What Counts as Wages for the Retention Credit?
Understand which types of employee compensation qualify as wages for the Employee Retention Credit and how they impact tax calculations and filings.
The Employee Retention Credit (ERC) was introduced to help businesses keep employees on payroll during economic disruptions. A key factor in determining eligibility and the credit amount is understanding what qualifies as wages. Misclassifying compensation can lead to incorrect claims, affecting tax liability.
Not all employee pay counts toward the credit, so distinguishing between eligible and excluded wages ensures accurate claims and compliance with IRS guidelines.
Qualifying Employers
A business qualifies for the ERC if it experiences a significant decline in gross receipts or faces operational restrictions due to government orders.
A decline in gross receipts is measured by comparing quarterly revenue to 2019. In 2020, a business qualified if gross receipts fell by more than 50% compared to the same quarter in 2019. In 2021, the threshold was lowered to a 20% decline. Once eligible, a business remained so until the quarter after gross receipts recovered to at least 80% of 2019 levels.
Businesses affected by government-mandated restrictions could also qualify. A full or partial suspension of operations had to significantly limit the company’s ability to provide goods or services. For example, a restaurant forced to close indoor dining but allowed to offer takeout could qualify if the restriction substantially reduced revenue.
Types of Compensation
Qualified wages for the ERC include more than an employee’s base salary or hourly pay. Compensation subject to Social Security and Medicare taxes under IRS rules counts toward the credit, including employer-paid health plan expenses, bonuses, and hazard pay.
Employer-paid health plan expenses qualify even if no wages were paid during a furlough or temporary leave. The full cost of maintaining a group health plan—including both the employer’s contribution and the portion paid by employees through pre-tax salary reductions—can be counted.
Bonuses and hazard pay qualify if they are subject to payroll taxes and were provided during the ERC period. This was relevant for businesses offering extra compensation to employees working under difficult conditions, such as healthcare workers or essential retail staff. However, severance pay and post-employment compensation do not qualify.
Tax Credit Calculation
The ERC amount depends on wages paid during eligible periods and the maximum credit per employee.
In 2020, the credit was 50% of qualified wages, up to $10,000 per employee for the year, with a maximum credit of $5,000 per worker. In 2021, the credit increased to 70% of qualified wages per quarter, capped at $10,000 per employee each quarter. This allowed businesses to claim up to $7,000 per employee per quarter for the first three quarters of 2021, totaling a potential $21,000 per worker.
Employer size affected how wages were counted. In 2020, businesses with 100 or fewer full-time employees could claim the credit on wages paid to all employees, whether working or not. In 2021, this threshold increased to 500 employees. Larger employers could only claim the credit for wages paid to employees who were not providing services.
Overlapping Government Incentives
Businesses claiming the ERC had to coordinate with other relief programs, particularly the Paycheck Protection Program (PPP). Initially, wages used for PPP loan forgiveness could not be used for ERC claims. However, a legislative change allowed businesses to use both programs as long as the same wages were not applied to both benefits. Careful payroll allocation was necessary to maximize the ERC while maintaining full PPP loan forgiveness.
The Work Opportunity Tax Credit (WOTC) also overlapped with the ERC. Since both credits applied to wages, businesses had to ensure the same wages were not claimed under both programs. IRS guidance clarified that wages used for WOTC could not be included in ERC calculations, making accurate payroll records essential.
Filing and Documentation
To claim the ERC, businesses must maintain records proving eligibility and wage calculations. Required documentation includes payroll records, financial statements, and evidence supporting qualification, such as revenue comparisons or government orders affecting operations. These records must differentiate between wages used for the ERC and those allocated to other relief programs.
Employers claim the ERC on Form 941, the Employer’s Quarterly Federal Tax Return. Businesses that did not initially claim the credit can file Form 941-X to apply retroactively. Amendments are allowed for up to three years from the original filing date, giving businesses time to recover missed credits. Due to the complexity of ERC claims, many businesses consult tax professionals to ensure compliance and optimize filings.
Reconciliation on Returns
Once a business claims the ERC, it must adjust its tax filings accordingly. Since the credit reduces deductible wage expenses, companies must reflect this on their income tax returns. Wages used for the ERC cannot be deducted as payroll expenses, preventing a double tax benefit.
If a business claimed the ERC after filing its income tax return, an amended return may be necessary to correct the wage deduction. This adjustment is reported on Form 1120 for corporations or Form 1065 for partnerships. Failure to reconcile the credit properly can lead to IRS scrutiny, penalties, and interest on underpaid taxes. Businesses following Generally Accepted Accounting Principles (GAAP) should also consider how ERC-related adjustments affect financial statements.