What Is the Nonrefundable Portion of Employee Retention Credit?

The Employee Retention Credit (ERC) was a federal relief program designed to support businesses during the COVID-19 pandemic. Its objective was to incentivize employers to retain employees on their payrolls. Understanding this credit, particularly its nonrefundable component, is important for businesses that claimed or are considering amending past filings to claim this benefit.

Understanding Refundable and Nonrefundable Credits

Tax credits generally reduce the amount of tax owed, but they operate in two distinct ways: nonrefundable and refundable. A nonrefundable tax credit can lower a taxpayer’s tax liability to zero, but it cannot generate a refund beyond that amount. For instance, if a business owes $800 in taxes and qualifies for a $1,000 nonrefundable credit, the tax liability is reduced to $0, but the remaining $200 of the credit is forfeited.

In contrast, a refundable tax credit can reduce a taxpayer’s liability below zero, resulting in a direct payment or refund. If that same business had a $1,000 refundable credit against an $800 tax liability, the $800 tax would be eliminated, and the business would receive a $200 refund. This distinction determines whether an excess credit amount translates into a cash payment or merely offsets existing tax obligations.

The Employee Retention Credit Framework

The Employee Retention Credit originated from the CARES Act in March 2020 and was later expanded. This credit aimed to help businesses keep their workforce employed during periods of government-mandated shutdowns or significant declines in gross receipts. The ERC was a credit against certain employment taxes, and its availability and amount depended on specific criteria and the period for which it was claimed.

Eligible employers included those whose operations were fully or partially suspended due to government orders related to COVID-19, or those who experienced a significant decline in gross receipts. For 2020, a significant decline meant gross receipts were less than 50% of the same quarter in 2019. For 2021, this threshold was adjusted to a decline of less than 80% compared to the same 2019 quarter. The credit was generally based on qualified wages paid to employees, including certain health plan expenses.

The Nonrefundable Aspect of the ERC

While the Employee Retention Credit is often referred to as a “refundable” credit overall, it contained both nonrefundable and refundable components. The nonrefundable portion of the ERC was applied against the employer’s share of certain payroll taxes. For most periods, this primarily involved the employer’s 6.2% share of Social Security taxes. For wages paid after June 30, 2021, the nonrefundable portion shifted to be applied against the employer’s 1.45% share of Medicare taxes.

This nonrefundable part could reduce the employer’s liability for these specific payroll taxes to zero. For example, if an employer’s share of Social Security tax for a quarter was $5,000, and the calculated ERC was $7,000, the first $5,000 of the credit would be considered the nonrefundable portion. This amount would offset the $5,000 Social Security tax liability. Any credit amount exceeding this specific payroll tax liability for the quarter was then considered the refundable portion, which could result in a direct refund to the employer.

The term “nonrefundable” in this context indicated that this segment of the credit could not reduce the employer’s payroll tax liability below zero for the specific taxes it was designed to offset. However, if an eligible business had already paid its Social Security tax share through federal deposits, the “nonrefundable” part of the ERC effectively became recoverable. This meant that even the portion initially classified as nonrefundable could ultimately be received by the employer if it had already been remitted.

Reporting the Nonrefundable Portion

Employers reported the Employee Retention Credit, including its nonrefundable portion, on Form 941, Employer’s Quarterly Federal Tax Return. If a business needed to claim the credit retroactively or correct a previously filed return, it would use Form 941-X, Adjusted Employer’s Quarterly Federal Tax Return or Claim for Refund.

On Form 941-X, the nonrefundable portion of the ERC was reported on specific lines, such as line 18a, which reduced the employer’s share of Social Security tax reported elsewhere on the form. The refundable portion was reported separately, on line 26a. Employers would often reduce their employment tax deposits in anticipation of receiving the credit. When filing Form 941-X, employers were instructed to use worksheets provided in the form’s instructions to accurately calculate and separate the nonrefundable and refundable components of the credit. Claiming the ERC required employers to reduce their deduction for wages on their income tax returns by the amount of the credit.