Is the Employee Retention Credit Taxable Income?

The Employee Retention Credit (ERC) was established to assist businesses that retained employees during the COVID-19 pandemic. This refundable tax credit provided financial relief to eligible employers by offsetting certain payroll taxes. While the ERC is a beneficial program, its tax treatment can be a source of confusion for many business owners. The Employee Retention Credit itself is not considered taxable income. However, claiming the credit does impact a business’s taxable income indirectly. This occurs because the amount of qualified wages used to calculate the credit must reduce the deductible wage expenses on the business’s federal income tax return. This adjustment effectively increases taxable income, leading to a higher tax liability.

Understanding the Taxable Nature

The ERC’s taxability arises from a required reduction in the wage expense deduction, preventing businesses from “double dipping” by claiming a credit for wages and also deducting those same wages. The Internal Revenue Service (IRS) clarifies this through official guidance, including Notice 2021-20 and Notice 2021-49. These IRS notices emphasize that the reduction in deductible wage expense applies to the tax year in which the qualified wages were paid, not necessarily when the credit is actually received. For instance, if a business received a $10,000 ERC, their taxable income would effectively increase by $10,000 because their deductible wage expenses would be reduced by that amount. This rationale prevents a double benefit, ensuring the credit aligns with general tax principles regarding expense deductibility.

Adjusting Business Deductions

Businesses claiming the ERC must reduce their total wage deduction by the amount of qualified wages used to calculate the credit. This adjustment directly influences a business’s financial statements and its ultimate taxable income. The impact of this wage reduction varies depending on the business structure, flowing through to C-corporations, S-corporations, partnerships, and sole proprietorships. From an accounting perspective, the wage reduction is typically treated as a decrease in either cost of goods sold or operating expenses, depending on how the wages are classified. Maintaining accurate payroll records and reconciling them with tax filings helps ensure the correct wage expense reduction is made. The reduction applies to the tax year the wages were paid, even if the ERC refund is received in a later tax year. However, recent IRS guidance provides flexibility, allowing some taxpayers to include the overstated wage expense as gross income in the year the ERC is received if prior year returns were not amended.

Reporting the Credit on Tax Forms

Reporting the Employee Retention Credit and its corresponding wage expense adjustment requires careful attention to specific federal income tax forms, with the particular forms impacted depending on the business’s legal structure.

For C-corporations, the adjustment affects Form 1120. S-corporations report these changes on Form 1120-S. Partnerships utilize Form 1065 for their reporting. Sole proprietors, who typically report their business income and expenses on Schedule C (Form 1040), will reflect the wage reduction on that schedule.

The qualified wage expense is reduced on the appropriate line item for wages or salaries on these forms.

If the ERC was claimed for prior periods after the initial income tax return was filed, businesses generally need to file an amended income tax return to reflect the reduced wage deduction.

For claiming the ERC itself, businesses typically use Form 941-X, Adjusted Employer’s Quarterly Federal Tax Return or Claim for Refund. Businesses should maintain thorough documentation of all qualified wages and ERC calculations to support their tax filings.