Is The Employee Retention Credit Taxable Income? Yes or No?

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An eligible employer receiving advance payments or a refund related to employer tax credits must also know what qualifies as gross income. Filings related to the Paycheck Protection Program (PPP) and expense disallowance, rather than those related to qualified health plan expenses or payroll taxes will help determine the answer to the question, are ERTC refunds considered taxable income or not?

Refund vs. Tax

The Employee Retention Tax Credit (ERTC) is a refundable payroll tax credit, similar in some ways to a payroll expense deduction that does not have to be paid back. The money is refunded via claims based on an eligible employer’s applicable employment taxes and qualified wages paid to W2 employees during the COVID-19 pandemic.

For the year 2020, a maximum credit of $5,000 per eligible employee is allowed, while 2021 claims can go as high as $21,000. This allows for a maximum refund amount of $26,000 per employee in tax credit reimbursements. Under the section 2301 provision of the Cares ACT, certain advance payments were made available via IRS Form 7200, but now fast ERC refunds are only available through a third-party payer.

Taxable Income

When consulting a tax professional or your normal tax preparer about yourEmployee Retention Credit (ERC) refund amount, reference IRS Notice 2020-21, FAQs 85 and 86, along with Q&A 60, and 61. The Internal Revenue Code in FAQ 86, mentions an eligible employer’s gross income on their federal income tax return should not include the refundable portion in gross earnings. However, the rules of expense disallowance regarding this fully refundable tax credit still apply.

Income Tax Return

Although ERC refund amounts are not taxable under the Internal Revenue Code §280C, the wage reduction amount pertains to the taxable year in which they were paid. This rule generally applies to companies who filed Form 7200 and received an ERC advance via withholding federal employment taxes.

Receiving a payroll tax credit or any other income tax credit in 2021 must be reflected on your 2021 federal tax return. A business that did not claim the ERC during 2020 or 2021, must file amended payroll tax returns (Form 941-x) for the years of the ERC claims and adjusting wages per employee.

For partnerships, a revised administrative adjustment request must be filed via Form 1065-x. The Form 990 series is needed for nonprofits and tax-exempt organizations while filing a Form 943-x is required for farmers and agricultural businesses.

ERC vs. PPP

The Consolidated Appropriations Act (CAA) ensured that eligible employers could apply for both the ERC and PPP loan forgiveness. In fact, loan approval qualifications closely match those required to claim the ERC credit. Eligible businesses need to pass a gross receipts test or a government orders test related to partial or full shutdowns to gain the required status for the refundable credit.

Double-dipping of qualifying employee wages related to Paycheck Protection Program (PPP) loans is not allowed. Monies received via other tax-incentive programs like the Paid Sick and Family Leave Tax Credit or Restaurant Revitalization Grant should also not be included in ERTC-eligible wages paid.

ERC Claim

The allowable tax credit per employee was substantially increased for businesses eligible to claim the employee retention credit in 2021. ERC-eligible wages paid to employees can now equal to 70% of $10,000 per qualifying quarter. While the maximum 2021 refund is $21,000 per employee, it can be claimed for up to 500 or fewer full-time employees and an unlimited number of part-time ones. When combined with a $5,000 credit from 2020, a total of $26,000 per employee can be gained from this valuable tax credit.

The Infrastructure Investment and Jobs Act, unfortunately, called for the end of the Employee Retention Credit, but even recovery startup businesses have up to three years to make a claim. If your business had a significant decline in gross receipts, this is a lot easier to prove than supply chain disruptions or difficulty with business travel or group meetings.

Recovery startups are designated as businesses that commenced operations on or after Feb 15, 2020. RSBs can also only claim a maximum of $50,000 per quarter and $100,000 total on payroll taxes paid between the third and fourth quarters of 2021.

Expense Disallowance

When considering payroll deductions, it’s essential to note that while the CARES Act introduced both the PPP and ERC; expense disallowances were filed in the same year the borrower received the funds, rather than the subsequent tax year. IRS Notice 2021-49 noted that PPP expense disallowance for the retroactively claimed 2020 and 2021

2020 Returns

Taxpayers who already filed a 2020 income tax return would thus be required to amend the 2020 business income tax return. Pass-through entities (S-corporations and partnerships) issuing amended 2020 K-1s would result in multiple shareholders and partners incurring the expense and administrative burden of filing amended 2020 personal income tax returns.

All occurrences, including those about paying taxes and qualified business income, relate to the taxpayer’s right to income or liability for payment. The 2020 ERC expense disallowance allowance also applies to 2021. On an accrual basis, recognition of income, as well as deductions, are done in the year that meets the following criteria.

2022 Provisions

You cannot take the expense disallowance in 2022 if you are just filing for the 2020 ERC this year. This is because it only applies to 2020, so any ERC-related income after 2020 cannot be deferred like was previously through Form 7200 advance payments.

Amended Returns

ERCs should be filed for the taxable year in which the qualified wages were paid. Typically, this is done via amended federal income tax returns (IRS form 941x) or administrative adjustment requests (AAR) through Form 1065-x.

The idea is that if the business fulfilled the requirements to receive ERC in the same year, it could claim expense disallowance. Note that Revenue Ruling 2020-2027 mentions that expedient expense reduction should take place in the year you earn the credit, which aligns with the Treasury Regulations §1.280C-1.

Qualified Wages

Paid qualified wages in 2020 for which employer credits were utilized and reimbursed through Employee Retention Credits are also subject to the same expense reduction rules. However, no portion of the ERC reduces the employer’s deduction for its social security and Medicare taxes paid, nor should you include the gross income credit for federal income tax purposes.

Depreciation Reduction

Although not stated in the IRS notices or FAQs, expense disallowance rules are likely to require a depreciation reduction from taxpayers of any capitalized wages included in inventory following the full absorption method of costing. You can review Treasury Regulations sections 1.280C-1 and 1.280C-3(b) for more details.

Examples

If an eligible employer receives $250,000 in ERC credits. they would need to reduce their deductible wage expenses, including the qualified health plan expense, by $250,000. This will subject it to tax for an additional $250k of income or a lower net loss.

US Tax Code

The U.S. Code § 265, Expenses and Interest Relating to Tax-exempt Income goes into great detail about how your tax credit reimbursements should be handled. § 280C tax code related to certain allowable expenses must also be taken into consideration.

FICA Tip Credit

Thankfully, IRS guidance states that tips received by employees can be counted as qualifying wages when applying for ERC credits. However, the treatment of owner wages is not very favorable.

FAQ

Below you’ll find answers to our most frequently asked questions about taxable income related to claiming employee retention credits.