The Employee Retention Credit (ERC) was first introduced in the Coronavirus Aid, Relief and Economic Security (CARES) Act on March 27, 2020. The ERC provisions have been subsequently modified by both the Consolidated Appropriations Act of 2021 (CAA) and the Infrastructure Investment and Jobs Act (IIJA). Since the ERC was not widely used in 2020, there has not been significant discussion of its impact on income tax reporting.
The credit’s 2021 expansion is now bringing some of these issues to light at the start of the filing season for the 2021 tax year. Key considerations include:
- The taxation of ERC credits and wages
- The timing for inclusion of ERC-related items on income tax returns
TAXATION OF ERC
The ERC refund is not taxable when received, however, wages equal to the amount of the ERC are subject to expense disallowance rules.
A taxpayer’s wage deduction for a taxable year must be reduced by the amount of the ERC related to that taxable year. This is so that a taxpayer cannot “double dip” and receive a wage deduction and a credit for the same wage expense. Note that a taxpayer may still deduct its share of applicable Social Security and Medicare taxes.
TIMING FOR INCLUSION OF ERC-RELATED ITEMS
Here, the rules of IRC section 280C control for both cash basis and accrual basis taxpayers. IRC section 280C states that “no deduction shall be allowed for that portion of the wages or salaries paid or incurred for the taxable year which is equal to the sum of the credits determined for the taxable year.”
By the end of a taxable year, a taxpayer has already paid or incurred the wages that will be used to claim any applicable ERC and, presumably, has sufficient information to determine the amount of the ERC with reasonable accuracy. A taxpayer may actually file an amended payroll tax return in a subsequent tax year, but would be required to apply the wage expense disallowance in the year to which the ERC claim relates, rather than when the ERC claim is made or when the funds are received. In these cases, the taxpayer should amend its prior year income tax return to account for the wage deduction disallowance.
To alleviate some of the administrative burden for 2021 income tax filings, it may make sense for a taxpayer to extend its 2021 income tax return filing until potential claims for the 2021 ERC can be made. Given current IRS processing time on amended payroll tax returns, a taxpayer may need to pay the taxes owed due to the expense disallowance before they receive funds from the ERC refund. A taxpayer should plan to have other funds available to cover such taxes.
The Employee Retention Credit and related income tax compliance is complex and nuanced. If you have any questions about the ERC or its impact on you or your business, please contact the tax advisors at GHJ.