Cashing a check for the Employee Retention Credit seems like a great deal for many business owners, but when does the stress hit? It’s when it’s time to file the taxes. Wait, what? Is the Employee Retention Credit taxable income? One of the most common questions business owners ask is whether the ERC counts as taxable income.
While this credit offers much-needed relief by helping businesses keep their employees on payroll, it also comes with a few strings attached. The answer isn’t as straightforward as you think, and misunderstanding the tax implications could spell doom. This blog will explain what you need to know about the ERC and its tax conditions.
What Is The Employee Retention Tax Credit?
The Employee Retention Credit (ERC) is a refundable tax credit introduced under the Coronavirus Aid, Relief, and Economic Security (CARES) Act in March 2020. Its main goal is to encourage businesses to keep employees on their payroll during the economic downturn caused by the COVID-19 pandemic.
The ERC is calculated as a percentage of qualified employee wages during specific pandemic periods. Initially, the credit was 50% of up to $10,000 in wages per employee for wages paid from March 13, 2020, to December 31, 2020. This means eligible employers could receive a maximum credit of $5,000 per employee for 2020. However, the Consolidated Appropriations Act of 2021 and the American Rescue Plan Act of 2021 extended and expanded the ERC into 2021, increasing the credit to 70% of up to $10,000 in wages per employee per quarter, allowing for a much more significant potential benefit.
The ERC applies to employers that experienced a significant decline in gross receipts or were subject to a full or partial suspension of operations due to governmental orders related to COVID-19. This credit has been a critical resource for businesses struggling to maintain their workforce during the pandemic’s uncertainty.
Is The Employee Retention Credit Taxable Income?
Now, let’s talk about the real deal. If you recently received an ERC, you should know that while the ERC isn’t technically seen as a taxable income, it does affect your payroll deduction and, ultimately, your taxable profits.
However, how much the employee retention credit can affect your taxable income depends on these three factors:
- How much you claim under the credit
- How much payroll expense deductions you take during the year
- The type of business entity you operate.
While the refund itself is not taxable, it also affects your taxes because the amount of the credit needs to be deducted from wages so that you can calculate your taxable income.
This means that you are adding back the amount of credit in the year you earned the income.
If your business received the ERC, you must reduce your payroll expense deduction by the credit amount. The point is to reduce your payroll expense deduction by the amount you claimed for your ERC, so it doesn’t affect your taxable income.
IRS Section 280C requires taxpayers to reduce their deductible expenses by the amount of the R&D credit for the tax years in which the credit was taken.
Although R&D credits belong to separate categories, the IRS has expressed that any tax credit claimed under the ERC cannot be claimed under R&D simultaneously and vice versa. This rule prevents businesses from “double dipping.”
If you applied for the ERC retroactively with the IRS Form 941-X and submitted your income taxes for the year, you must amend your income tax return to adjust the payroll deduction.
Accounting For The ERC
While it’s great to know that your employee tax credit is not directly taxable, it could affect your 2020 and 2021 financial statements. Your company’s ERC should be recorded as a credit to grant income and debit to account receivable A/R. If you received the Employee Retention Credit as an advanced payment, you should credit the refundable advance liability and debit the cash.
Whichever method you choose for accounting for your employee retention income to credit, include disclosures about the accounting standard/method you chose in your financial statements to ensure compliance with the IRS regulations.
How Do I Apply For The Employee Retention Credit?
Still haven’t applied for the ERC? The good news is that eligible employers still have time to claim it by filing Form 941-X for relevant quarters. For the four quarters in 2020, the application deadline is April 15, 2024, and for the four quarters of 2021, the application deadline is April 15, 2025
Take Home
Reading so much information about claiming the employee tax credit can be overwhelming. If you’re unsure where to start, working with a trusted tax expert like Tax Goddess is your best bet. Don’t miss out on a fantastic opportunity to maximize your tax credit; book a free consultation call with the Tax Goddess Team today!
