What Is ERTC and How Does the Tax Credit Work?

The Employee Retention Tax Credit (ERTC) is a refundable tax credit introduced under the CARES Act in 2020 to assist businesses that retained employees during the COVID-19 pandemic. Subsequent legislation expanded its scope, providing financial relief to eligible employers.

Understanding this tax credit is crucial for businesses looking to claim it correctly. Key factors include eligibility, qualifying wages, the filing process, and maintaining proper documentation.

Eligibility Requirements

To qualify, businesses must meet specific financial and operational criteria. One requirement is a decline in gross receipts—at least 50% in a 2020 quarter compared to the same quarter in 2019, or a 20% decline in 2021. This adjustment made it easier for businesses to qualify in 2021.

Businesses could also qualify if they experienced a full or partial suspension of operations due to government mandates, including capacity limits, restricted hours, or supply chain disruptions. The IRS clarified that limitations on customer access could also meet this requirement.

Nonprofits, including churches and charitable organizations, were eligible under the same criteria. Initially, businesses that received Paycheck Protection Program (PPP) loans were ineligible, but later legislation allowed them to claim the credit as long as they didn’t use the same wages for both programs.

Qualifying Wages

The wages that count toward the credit depend on business size and when the wages were paid. In 2020, businesses with 100 or fewer full-time employees could claim the credit for all wages paid in an eligible quarter, whether employees worked or not. In 2021, this threshold increased to 500 employees.

For larger businesses exceeding these limits, only wages paid to employees who were not working due to pandemic-related disruptions qualified. Smaller businesses had more flexibility in applying the credit.

Employer-paid healthcare costs also qualified. Even if no wages were paid during a shutdown, businesses could claim the credit based on healthcare expenses. The IRS confirmed that both employer and pre-tax employee contributions to group health plans counted toward the credit.

Filing Process

Employers claim the credit through IRS Form 941, the quarterly payroll tax return. Since the credit offsets payroll taxes rather than income taxes, it must be applied through the same form used to report wages and tax withholdings. If the credit exceeds payroll taxes owed, the employer receives a refund.

Businesses that previously filed Form 941 without claiming the credit can amend returns using Form 941-X. The IRS allows amendments within three years of the original filing date, meaning businesses can still claim missed credits from 2020 and 2021.

Employers expecting to qualify in real time could reduce payroll tax deposits instead of waiting for a refund. In 2020, businesses could also request an advance payment using Form 7200, but this option was discontinued in 2021.

Amending Past Returns

Businesses that overlooked or miscalculated their credit can amend payroll tax returns within three years of the original filing date. Since the credit applies to specific quarters, businesses must identify eligible periods and ensure adjustments align with prior tax filings to avoid discrepancies that could trigger an audit.

A key challenge is adjusting payroll tax deductions. Wages used to calculate the credit must be excluded from deductible payroll expenses on an income tax return. If a business already deducted these wages, it must file an amended income tax return (such as Form 1120-X for C corporations or Form 1065 for partnerships) to correct the deduction. Failing to do so could result in overstated deductions, leading to penalties or interest charges.

Documentation Considerations

Proper record-keeping is essential for verifying eligibility and wage calculations. Without adequate records, claims may be delayed or denied during an audit.

Employers should retain payroll records, financial statements, and government orders that impacted operations. Documentation should include payroll reports for eligible quarters and proof of employer-paid health insurance costs if included in the credit calculation. Businesses qualifying due to a revenue decline must keep financial statements or tax returns demonstrating the reduction. Those qualifying based on government restrictions should retain copies of official orders and internal communications showing compliance. The IRS recommends keeping these records for at least four years from the date of filing.