On Thursday, March 20, the Internal Revenue Service (IRS) updated its Frequently Asked Questions (FAQs) regarding the Employee Retention Credit (ERC) to add three questions on Income Tax and ERC. The FAQs provide guidance of when to report ERC Income and timing considerations for ERC denials in tax years that have expired or are expiring. Below are the three new questions and summaries of the IRS answers as well as some examples.
Question 1: Should I have reduced my wage expense on my income tax return when I filed for the ERC?
Yes, the ERC amount reduces your wage expense deduction for the tax year in which you paid or incurred the qualified wages. Generally, a taxpayer cannot deduct an expense as an ordinary and necessary business expense if they have a right or reasonable expectation of reimbursement at the time the expense was paid or incurred. Since the ERC serves as a reimbursement for qualified wage expenses, you should adjust your wage expense accordingly. If you did not make this adjustment when filing your income tax return, the IRS provides guidance on how to resolve this issue, including instructions for amending your return or making adjustments in subsequent tax years.
Question 2: I claimed the ERC but didn’t reduce my wage expenses on my income tax return. The ERC claim was paid in a subsequent year. What do I do?
If you claimed the ERC without reducing your wage expenses and received the credit in a later tax year, you should address the overstated wage expense. According to the IRS, you are not required to file an amended return to correct the overstated wage expenses. Instead, you can include the overstated wage expense amount as gross income on your income tax return for the tax year when you received the ERC. This approach aligns with the tax benefit rule, which requires taxpayers to include previously deducted amounts in income when a later event is fundamentally inconsistent with the premise on which the deduction was based.
The IRS FAQ provides the following example:
Business A claimed an ERC of $700 based on $1,000 of qualified wages paid for tax year 2021 but did not reduce its wage expense on its income tax return for 2021. The IRS paid the claim to Business A in 2024, so Business A received the benefit of the ERC but hasn’t resolved its overstated wage expense on its income tax return. Business A does not need to amend its income tax return for tax year 2021. Instead, Business A should account for the overstated deduction by including the $700 in gross income on its 2024 income tax return. If the taxpayer capitalized wages or did not otherwise experience a reduction in tax liability for the overstated wage expense, the taxpayer might not need to include the overstated wage expense amount in gross income on the income tax return for the tax year in which the taxpayer received the ERC. Instead, the taxpayer may need to make other adjustments such as a reduction in basis for capitalized wages.
Question 3: What can I do if my ERC claim was disallowed and I’d already reduced my wage expense on my income tax return by the amount of ERC I expected?
If your ERC claim was disallowed after you had already reduced your wage expense on your income tax return, you have options to correct this. In the year when the disallowance becomes final (meaning you are not contesting the disallowance or have exhausted your remedies), you can increase your wage expense by the amount previously reduced. Alternatively, you may choose to file an amended return or an administrative adjustment request to deduct the wage expense for the year in which the ERC was originally claimed. This flexibility helps taxpayers address adjustments without being constrained by the limited timeframe for filing amended returns.
The IRS FAQ provides the following example:
Business B claimed the ERC for tax year 2021 and reduced its wage expense on its income tax return for tax year 2021 because it expected the credit would be allowed and paid. In 2024, the IRS disallowed Business B’s ERC claim. Business B does not challenge the denial of the ERC claim and, accordingly, the disallowance is final. Business B does not need to amend its income tax return for tax year 2021. Instead, Business B can address this adjustment on its 2024 income tax return by increasing its wage expense by the amount of the previously reduced wage expense from its 2021 income tax return. Because taxpayers have a limited amount of time to file amended returns or AARs, if applicable, this process prevents the need for taxpayers to file protective claims for years where the time to file an amended return or AAR is quickly coming to a close. This process also gives relief to taxpayers who previously reduced wage expenses in tax years for which the assessment period has expired, and the taxpayer did not file a protective refund claim.
Planning Ahead
Navigating the tax implications of the Employee Retention Credit requires careful attention to IRS guidelines and timely adjustments to your income tax returns. The recent updates to the IRS FAQs provide valuable clarity on how to properly account for the ERC, whether you are claiming the credit, addressing overstated wage expenses, or dealing with disallowed claims. For more details, you can review the full IRS FAQ on the Employee Retention Credit here. Given the complexities involved, it’s essential to consult a qualified tax advisor to ensure compliance and optimize your tax position. If you have questions about how these changes impact your business, reach out to a tax professional for personalized guidance.
Matt Pore is a principal at ARB and works extensively with private clients & family offices, closely-held businesses, and automotive dealerships. As a Private Client Advisory Services Team Leader, Matt is actively involved with his clients in all aspects related to “Tax,” whether they’re buying or selling their businesses, harvesting tax credits, cash flow planning for estimated tax payments, or restructuring for optimal estate and wealth transfer considerations.
