Is the ERC Credit Taxable? How It Impacts Your Business

The Employee Retention Credit (ERC) was a government initiative designed to support businesses that retained employees during the economic disruptions of the COVID-19 pandemic. This refundable tax credit provided financial relief to eligible employers, encouraging them to maintain payroll. Understanding the tax implications of receiving the ERC is important for accurate financial reporting and compliance.

Taxability of the ERC Credit

The Employee Retention Credit itself is not taxable income. Instead, the ERC impacts a business’s taxable income by reducing the amount of qualified wages deductible for federal income tax purposes. This adjustment is based on Internal Revenue Code Section 280C, which prevents businesses from claiming both a credit and a deduction for the same wages.

IRS guidance, including Notice 2021-20 and Notice 2021-49, clarifies that businesses must reduce their deductible wage expenses by the ERC amount claimed. This reduction applies to the tax year in which the qualified wages were paid or incurred, regardless of when the credit was received. For example, if a business claimed the ERC for wages paid in 2020 or 2021, the wage deduction for that tax return must be reduced.

For accrual method taxpayers, the wage expense reduction is recognized in the period wages were incurred, even if the ERC payment arrives later. Cash basis taxpayers recognize income and expenses when cash is exchanged, but for ERC, the wage expense reduction still relates to the period wages were paid. Recent IRS FAQs, updated March 20, 2025, offer an alternative: taxpayers who did not reduce their wage expense in the original year can include the overstated wage expense as gross income in the tax year the ERC was received.

Impact on Business Tax Returns

Reducing deductible wage expenses directly affects a business’s taxable income. Lowered wage deductions increase the business’s net income for tax purposes, potentially leading to a higher tax liability. This adjustment prevents businesses from benefiting twice from the same wages—once as a deductible expense and again as a refundable credit.

For corporations, this adjustment impacts Form 1120, U.S. Corporation Income Tax Return. S-corporations report this on Form 1120-S. Partnerships reflect the change on Form 1065, U.S. Return of Partnership Income. Sole proprietors report their business income and expenses on Schedule C, Profit or Loss from Business, which is part of their individual Form 1040.

The increased taxable income from the reduced wage deduction must be accurately reflected on the appropriate tax form for the year the qualified wages were paid or incurred. This can lead to a recalculation of tax owed for that period. Businesses should maintain thorough documentation to support the ERC claim and corresponding adjustments.

Amending Prior Tax Returns

Businesses that claimed the ERC after filing their original tax returns for the affected years will need to amend those prior returns to reflect the reduced wage expense. This ensures compliance with IRS guidance on the taxability of the ERC.

The specific form used for amendment depends on the business entity structure.

Corporations file Form 1120-X to correct a previously filed Form 1120. Partnerships use Form 1065-X to correct errors on a previously filed Form 1065. Individuals who filed Schedule C for their sole proprietorship or single-member LLC would use Form 1040-X to make the necessary adjustments to their personal tax return.

The amendment process involves identifying the specific tax year impacted by the ERC, calculating the adjustment to the wage expense deduction, and completing the relevant amended return form. These forms require taxpayers to show the amounts as originally reported, the corrected amounts, and the changes being made. It is advisable to submit these amended returns with supporting documentation related to the ERC claim and the recalculation of taxable income.