Is the Employee Retention Credit Taxable Income?

The Employee Retention Credit (ERC) provided financial relief to businesses that continued to pay employees during the COVID-19 pandemic. This refundable payroll tax credit helped many employers navigate economic challenges by offsetting a portion of their wage costs. While the ERC is not directly included in gross income, it generally impacts a business’s taxable income by requiring an adjustment to wage expense deductions.

Tax Treatment of the Employee Retention Credit

The Employee Retention Credit is not treated as taxable income. Instead, its tax impact arises from a required reduction in the amount of qualified wages a business can deduct for federal income tax purposes. This effectively increases a business’s taxable income by disallowing a corresponding wage expense deduction. This treatment is outlined in Internal Revenue Service (IRS) guidance, including Notice 2021-20 and Notice 2021-49.

This adjustment is rooted in the principle that a business cannot receive a tax credit and also claim a deduction for the same expenses, often referred to as “double-dipping.” Internal Revenue Code Section 280C requires taxpayers to reduce their deductible expenses by the amount of certain credits received. For the ERC, this means the wage expenses used to calculate the credit must be reduced, which increases the business’s taxable income.

Impact on Wage Expense Deductions

Businesses that claimed the Employee Retention Credit are required to reduce their deductible wage expenses by the amount of the credit. This reduction applies to the qualified wages for which the credit was calculated. For example, if a business paid $100,000 in qualified wages and received a $70,000 ERC, its deductible wage expenses would be reduced by $70,000. This adjustment ensures that the portion of wages effectively reimbursed by the credit is not also deducted as a business expense.

The wage expense reduction generally applies to the tax year in which the qualified wages were paid or incurred. This means that even if the credit was received in a later year, the income tax impact relates back to the year the wages were originally paid. This accounting adjustment can lead to a higher taxable income for that specific year, as the available deductions are decreased.

Timing of Credit Inclusion

The timing of when the ERC’s impact is recognized for income tax purposes depends on a business’s accounting method. For accrual basis taxpayers, the credit’s effect on wage deductions is generally recognized in the tax year the qualified wages were paid or incurred, provided the right to the credit became fixed and determinable in that year. This is true even if the actual credit payment from the IRS was received in a subsequent tax year. Accrual basis accounting aims to match expenses with the revenues they help generate, so the reduction in wage expense aligns with when those wages were incurred.

For cash basis taxpayers, the income tax impact of the ERC is typically recognized in the tax year the credit is actually received. However, recent IRS guidance, issued on March 20, 2025, provides an alternative for certain situations. If a taxpayer claimed the ERC but did not reduce their wage expenses on their income tax return for the year the wages were paid, and they received the ERC in a subsequent year, they are not required to amend the prior year’s return. Instead, they can include the overstated wage expense amount as gross income on their income tax return for the year in which they received the ERC. This flexibility can simplify compliance for businesses that received ERC payments long after the original tax year.

Amending Prior Tax Returns

For many businesses that claimed the Employee Retention Credit, amending prior income tax returns may be necessary to properly reflect the reduced wage expense deduction. If the original income tax return for the year qualified wages were paid was filed before the ERC was claimed or its tax implications were fully understood, an amendment is typically required. This involves filing an amended return for the relevant tax year to reduce the previously deducted wage expenses by the amount of the ERC.

The specific form used for amendment depends on the business entity type. Corporations generally file Form 1120-X, Amended U.S. Corporation Income Tax Return. Individuals or sole proprietors use Form 1040-X, Amended U.S. Individual Income Tax Return. Partnerships typically amend with Form 1065, U.S. Return of Partnership Income, often accompanied by an Administrative Adjustment Request (AAR).