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Does ERC affect state tax returns?

Does the Employee Retention Credit (ERC) Affect State Tax Returns?

The Employee Retention Credit (ERC) was a refundable tax credit, introduced to help businesses retain employees during the COVID-19 pandemic, but, it has since been discontinued. While the ERC did not directly impact state income tax returns, there were some nuances to consider, depending on the state.

Federal Tax Treatment

At the federal level, the ERC was not considered taxable income when received, however, wages equal to the ERC amount were subject to expense disallowance rules. This meant that businesses had to reduce their wage deductions by the amount of the ERC claimed, to avoid “double-dipping” – receiving both a wage deduction and a credit for the same expense.34The timing of this wage expense disallowance was crucial. According to IRS guidance, the disallowance had to be applied in the same tax year the ERC-eligible wages were paid, not when the credit was claimed or received.4 So, if a business claimed the ERC for 2020 wages but filed for it in 2021, they had to amend their 2020 federal return to reflect the wage deduction disallowance.

State Tax Treatment

At the state level, the tax treatment of the ERC varied. Some states, like New York and California, allowed a subtraction adjustment, meaning the ERC refund was not taxable income.3 For example, in California, businesses did not have to include the ERC refund as income or reduce their wage deductions.1However, other states, like New Jersey, did not have a specific adjustment for the ERC. In these cases, since the state taxable income calculation started with the federal taxable income, the ERC refund remained taxable at the state level, unless the state issued separate guidance.3It’s important to note that state tax treatment was still evolving, so businesses should have consulted with tax advisors to ensure compliance with the latest guidance in their respective states.

Practical Considerations

Given the complexities around the ERC and its tax implications, businesses should have:

1. Maintained thorough documentation to support their eligibility for the credit and the calculation of qualified wages.
2. Consulted tax professionals to navigate the nuances of federal and state tax reporting for the ERC.
3. Considered extending their 2021 tax filings until potential ERC claims could be made, to streamline the reporting process.
4. Planned for potential tax payments before receiving the ERC refund, due to the wage deduction disallowance.