We have assisted many of our clients with claiming the Employee Retention Credit (“ERC”). The ERC is a government stimulus program designed to help small businesses that were able to retain their employees during the Covid-19 pandemic. Qualifying businesses that experienced the requisite drop in gross receipts are able to claim a refund on qualified wages paid to their employees for 2020 and 2021.
Your business qualified for the ERC. You claimed the ERC. Now what?
The biggest difference between the ERC and the other big government stimulus like the Payroll Protection Program (“PPP”) is that the ERC is taxable.
The IRS does not allow for double-dipping on credits. This means you are not allowed to deduct the expense that generated the credit. With the ERC, you are not allowed to deduct the payroll used to claim the ERC. As a result, your business’s income will increase by the payroll expenses used to claim the ERC credit. Ultimately, even with the ERC being taxable, you still come out ahead because the credit is worth more than the deduction, but it’s not the same windfall as the PPP.
So, when is the tax on the ERC due? In August of 2021, the IRS issued Notice 2021-49, which clarified the timing of the disallowed wage deduction for businesses claiming the ERC. According, to the Notice the deduction of the wages is disallowed in the year the wages were paid; not when the credit is received. This applies to cash basis taxpayers as well.
This timing difference could mean a large tax bill for small businesses and their owners, which does not align with the timing of the receipt of the credits. For example, if you claimed the ERC on wages paid in 2021, you must reduce your 2021 wage deduction resulting in an increase in 2021 taxable income. You will have to pay tax on this income in April of 2022 regardless of whether you received your ERC credit.
If you claimed the ERC for 2020 in 2021 you will need to amend your 2020 tax returns to show the increase in taxable income.
Unfortunately, the IRS is experiencing major backlogs in processing returns, especially amended returns claiming the ERC. If you claimed the ERC in 2021, it is likely that you will not receive your refund until much later in 2022 and will thus find yourself caught in this timing trap. We will be on the lookout for any IRS updates that hopefully alleviate this issue.