If you are one of the many businesses that have taken advantage of the Employee Retention Credit (ERC) or plan to, you may be wondering about the impact the ERC refund has on your income tax return. In this blog post, we review the ERC and discuss the income tax implications of receiving the credit.
Refresher on the ERC
Designed to help employers retain employees during the COVID-19 public health emergency, the ERC was initially made available to businesses that experienced full or partial suspension of operations due to government orders or who had a significant decline in gross receipts. The credit was structured so that reimbursement occurred when processing payroll.
Initially, eligible dates to claim the credit ran from March 13 to December 31, 2020. This credit was 50% of up to $10,000 in qualifying compensation, including health insurance, per employee, per year. The credit was expanded to the first three quarters of 2021 to allow 70% of employee compensation up to $10,000 per employee per quarter, with some businesses qualifying for a fourth quarter 2021 credit as well.
The rules to be eligible to take the ERC are complex. For a more detailed summary, Weinstein Spira’s blog post “Employee Retention Credit” reviews the in-depth calculations and eligibility requirements for both the 2020 and 2021 tax years.
Taxation of the ERC Refund
The ERC refund is not taxable when received. According to IRS Notice 2020-21, 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. However, the credit is subject to expense disallowance rules.
IRS Notice 2021-20, Q&A 60-61 states that rules similar to section 280C(a) of the Internal Revenue Code shall apply for purposes of applying the ERC. Section 280C(a) of the Code generally disallows a deduction for the portion of wages paid equal to the sum of certain credits determined for the taxable year. This is consistent with the IRS not allowing “double-dipping”, meaning that generally a taxpayer cannot utilize more than one tax benefit on the same expenditure.
Following these rules, a taxpayer must reduce deductible wage expense for the full amount of the ERC refund they receive.
Timing of Reporting
Determining what year the expense disallowance is reported on your income tax return is an important issue. It is clear that a taxpayer who claimed and received a 2020 ERC refund in 2020 would report the expense disallowance on their 2020 tax return by reducing wage expense for the amount of the credit received. However, there are many who received an ERC refund in 2021 or 2022 that related to 2020 or 2021 wage expense.
IRS Notice 2021-34 emphasized that expense disallowance occurs in the year the qualifying wages are paid or incurred, not the year in which the ERC is claimed or received. Thus, wages giving rise to the 2020 ERC are disallowed in 2020, and wages giving rise to the 2021 ERC are disallowed in 2021. This will cause many taxpayers to have to file amended tax returns or administrative adjustment requests if they already filed their income tax returns without reducing wage expense for the credit.
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Can I still apply for the ERC?
Going forward, the only way to receive an ERC refund is by filing an amended Form 941-X for each quarter that you are eligible. The deadline for filing an amended return is three years from the date of the original Form 941 filing. That means that if businesses have not yet applied for the ERC for 2020 or 2021, there is still time to take advantage of this credit that can result in substantial tax savings.