Is the ERTC Taxable? The Impact on Your Wage Deductions

The Employee Retention Tax Credit (ERTC) offered a financial lifeline to businesses that retained employees during the COVID-19 pandemic. This refundable payroll tax credit helped employers offset wage costs during periods of government-mandated shutdowns or declines in gross receipts. Understanding the tax implications of receiving the ERTC is important for businesses, as it affects taxable income and reporting obligations.

Understanding ERTC Taxability

The Employee Retention Tax Credit is not considered taxable income for federal income tax purposes. It operates as a refundable payroll tax credit, meaning it can reduce a business’s payroll tax liability and even result in a refund if the credit amount exceeds the payroll taxes owed. This distinction is important because the credit is not treated as revenue that directly adds to a business’s gross income.

However, the ERTC indirectly affects a business’s taxable income by requiring an adjustment to wage expense deductions. Businesses must reduce their deductible wage expenses by the amount of the ERTC claimed. This mechanism prevents a “double benefit” where a business would both receive a credit for wages paid and deduct those same wages as an expense. This reduction in deductible expenses effectively increases a business’s net taxable income, even though the credit itself is not taxed as a direct revenue stream.

Impact on Wage Deductions

The core impact of the ERTC on a business’s tax liability stems from the requirement to reduce wage deductions. Under Internal Revenue Code Section 280C, businesses cannot deduct the portion of wages that were used to calculate the ERTC. This means if a business received an ERTC based on $100,000 of qualified wages, those specific $100,000 cannot also be claimed as a wage expense deduction on their income tax return.

This reduction in deductible wages directly increases a business’s taxable income. For instance, a sole proprietorship reporting on Schedule C (Form 1040) would see their net profit increase due to lower wage expenses. Similarly, partnerships filing Form 1065, S-corporations filing Form 1120-S, and C-corporations filing Form 1120 would all experience an increase in their respective taxable income as a result of this wage deduction adjustment. This adjustment is made for the tax year in which the qualified wages were paid or incurred, regardless of when the ERTC refund was actually received.

The IRS has provided guidance clarifying that the wage deduction must be reduced by the amount of the credit. This ensures that the financial relief provided by the ERTC is appropriately accounted for in the overall tax calculation, preventing taxpayers from receiving both a credit and a deduction for the same payroll costs.

Reporting Requirements

Reporting the ERTC’s impact on wage deductions requires specific adjustments on a business’s federal income tax return. When a business claims the ERTC, typically by filing an amended employment tax return like Form 941-X, it must reduce its wage deduction by the credit amount for the tax period the wages were paid. This often necessitates amending the corresponding income tax return for that year.

Businesses adjust wage expenses on their respective forms: Form 1120 for C-corporations, Form 1120-S for S-corporations, Form 1065 for partnerships, and Schedule C (Form 1040) for sole proprietors. The reduction applies to the tax year in which the qualified wages were paid, even if the ERTC was claimed or received in a later year. The IRS has also provided alternative approaches, allowing some taxpayers to include the overstated wage deduction as gross income in the year the ERTC refund is received, rather than amending prior-year income tax returns, especially if the statute of limitations for amendment has passed.