Does ERC refund count as income?

Taxability of Employee Retention Credits

Overview of the Employee Retention Credit

The Employee Retention Credit (ERC) was created by the Coronavirus Aid, Relief, and Economic Security (CARES) Act to incentivize employers to keep employees on payroll during the COVID-19 pandemic. The ERC provides a refundable tax credit equal to a percentage of qualified wages and health plan expenses paid to employees between specific dates.

Key provisions of the ERC include:

Initially 50% of up to $10,000 in eligible wages per employee for 2020. Increased to 70% of wages up to $10,000 per quarter in 2021.
Applies to qualified wages paid after March 12, 2020 and before January 1, 2022.
Employers must meet certain criteria related to business suspensions or revenue declines to qualify.
Credit can be taken against the employer’s share of Social Security taxes and received as an advance refund.
Wages paid with forgiven Paycheck Protection Program (PPP) loans cannot also claim the ERC.

Tax Treatment of ERC for Employers

The IRS has provided guidance confirming that ERC amounts are not considered taxable income to employers. This applies whether the credit is used to offset a company’s payroll tax obligations or is received as an advance refund.

Some key reasons the ERC is nontaxable include:

Refundable Credit

The ERC is a refundable tax credit, which means even if it exceeds the employer’s tax liability, the excess is paid as a refund. Refundable credits that do not rely on incurred tax liabilities are generally not included in taxable income.

No Basis in Assets

The qualified wages generating the ERC are a business expense rather than capital investment, so the credit does not reduce any asset basis. There is no taxable gain resulting from receipt of the credit.

Not Considered a Payment

The ERC is taken against taxes the business already owes based on employee wages. It is not considered a separate payment of funds that could be taxable income.

Statutory Construction

Nothing in the legislative language creating the ERC treats the credit as taxable income to employers. Congress did not intend for employers to be taxed on amounts designed to support business continuity and employment.

Tax Treatment for Employees

Just as the ERC does not create taxable income for employers, wages paid to employees using the credit do not count as additional taxable income for employees either. The wages are treated the same as any normal wage payments subject to standard payroll tax withholding.

The ERC has no impact on the amount of gross wages employees must recognize and pay income and payroll taxes on. Employees are taxed in the same manner whether their wages are subsidized by the credit or not.

Using ERC Funds

Since the ERC does not count as taxable income, employers can use ERC funds received for any business purpose, including:

Paying employee wages, health benefits, and retirement contributions
Funding paid sick and family leave
Paying business mortgage interest or rent
Acquiring equipment and software
Settling outstanding debts and accounts payable
Expanding facilities
Investing in safety measures for COVID-19
The ERC gives employers flexibility to use funds where most needed to cover costs and navigate the challenges posed by the pandemic.

Reporting Requirements

Employers should still track ERC amounts claimed correctly on tax returns. Key reporting requirements include:

Quarterly Payroll Tax Returns

Form 941: Report total ERC amounts applied to payroll tax deposits each quarter.

Unemployment Tax Return

Form 940: Report ERC amounts used to offset federal unemployment (FUTA) tax liabilities.

Business Income Tax Return

Form 1120: Report total ERC claimed on the applicable line.
Include IRS Notice 2021-20 stating the ERC is not taxable income.

W-2 and W-3

The ERC credit should not be included in Box 1 taxable wages.
A special code may be entered in Box 14 indicating the employee received ERC qualified wages.

Substantiating ERC Claims

To withstand IRS scrutiny, thorough records should be retained providing the following documentation:

Government orders or evidence of revenue reductions supporting eligibility
Quarterly qualified wage amounts per employee
Quarterly health plan expenses entitling credit
Completed Request for Advance Payment forms if obtaining advance refund

IRS Guidance on ERC Taxability

The nontaxable nature of the ERC is affirmed by the following IRS notices and guidance:

IRS FAQs on the Employee Retention Credit
IRS News Release on the ERC
IRS Notice 2021-20 (PDF)

State Tax Treatment of ERC

Most states adhere to the federal tax treatment of the ERC as nontaxable income for employers. However, employers should confirm with their own state tax authority whether any differences apply to state tax returns.

Some states, such as California, specifically conform to the federal rules on not taxing ERC funds. Others may require reporting the ERC on state returns even if it is non-taxable.

Example of ERC Tax Treatment

ABCD Corporation qualified for a $100,000 ERC in Q2 2021. ABCD can apply the credit in the following tax-free manner:

Reduce payroll tax deposits by $100,000 in Q2 2021.
Report $100,000 ERC credit on Form 941 and Form 1120 for 2021.
Include IRS Notice 2021-20 with Form 1120 to confirm non-taxable treatment.
Use $100,000 received from ERC for any operational or capital needs.
Report employee wages normally; ERC does not create additional taxable pay.

Tax Planning for ERC

Tax professionals advise maximizing use of the ERC under the CARES Act relief provisions. Key planning considerations include:

Claiming the credit retroactively if qualified under prior rules.
Reviewing eligibility criteria closely if not yet claimed.
Considering impact of PPP loans on eligibility.
Tracking employee retention and wages to support credit amounts.
Modeling cash flow needs to use ERC funds optimally.
Documenting compliance in case of future IRS audit.
With proper planning, employers can utilize this valuable program to improve liquidity and retain employees without tax consequences.

Conclusion

The IRS has definitively characterized the Employee Retention Credit as exempt from federal income tax for employers. This clarification enables companies to utilize ERC funds to address pandemic challenges without worry of tax liabilities. Proper tax reporting and documentation is still required to substantiate eligibility for the credit. But the ERC ultimately provides a tax-advantaged form of relief to strengthen business operations and employment through an extended crisis.