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, is ERTC taxable income or not?
Refund vs. Tax
The Employee Retention Tax Credit (ERTC) is a refundable payroll tax credit that does not have to be paid back. The money is refunded via claim 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 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.
According to the Internal Revenue Code found in IRS Notice 2020-21, FAQs 85 and 86, along with Q&A 60, and 61 provide further clarity on how to properly file an employer’s gross income amount.
IRS guidance in FAQ 86, states that eligible employers for the Employee Retention Credit (ERC) are told not to include the refundable portion in gross earnings on their federal income tax return. The rules of expense disallowance regarding this fully refundable tax credit, however, 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 in 2021 is reflected on the 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.
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 a Form 943-x is required for farmers and agricultural businesses.
ERC vs. PPP
The Consolidated Appropriations Act (CAA) ensured that qualifying businesses could apply for both the ERC and PPP loan forgiveness. In fact, loan approval qualifications closely match those required to claim the ERC credit. Passing a gross receipts test or a government orders test related to partial or full shutdowns, however, is still required t gain eligible employer status for the refundable credit.
Double-dipping of qualifying employee wages related to Paycheck Protection Program (PPP) loans is definitely not allowed. Monies received via other tax-incentive programs like the Paid Leave and Family Tax Credit or Restaurant Revitalization Grant should also not be included in ERTC-eligible wages paid.
The ERC’s allowable tax credit per employee was substantially increased in 2021. Businesses are now able to claim wages paid 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 grand 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.
When 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
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.
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 meet the following criteria. All occurrences relating to the taxpayer’s right to income or liability for payment take place, and, you can decide the amount with flawless accuracy.
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.
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.
in 2020 that were reimbursed through Employee Retention Credits are also subject to the same expense reduction rules, but it does not include the gross income credit for federal income tax purposes. No portion of the ERC reduces the employer’s deduction for its social security and Medicare taxes either.
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.
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.
Below you’ll find answers to our most frequently asked questions about taxable income related to claiming employee retention credits.
Yes, and no. You should not include your ERC refund in gross income; but when following expense disallowance rules, it is taxable. Check out Notice 2020-21, IRS FAQs 85 and 86, and Q &As 60-61 for more info on ERTC taxable income.
No, you must make an ERC claim or have applied for an advance credit from the IRS through tax withholding for this to be declared as taxable income. Large and small business owners can also still apply for an ERTC refund via a 941x form (Adjusted Employer’s Quarterly Federal Tax Return) for up to three years from their original calendar quarter filing date.
Yes, amendments to individual income tax returns (Form 1040) may be required when a business they invest in, sends out another amended K-1 due to ERC wage disallowance.