Is the Employee Retention Credit Taxable in California?

The Employee Retention Credit (ERC) was established to provide financial relief to businesses that maintained their payroll during the COVID-19 pandemic. This refundable tax credit aimed to help employers keep their workers employed, even when facing significant economic disruption or government-mandated shutdowns. Understanding the specific tax implications of receiving the ERC is important for businesses to ensure accurate financial reporting and compliance with tax regulations.

Federal Tax Implications of the Employee Retention Credit

Federally, the Employee Retention Credit itself is not considered taxable income to the recipient business. However, businesses claiming the ERC must reduce their deductible wage expenses by the amount of the credit received. This reduction applies to the qualified wages that were used to calculate the ERC. This rule, outlined in Section 2301 of the CARES Act, prevents businesses from receiving a double benefit by both deducting the wages as an expense and also receiving a tax credit based on those same wages.

The wage expense reduction applies to the tax year in which the qualified wages were paid, regardless of when the ERC refund was actually received. For instance, if a business paid qualified wages in 2020 and claimed the ERC for those wages, the 2020 wage deduction must be reduced, even if the ERC refund was not received until 2021 or 2022.

This adjustment means that while the credit itself is not taxed, the taxable income of the business will increase due to the lower wage deduction. Businesses that filed their original tax returns without accounting for this wage reduction may need to file amended returns to correct their reported taxable income. The Internal Revenue Service (IRS) guidance emphasizes this point for proper compliance.

California State Tax Treatment of the Employee Retention Credit

California conforms to federal law regarding the income tax treatment of the Employee Retention Credit (ERC), particularly concerning the wage expense reduction. The California Franchise Tax Board (FTB) has issued guidance clarifying that businesses in California must reduce their deductible wage expenses by the amount of the ERC received for state income tax purposes.

The FTB’s position aligns with the federal requirement, ensuring consistency between federal and state income tax reporting for the credit. Businesses operating in California that claimed the ERC are therefore required to make this adjustment when calculating their taxable income for state purposes. This includes corporations subject to the corporation tax and pass-through entities like partnerships and S corporations.

This conformity simplifies compliance for many businesses, as they do not need to navigate significantly different rules between federal and California tax codes regarding the ERC’s impact on deductible wages. Businesses should consult FTB publications or guidance for any specific nuances or updates regarding California’s tax treatment of the ERC. Failure to properly adjust wage expenses for California tax purposes could result in underreported income and potential penalties.

Accounting for and Reporting the Employee Retention Credit

Businesses must accurately reflect the impact of the Employee Retention Credit (ERC) on their financial records and tax returns. The primary accounting adjustment involves reducing the wage expense recorded in the period when the qualified wages were paid. This ensures that financial statements accurately reflect the true cost of labor after considering the credit’s benefit. For example, if a business paid $100,000 in qualified wages and received a $50,000 ERC, their deductible wage expense for that period would be $50,000.

On federal income tax returns, this wage expense reduction is reflected on the line where wage expenses are reported. For example, on Form 1120 (U.S. Corporation Income Tax Return), the amount entered for salaries and wages would be the gross wages paid minus the ERC amount. Partnerships filing Form 1065 (U.S. Return of Partnership Income) and sole proprietors filing Schedule C (Form 1040, Profit or Loss from Business) must also make this adjustment.

For California state income tax purposes, the same principle applies. Businesses will report their adjusted wage expenses on their California tax forms, such as Form 100 (California Corporation Tax Return) or Form 565 (Partnership Return of Income). The amount reported for wages or salaries should reflect the reduction for the ERC received. Maintaining detailed records of qualified wages, ERC calculations, and corresponding tax adjustments is important for audit purposes and to support reported figures.