What Is the Non-Refundable Portion of Employee Retention Credit?

Understanding Tax Credits

Tax credits directly reduce the amount of tax owed, offering a dollar-for-dollar reduction in a taxpayer’s liability. These credits differ fundamentally from tax deductions, which only reduce the amount of income subject to tax. The impact of a credit varies significantly based on whether it is refundable or non-refundable, determining if a taxpayer can receive money back beyond their initial tax obligation.

Non-refundable tax credits can reduce a taxpayer’s tax liability to zero, but they cannot create a refund. If the amount of the non-refundable credit exceeds the tax owed, the excess credit is lost and does not result in a payment to the taxpayer. Examples include the credit for child and dependent care expenses or certain education credits. They alleviate a tax burden up to the point of no liability.

Conversely, refundable tax credits have the potential to reduce a taxpayer’s tax liability below zero, leading to a direct payment or refund from the government. If a refundable credit’s value is greater than the tax owed, the taxpayer receives the difference as a refund check. The Earned Income Tax Credit and the Premium Tax Credit are common examples, providing financial assistance even if no tax was initially due. Understanding this difference is fundamental to comprehending how various tax relief measures, including the Employee Retention Credit, are applied.

Applying the Employee Retention Credit

The Employee Retention Credit (ERC) was established as a refundable tax credit to encourage businesses to keep employees on their payroll during the COVID-19 pandemic. While the ERC is ultimately a refundable credit, its application involves a specific order that creates a “non-refundable portion” by initially applying against certain payroll tax liabilities.

The credit is first applied to offset the employer’s share of Social Security tax. This portion, which reduces the employer’s payroll tax liability, is the “non-refundable portion” of the ERC. For instance, in 2020, the employer’s share of Social Security tax was 6.2% of wages up to the annual wage base limit. The ERC would first reduce this tax obligation.

Any ERC amount exceeding the employer’s share of Social Security tax for a given quarter becomes the refundable portion, potentially resulting in a direct payment. For example, if a business had an ERC of $10,000 and its employer’s Social Security tax was $3,000, the first $3,000 would offset that tax, while the remaining $7,000 would be fully refundable. This mechanism provided significant financial relief.

The ERC calculation was based on qualified wages paid to employees, including certain qualified health plan expenses. For 2020, the credit was 50% of up to $10,000 in qualified wages per employee, maxing out at $5,000 per employee. In 2021, the credit increased to 70% of up to $10,000 in qualified wages per employee per quarter, potentially allowing up to $7,000 per employee per quarter. These differences affected the total credit amount available.

The credit’s interaction with the employer’s Social Security tax liability meant businesses could benefit from the ERC even with no income tax liability. If the credit was less than the employer’s Social Security tax, it would fully offset that tax. If greater, the excess was refunded, providing cash flow. This structure provided broad relief, directly supporting businesses through wage subsidies.

Claiming the Credit

Businesses primarily claimed the Employee Retention Credit by making adjustments on their employer’s quarterly federal tax returns. The main form used for this purpose was IRS Form 941, Employer’s Quarterly Federal Tax Return. On this form, businesses reported total wages, tips, compensation, federal income tax withholding, and Social Security and Medicare taxes.

The ERC was reported on specific lines of Form 941. The non-refundable portion, offsetting the employer’s Social Security tax, was included in tax liability adjustments. The refundable portion, which could lead to a direct payment, was reported separately. This distinction allowed the IRS to track credit application.

Businesses that did not initially claim the ERC or made errors could claim it retroactively by filing an amended return, IRS Form 941-X, Adjusted Employer’s Quarterly Federal Tax Return or Claim for Refund. This form allowed employers to correct errors or adjust previously filed Forms 941, including claiming the ERC.

When filing Form 941-X, businesses detailed changes to their original tax liability and the ERC amount claimed. The form required entries for the non-refundable portion, which reduced the employer’s Social Security tax, and the refundable portion, which could result in a refund. Generally, claims for refund or credit had to be filed within three years from the original return’s filing date or two years from the tax payment date, whichever was later.

Businesses received the credit through reduced federal tax deposits or as a direct refund check. If a business anticipated the credit, it could reduce federal employment taxes deposited. If the credit exceeded current tax deposits or was claimed retroactively via Form 941-X, the IRS would issue a refund. This dual approach provided flexibility for businesses to access the credit.