Is the ERC Tax Credit Considered Taxable Income?

The Employee Retention Credit (ERC) was a refundable tax credit established to encourage businesses to retain employees during the economic disruptions caused by the COVID-19 pandemic. Introduced under the Coronavirus Aid, Relief, and Economic Security (CARES) Act in March 2020, its primary purpose was to help eligible employers cover a portion of their payroll costs. The credit was available to businesses that experienced a full or partial suspension of operations due to government orders or a significant decline in gross receipts.

How the ERC Affects Taxable Income

The Employee Retention Credit itself is not considered taxable income, meaning it does not directly increase a business’s gross income. Instead, the mechanism by which the ERC impacts a business’s tax liability is through a required reduction in the amount of wage expenses that can be deducted for federal income tax purposes. This adjustment prevents a business from receiving a “double benefit” by both claiming the credit and fully deducting the wages that generated that credit.

Specifically, the amount of qualified wages used to calculate the ERC must be reduced by the credit amount. For example, if a business received a $100,000 ERC, its deductible payroll expenses would decrease by that same $100,000. This reduction effectively increases the business’s net taxable income, as a smaller deduction leads to a higher amount of income subject to tax. This treatment is mandated by rules similar to Internal Revenue Code Section 280C, which disallows a deduction for expenses equal to certain credits.

IRS guidance clarifies this wage expense reduction. Notice 2021-20, for instance, details the initial ERC provisions and their interaction with other relief programs like the Paycheck Protection Program (PPP), emphasizing that wages used for PPP loan forgiveness cannot also be used for ERC.

Timing for Tax Reporting

The reduction in deductible wage expenses must be accounted for in the tax year in which the qualified wages were paid or incurred, not in the year the ERC is actually received. This principle applies regardless of whether the business uses the cash or accrual method of accounting. For example, if a business paid qualifying wages in 2020 that generated an ERC, the wage expense deduction for its 2020 income tax return must be reduced by the credit amount, even if the ERC refund was not received until 2023 or 2024.

This timing can create complexities, particularly for businesses that filed their original tax returns before claiming the ERC retroactively. The IRS has recently provided some flexibility, stating that if a taxpayer claimed the ERC but did not reduce wage expenses for the year the wages were incurred, and then received the ERC in a subsequent year, they can include the overstated wage expense as gross income in the year they received the ERC. This alternative can simplify compliance for businesses that received refunds well after the qualifying periods.

Accounting for the Credit

Recording the Employee Retention Credit on financial statements differs from its tax treatment. For financial reporting purposes, businesses must apply generally accepted accounting principles (GAAP). While specific GAAP guidance for the ERC was not initially provided, businesses typically account for it as a government grant. This approach means the credit should be recognized as income or a reduction of expense on the income statement once the eligibility conditions are met and the credit is deemed realizable.

For-profit entities may treat the ERC as a gain contingency, recognizing it as other revenue on the income statement once uncertainties regarding its receipt are resolved. Not-for-profit entities typically recognize the ERC as a conditional contribution, with revenue recognized as conditions are met. Regardless of the chosen method, the financial statement presentation should clearly reflect the nature of the credit and its impact on the business’s financial position and performance.

Impact on Amended Tax Filings

Many businesses claimed the Employee Retention Credit retroactively for prior tax years, necessitating adjustments to previously filed income tax returns. The requirement stems from the need to reflect the reduced wage expense deduction in the tax year the qualified wages were paid. For C corporations, this typically involves filing Form 1120-X, Amended U.S. Corporation Income Tax Return. Partnerships and multi-member LLCs generally amend Form 1065, U.S. Return of Partnership Income, and issue corrected Schedules K-1 to partners. Sole proprietors and single-member LLCs report business income on Schedule C of their personal Form 1040, and thus amend their individual returns using Form 1040-X.

The amended return specifically adjusts the wage expense line item to reflect the ERC amount, thereby increasing taxable income for that prior year. Businesses that had already reduced their wage expenses on prior returns and later had their ERC claim disallowed can now increase their wage expense in the year the disallowance becomes final, offering a pathway to reclaim the deduction.