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Understanding The Income Tax Treatment Of The Employee Retention Credit

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 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 how do I account for it?

The ERC itself is not taxable income. However, a taxpayer may have to reduce its wage expense for the corresponding tax year 2020/2021.

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 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.

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.

Taxpayers should consult with their tax professional for assistance in order to take advantage of the ERC and apply the proper tax treatment.

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