Many taxpayers have spent the past year reviewing eligibility and filing refund claims for the Employee Retention Credit (“ERC”). The popular tax credit enacted by the CARES Act in March 2020 gave many businesses impacted by COVID-19 the opportunity to file payroll tax refund claims for a much-needed infusion of cash to keep their businesses running. Now, as we begin the 2021 tax filing season, those businesses are wondering about the income tax treatment of the ERC. The biggest question is – is the ERC refund income? And if so, when?
On March 1, 2021, the Internal Revenue Service (“IRS”) issued guidance in question and answer format in IRS Notice 2021-20 for employers claiming the ERC. As part of that guidance, the IRS included the following two questions and answers regarding the income tax treatment of the ERC:
Question 60: Does the employee retention credit reduce the expenses that an eligible employer could otherwise deduct on its federal income tax return?
- Answer 60: Section 2301(e) of the CARES Act provides that rules similar to section 280C(a) of the Code shall apply for purposes of applying the employee retention credit. Section 280C(a) generally disallows a deduction for the portion of wages or salaries paid or incurred equal to the sum of certain credits determined for the taxable year. Accordingly, a similar deduction disallowance applies under section 2301(e) of the CARES Act with regard to the employee retention credit, such that an employer’s deduction for qualified wages, including qualified health plan expenses, is reduced by the amount of the employee retention credit. (An employer does not, however, reduce its deduction for the employer’s share of social security and Medicare taxes by any portion of the credit).
Question 61: Does an eligible employer receiving an employee retention credit for qualified wages need to include any portion of the credit in income?
- Answer 61: An employer receiving a tax credit for qualified wages, including allocable qualified health plan expenses, does not include the credit in gross income for federal income tax purposes. Neither the portion of the credit that reduces the employer’s applicable employment taxes, nor the refundable portion of the credit, is included in the employer’s gross income.
Based on this guidance, it is clear that the ERC is not included in a taxpayer’s income. However, a taxpayer must reduce its wage expense for the ERC, effectively increasing taxable income by the amount of the credit.
In regards to the timing of this adjustment, the IRS addressed this question in Notice 2021-49 issued in August 2021. The guidance explains that the reduction in the amount of the deduction for qualified wages caused by receipt of the ERC occurs for the tax year in which the qualified wages were paid or incurred. Therefore, if a taxpayer claims the ERC for wages paid during 2021, the wage expense on the 2021 federal income tax return must be reduced. If an ERC refund claim is filed in 2022 for eligible wages paid in 2020, the 2020 federal income tax return should be amended to correct the overstated 2020 deduction. Notice 2021-49 goes on to state that section 280C(a) requires tracing to the specific wages generating the applicable credit.
Article written by:
Sara Goldhardt, CPA
Director, State & Local Tax Services