Is the Employee Retention Credit Taxable Income?

The Employee Retention Credit (ERC) was a refundable tax credit established to assist businesses that maintained employees during the COVID-19 pandemic. Businesses that experienced a full or partial suspension of operations due to government orders or a significant decline in gross receipts were eligible to claim the ERC. While the ERC offsets payroll tax liabilities, its interaction with income tax deductions for wages creates specific considerations for businesses.

Understanding ERC Taxability

The Employee Retention Credit itself is not considered taxable income. This means that when a business receives an ERC refund, the cash received is not directly added to its gross income for tax calculation purposes. The ERC functions as a credit against payroll taxes, not as a direct revenue stream that is subject to income tax.

Despite the ERC not being taxable income, it impacts a business’s income tax liability through a different mechanism. Businesses generally cannot “double-dip” by both claiming a tax credit for wages and simultaneously deducting those same wages as a business expense. This rule, rooted in principles similar to Internal Revenue Code Section 280C, requires a reduction in the deductible wage expense by the amount of the ERC.

This wage expense reduction applies to the tax year in which the qualified wages were paid or incurred, not necessarily when the ERC refund is received. This prevents businesses from gaining two tax benefits from the same payroll costs. Businesses may still deduct their share of Social Security and Medicare tax contributions.

Impact on Business Taxable Income

The reduction in deductible wage expenses directly increases a business’s taxable income. When deductible wages are lowered by the ERC amount, net income subject to tax rises. This means a portion of the ERC’s financial benefit is recouped through higher income taxes.

For example, a business with $500,000 in revenue and $300,000 in payroll expenses that claims a $100,000 ERC must reduce its deductible payroll expenses by $100,000. This means only $200,000 of the original expenses can be deducted, leading to higher taxable income.

This impact applies to various business structures, including sole proprietorships, partnerships, and corporations. A reduced wage deduction translates to higher net profit for sole proprietorships, increased ordinary business income for partnerships, and higher taxable income for corporations.

Reporting ERC on Tax Returns

Businesses must reflect the reduced wage expense on their federal income tax returns for the year the qualified wages were paid. This procedural adjustment ensures compliance with tax rules that prevent “double-dipping”. The specific forms and lines affected depend on the business entity type.

For corporations, the adjustment to wage expenses is typically made on Form 1120, U.S. Corporation Income Tax Return, on the line designated for salaries and wages. Similarly, S-corporations would reduce their wage expense on Form 1120-S, U.S. Income Tax Return for an S Corporation, often on lines 7 and 8. The reduced amount should align with the wages claimed for the ERC.

Partnerships and limited liability companies (LLCs) taxed as partnerships report their reduced wage expense on Form 1065, U.S. Return of Partnership Income, generally on line 9. Sole proprietors, who report their business income and expenses on Schedule C (Form 1040), Profit or Loss from Business, would also reduce their deductible wage expense on this form. It is important to maintain detailed records of qualified wages and health plan expenses to support the credit claim and the corresponding wage reduction.

Considerations for Amended Returns and Timing

Businesses often claimed the ERC retroactively, which frequently necessitated filing amended income tax returns. The wage expense reduction relates to the tax year in which the wages were paid, not the year the ERC refund was received. This means if a business paid qualified wages in 2020 but claimed the ERC in 2023, the wage deduction for 2020 would need to be adjusted.

Historically, businesses would file an amended income tax return, such as Form 1120-X for corporations, Form 1040-X for individuals (including sole proprietors), or Form 1065-X for partnerships, to reflect the reduced wage expense for the prior year. However, recent guidance from March 20, 2025, provides flexibility. If a business did not reduce its wage expense on its original return and received the ERC refund in a subsequent year (e.g., 2024 for 2021 wages), it is now generally not required to amend the prior-year return. Instead, the business can include the ERC refund amount as gross income on its income tax return for the year the credit was received.

This updated guidance simplifies compliance for many businesses, especially if the statute of limitations for amending the original tax year has passed. If an ERC claim is later disallowed after a wage expense reduction was made, businesses may increase their wage expense on the return for the year the disallowance becomes final. This approach aims to prevent the need for additional amended returns or protective claims.