Is the Employee Retention Credit Taxable?

Understanding the Employee Retention Credit

The Employee Retention Credit (ERC) was established as a refundable payroll tax credit designed to provide financial relief and incentivize businesses to retain their employees during the economic challenges posed by the COVID-19 pandemic. Introduced as part of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, the ERC offered eligible employers a credit against certain employment taxes. This program aimed to support businesses that experienced significant declines in gross receipts or were subject to full or partial suspension of their operations due to government orders. The ERC aimed to help businesses navigate an unprecedented period of economic uncertainty.

Understanding the Tax Treatment of the Employee Retention Credit

While the Employee Retention Credit provided substantial financial support to eligible businesses, the credit itself is not considered taxable income for federal income tax purposes. However, the ERC does impact a business’s tax liability through an adjustment to its deductible wage expenses.

The Internal Revenue Code Section 280C generally prevents a taxpayer from receiving a double benefit by disallowing a deduction for expenses equal to the amount of certain credits. In the context of the ERC, this provision requires businesses to reduce their deductible wage expenses by the amount of the credit received. Therefore, while the ERC itself is not income, the corresponding reduction in deductible wage expenses effectively increases a business’s taxable income. This adjustment ensures businesses do not claim a tax deduction for wages for which they also received a tax credit.

For instance, if a business paid $100,000 in qualified wages and received a $50,000 ERC related to those wages, the business would only be able to deduct $50,000 of those wages for income tax purposes. This reduction applies to the specific wages that were used to calculate the ERC.

How the ERC Reduces Deductible Wage Expenses

The reduction in deductible wage expenses due to the Employee Retention Credit requires attention to timing. This reduction must occur in the tax year in which the qualified wages giving rise to the credit were paid, regardless of when the ERC was actually received or claimed. For example, if a business paid qualified wages in 2020 and later received the ERC for those wages in 2023, the wage expense deduction must be reduced on the business’s 2020 tax return.

The accounting implications of this wage expense reduction vary depending on the business structure. For C corporations, the reduction directly impacts the company’s taxable income reported on Form 1120, decreasing the available wage deduction and potentially increasing the corporate tax liability. S corporations and partnerships, as pass-through entities, reflect this adjustment on their respective information returns, Form 1120-S and Form 1065. The reduction in deductible wage expenses flows through to the owners’ or partners’ individual income tax returns, typically affecting the ordinary business income reported on their Schedule K-1s and subsequently on their personal Form 1040s.

Sole proprietorships also experience this wage expense reduction, which directly impacts their net profit or loss reported on Schedule C (Profit or Loss from Business) within their individual Form 1040. The reduction applies only to the specific qualified wages that were used to compute the ERC, not the entirety of the business’s wage expenses. Businesses must accurately identify the qualified wages for each quarter and apply the corresponding ERC amount to reduce the deductible wages for the respective tax year.

Amending Prior Year Tax Returns

Businesses that received Employee Retention Credit funds for prior tax years, such as 2020 or 2021, often did so after their original income tax returns for those years had already been filed. In such scenarios, it becomes necessary to amend those previously filed income tax returns to properly account for the required wage expense reduction.

The process of amending a prior year tax return involves using specific forms tailored to the business entity type. C corporations typically use Form 1120-X, Amended U.S. Corporation Income Tax Return, to correct their previously filed corporate tax forms. Individuals who operate as sole proprietorships and report their business income on Schedule C of Form 1040 utilize Form 1040-X, Amended U.S. Individual Income Tax Return, to make the necessary adjustments. Partnerships, on the other hand, amend their returns using Form 1065-X, Amended Return or Administrative Adjustment Request (AAR).

When completing these amended forms, businesses must provide the original figures as filed, the corrected figures after accounting for the ERC wage expense reduction, and a clear explanation of the changes being made. This explanation should detail that the amendment is due to the reduction in deductible wage expenses corresponding to the Employee Retention Credit received. Once completed, the amended return and any supporting documentation are generally mailed to the Internal Revenue Service (IRS) at the address specified in the form’s instructions.

Failing to amend prior year tax returns to reflect the necessary wage expense reduction can lead to various consequences for businesses. The IRS may assess additional tax due, along with interest on any underpayment of tax from the original due date of the return. Businesses could also face penalties, such as accuracy-related penalties, if the underpayment is substantial or due to negligence. Therefore, promptly amending returns helps businesses ensure accurate tax reporting.