for wages equal to the amount of certain credits.

The rationale behind this rule is to prevent “double-dipping,” where a business would receive a tax benefit both from the credit and from deducting the wages that gave rise to the credit. Therefore, when the ERC is claimed, the corresponding wage expense is disallowed as a deduction to the extent of the credit.

Impact on Wage Deduction and Other Credits

The ERC directly impacts a business’s wage deduction by requiring that the amount of the credit reduces the deductible wage expense. For example, if a business claimed $50,000 in ERC, its payroll expense deduction for the applicable year would be reduced by that $50,000. This adjustment increases the business’s taxable income, which could lead to a higher tax liability for that specific year.

Beyond the direct wage deduction, the ERC also interacts with other federal tax credits. Wages used to calculate the Employee Retention Credit cannot be used to calculate other federal tax credits. This coordination rule prevents businesses from claiming multiple credits for the same qualified wages. For instance, wages that qualify for the ERC cannot also be used to claim the Work Opportunity Tax Credit or the Research and Development credit.

Businesses that also participated in the Paycheck Protection Program (PPP) need to carefully consider the interaction between the two programs. While businesses could claim both ERC and PPP loan forgiveness, the same wages cannot be used for both benefits. Wages that were reported as payroll costs for PPP loan forgiveness are not eligible to be included in the qualified wages for ERC calculations. This requires careful allocation of payroll costs to maximize the benefits from each program.

Amending Previously Filed Tax Returns

Many businesses received Employee Retention Credit funds after filing their original income tax returns for 2020 or 2021. Due to the requirement to reduce wage deductions in the year qualified wages were paid, an amendment to previously filed income tax returns is often necessary. This retroactive adjustment ensures tax compliance and accurate reporting of taxable income for the relevant periods.

To amend federal income tax returns for the ERC, businesses typically need to file specific forms. For adjustments related to employment taxes, Form 941-X, Adjusted Employer’s Quarterly Federal Tax Return or Claim for Refund, is used to correct previously filed Form 941s. Businesses must then amend their federal income tax returns. The specific form depends on the business entity type:
Form 1040-X for individuals (including sole proprietors)
Form 1120-X for corporations
Form 1065-X for partnerships

Recent guidance from the IRS, issued in March 2025, provides an alternative for taxpayers who did not reduce their wage expenses on their original income tax returns and received their ERC refund in a subsequent year. Instead of amending the prior-year return, these taxpayers may include the overstated wage expense amount (equal to the ERC received) as gross income on their income tax return for the tax year in which the ERC was received. This new option offers flexibility, particularly if the statute of limitations for amending the original year’s income tax return has expired. Businesses should consult with a tax professional to determine the most appropriate course of action for their specific situation.

State Tax Implications

The federal tax treatment of the Employee Retention Credit, specifically the reduction of wage expenses, is outlined by the IRS. State-level tax implications can vary significantly. Many states have their own tax laws that may or may not automatically conform to federal tax changes.

Some states may automatically follow the federal treatment, requiring a reduction in the wage deduction for state income tax purposes. Other states might have different rules, or they may not have a similar credit, leading to different tax outcomes. For example, some states may allow a deduction for wages that were disallowed at the federal level due to the ERC. Businesses should research their specific state’s tax laws or consult with a tax professional to understand how the ERC impacts their state income tax liability to ensure proper state tax compliance.