Is the ERTC Taxable Income? How It Affects Your Taxes

The Employee Retention Tax Credit (ERTC) was a refundable tax credit for businesses that retained employees during the COVID-19 pandemic, designed to provide financial relief for qualified wages paid. While the ERTC is a credit, its receipt has a direct impact on a business’s taxable income. This credit reduces the amount of wage expenses that can be deducted for tax purposes, effectively increasing a business’s net income subject to taxation. Understanding this tax consequence is important for proper financial reporting and compliance.

Understanding ERTC Taxability

The Employee Retention Tax Credit is not treated as a direct grant or subsidy that would be reported as taxable income. Instead, its taxability arises from its effect on deductible wage expenses. Businesses typically deduct wages paid to employees as a business expense, which reduces their taxable income. When a business claims the ERTC, the amount of the credit is directly tied to qualified wages.

The IRS clarifies that qualified wages used for the ERTC cannot also be deducted as a business expense. The wage deduction must be reduced by the credit amount, which increases taxable income. This principle is outlined in IRS guidance.

The ERTC program ended for most employers on September 30, 2021, though recovery startup businesses remained eligible through December 2021. Regardless of the claim period, the fundamental tax treatment remains consistent: the wage deduction is reduced to prevent a “double benefit” – both a credit and a full deduction for the same wages.

When to Recognize ERTC Income

The ERTC impacts a business’s taxable income in the year qualified wages were paid or incurred, not necessarily when the credit is received or an amended return is filed. For accrual-basis taxpayers, the right to the credit becomes fixed when qualified wages are paid, and the wage deduction should be accounted for in that tax year.

For example, if a business paid qualified wages in 2020 and claimed the ERTC in 2023, the tax effect of reducing the wage deduction still relates back to the 2020 tax year, necessitating an adjustment to that year’s taxable income. Cash-basis taxpayers also follow this principle, aligning the income recognition effect with the year wages were paid.

Recent IRS guidance, however, provides flexibility for taxpayers who received their ERTC refund in a tax year subsequent to the year the wages were paid and did not reduce their wage expense on the original income tax return. Under this updated guidance, taxpayers are not required to amend the prior year’s return. Instead, they can include the amount of the overstated wage expense as gross income on their income tax return for the tax year the ERTC is received. This alternative approach can simplify compliance for businesses that experienced processing delays in receiving their credit.

Reporting ERTC on Tax Forms

The ERTC’s impact on taxable income is reflected indirectly through the reduction of the deductible wage expense. Businesses must reduce the qualified wages deducted on their income tax return by the amount of the ERTC received or expected to be received.

For corporations, this adjustment is made on Form 1120. Sole proprietors report this change on Schedule C (Form 1040), and partnerships reflect the adjustment on Form 1065. The specific line item for wages or salaries on these forms shows a reduced amount to account for the credit. This procedural step ensures the tax benefit from the ERTC is properly offset by an increase in taxable income.

This reporting method prevents a double tax benefit, ensuring the same wage dollars are not both the basis for a credit and a full deduction. The focus is on adjusting the wage expense deduction, which directly influences a business’s taxable profit.

Amending Prior Year Returns

Businesses that claimed the Employee Retention Tax Credit need to adjust their previously filed income tax returns. Since the ERTC reduces the wage expense deduction for the year qualified wages were paid, and many businesses filed for the credit after their original returns, an amendment is necessary to accurately reflect taxable income.

To amend a previously filed income tax return, businesses use specific forms. Corporations file Form 1120-X. Sole proprietors filing Schedule C use Form 1040-X. Partnerships amend their returns using Form 1065-X.

The amendment process involves reducing the wage expense deduction on the relevant form, which then increases the business’s taxable income for that specific prior year. However, recent IRS guidance has provided an alternative: if a taxpayer did not reduce their wage expenses on the original return and received the ERTC in a subsequent year, they are not required to amend the prior return. Instead, they can include the overstated wage expense as gross income in the year the ERTC was received. This change offers administrative relief, particularly given the time elapsed for many ERTC claims.