Finally Received the Employee Retention Credit? Now What? A Guide to ERC Income Tax Consequences

It appears that the flood gates have opened and that the IRS is finally processing and paying claims for the employee retention credit (ERC) en masse. After waiting a very long time (often years) with no contact from the IRS, many employers suddenly find themselves receiving large checks. While this is a welcome change, it also creates new questions concerning the income tax impacts of receipt of the ERC. As it turns out, for many employers it may be the case that delays and other inexplicable procedural decisions made by the IRS result in no detrimental income tax impact – that is, no tax on the receipt of the ERC and no backdoor tax from the ERC reducing the employer’s deduction for the wages that allowed for the ERC.

Typical ERC Claim Scenario

Because of the background described below, many eligible employers did not claim the ERC until the second half of 2022 or later. These employers claimed their ERCs on amended payroll tax returns (Form 941-X) for the applicable quarters in 2020 and 2021. Further, these employers often made these refund claims after filing their original 2020 and 2021 income tax returns. In filing their income tax returns, most of these employers did not reduce their deduction for wages for amounts ultimately paid with ERC funds or otherwise take the ERC into account. Indeed, many or most of these employers did not even know about the ERC when they filed their 2020 and 2021 income tax returns.

During the process of claiming the ERC, many employers learned for the first time about the amended income tax return requirement described below. Questions arose about whether and when employers should or must file amended income tax returns for 2020 and 2021 to reduce the deduction for wages. Ultimately, many employers made the reasonable business decision to defer filing the amended income tax returns until receiving the ERC.

This Advisory focuses on employers who fall into this common fact pattern: employers that (1) claimed the ERC after filing original income tax returns for 2020 and 2021, (2) did not file amended income tax returns while waiting for the ERC, and (3) now have received the ERC.

Background For the ERC

Congress created the ERC as part of the CARES Act to provide much needed relief for the COVID-19 pandemic. A detailed discussion of the ERC can be found here, here, and here.

Congress structured the ERC as a refundable credit against the employer portion of social security tax. As a practical matter, this meant that employers could claim the ERC on original quarterly payroll tax returns (Forms 941) filed after the end of each quarter. Importantly, Congress included provisions to accelerate funding for employers by also allowing them to determine eligibility for a quarter based on the facts for the prior quarter and receive an advance payment of the ERC during the quarter. Congress thus designed the ERC to quickly provide cash to employers, much like payroll protection program (PPP) loans.

At the same time, the ERC contained design flaws that effectively nullified it as a relief measure for most employers. As originally enacted, recipients of a PPP loan could not claim the ERC. Further, the ERC initially only applied to 2020 and Congress limited the ERC to $5,000 per employer. The PPP loan often had more value, so most employers who could qualify for both programs elected to claim the PPP loan instead of the ERC.

The Consolidated Authorizations Act, 2021 (CAA21) enacted on December 27, 2020, retroactively allowed employers that received PPP loans to also claim the ERC. In addition, the CAA21 extended the ERC to the first two quarters of 2021 (with the America Rescue Plan of 2021 subsequently adding the third quarter of 2021) and increased the 2021 ERC to up to $7,000 per employee per quarter. Suddenly, many employers could claim a significantly increased ERC.

Given the timing of these retroactive changes, employers were forced to claim the 2020 ERC on Forms 941-X. Further, there were questions and complications about how the ERC interacted with a PPP loan. Moreover, by the time Congress made these changes, employers were in the midst of a global pandemic and understandably focused more on running their business than on obtaining ERC relief – especially when the employers had plenty of time to claim the ERC. An employer had until April 15, 2024, to file the Form(s) 941-X claiming the 2020 ERC and until April 15, 2025, to file the Form(s) 941-X claiming the 2021 ERC. With the end of the pandemic potentially in sight (COVID vaccines already had been developed), it made sense to also claim the 2021 ERC on amended payroll tax returns. 

Income Tax Impact of the ERC – Initial IRS Guidance

On March 2, 2021, the IRS issued Notice 2021-20, which provided comprehensive guidance about the ERC in question and answer format. In Q/A 61 of Notice 2021-20, the IRS stated that an employer does not include the ERC in income. Instead, as described in Q/A 60 of the notice, the ERC reduces the allowed deduction for wages. Further, in Notice 2021-49 issued on August 4, 2021, the IRS confirmed that employers that claimed an ERC after filing an income tax return must file an amended income tax return to reflect the reduced deduction for wages. Overall, the IRS took the position that the ERC itself does not result in taxable income, but increases income because employers could not claim a deduction for payroll expenses effectively/indirectly paid (or reimbursed) with ERC funds.

Interestingly, IRS also took this position with PPP loans. As discussed in this alert, in Rev Rul 2020-27 the IRS determined that although the receipt and forgiveness of a PPP loan does not itself result in income, a business could not claim a deduction for costs for which the business “reasonably expects to receive forgiveness.” Congress overrode this and included a provision in the CAA21 to allow deduction for expenses paid with PPP loan proceeds. In other words, for PPP loans, there was no tax owed from the receipt or forgiveness of the PPP loan and no backdoor tax from disallowing deductions. Many believed (or at least hoped) that Congress would similarly negate the IRS’s “no deduction” position for the ERC, but this never occurred.

IRS Delay in Processing ERC Claims and the Statute of Limitations

It generally appears that the IRS placed a very low priority on ERC claims filed after the pandemic ended. Further, with the pandemic over, people generally started questioning the wisdom of various pandemic relief measures. Fraud was allegedly rampant – as typically occurs, a few bad actors undermined relief for eligible and qualified employers. 

In fact, on July 26, 2023, the IRS issued a news release describing how the IRS “has entered a new phase of increasing scrutiny on dubious submissions” for the ERC. Later, the IRS announced a moratorium on processing new claims. In that announcement, the IRS stated that it would continue to process claims submitted before the moratorium, but delays continued given additional scrutiny described in the news release. In addition, at the end of 2023, the IRS issued Announcement 2024-3, creating an ERC voluntary disclosure program for ineligible employers that had nonetheless received the ERC. Presumably, the IRS shifted agents and resources away from reviewing ERC claims to this program, adding to the delays in processing claims. Ultimately, the IRS delayed processing and paying the ERC until the statute of limitations for 2020 expired and the statute of limitations for 2021 either expired or neared expiration.

Subject to various exceptions not relevant here, the IRS has three years starting from the due date of an income tax return (or date of filing, if later) to audit and assess tax with respect to such return. Further, the Treasury Regulations generally provide that a taxpayer should file an amended return if the taxpayer ascertains that the original return understates income, including by overstating a deduction, provided that the taxpayer makes this discovery within the period of limitations. In other words, even the IRS acknowledges that a taxpayer has no obligation to file an amended income tax return to correct an underpayment of tax after the expiration of the statute of limitations.

Overall, because of processing delays created by the IRS, the IRS is now paying ERC amounts after (or very near) the expiration of the statute of limitations for 2020 and 2021. Employers receiving these checks that have waited on filing amended income tax returns for 2020 and 2021 do not even have a “should” level requirement (and U.S. income tax law does not impose a “must” level requirement) to file an amended income tax return if the statute of limitations has expired.

Income Tax Impact of the ERC – Revised IRS Guidance

As we described in this alert, the IRS revised its guidance about the income tax impacts of the ERC in light of the fact that the IRS delayed payment to many employers until the expiration of the statute of limitations. Although the IRS maintains its position that receipt of the ERC does not result in taxable income and that taxpayers should file amended income tax returns to reduce the deduction for wages, the IRS also provides that employers that have not yet amended income tax returns “can” include the ERC in income for the year of receipt.

Obviously, taxpayers can (i.e., are able to) include in income any amounts, including amounts they did not earn. For example, the authors can include on our tax returns the amount Warren Buffet earns. We, of course, do not because we have no obligation to do so (and doing so probably renders the return not only imprudent but fraudulent). But nothing in the IRS guidance states that employers who received the ERC and have not filed amended income tax returns must include the ERC in income in the year of receipt.

Instead, under the caption “Why you need to include this amount in gross income”, the IRS describes the tax benefit rule, a general tax principle. Importantly, however, the IRS never asserts that the tax benefit rule applies, instead describing how “you may be claiming an unwarranted double benefit.” (Emphasis added.) To be clear, we are not stating that the tax benefit rule does not apply; we only point out that its application is not clear.

As background, the tax benefit rule generally applies if a taxpayer claims a deduction for an expense in one year, with that amount returned to the taxpayer in a subsequent year. Readers may be familiar with the application of the tax benefit rule with respect to state income tax refunds – especially before imposition of the $10,000 cap on the deduction for state taxes starting in 2018. For example, in preparing the 2016 federal income tax return, individuals itemizing deductions claimed a deduction for all state income taxes paid in 2016. If the individual claimed a refund for some of these state income taxes on their 2016 state income tax return, the individual would receive the refund in 2017 or a later year. The tax benefit rule resulted in income from the state tax refund in the year of receipt. A more apt analogy for the ERC may be an employer that overpaid an employee in one year, receiving a refund of the excess in a subsequent year.

Ultimately, the tax benefit rule generally appears to involve situations in which a taxpayer properly deducted a payment, receives a refund or reimbursement of that payment, and nothing about the refund or reimbursement (including the taxpayer’s claim to it) undermines or invalidates the initial deduction. The ERC issue does not appear to fit within these parameters: (1) employers receive the ERC from the IRS, rather than a reimbursement from the employee of previously paid wages, and (2) as explained by the IRS, claiming or receiving an ERC invalidates the related portion of the deduction.

Next Steps

In light of the new guidance from the IRS, employers receiving the ERC after the expiration of the statute of limitations for 2020 or 2021, that have not amended their 2020 or 2021 income tax return, have two choices: include the ERC amount in 2025 income or ignore the receipt and obtain the “double benefit” if their 2025 returns are not successfully audited.

We suspect that that many such employers will forgo the IRS offer that they “can” include the ERC in income in the year received (2025 for purposes of this example), if legally allowed to do so. Such a determination requires a detailed analysis that takes into account the employer’s particular facts and circumstances and is well beyond the scope of this article. We encourage these employers to consult a tax professional. That said, we believe that such employers can take comfort from the following:

1. The employer properly claimed a deduction for all wages paid on the original 2020 and 2021 income tax return because the employer had not claimed the ERC and the decision to wait on filing the amended return until receiving the ERC generally was arguably reasonable (as evidenced by the IRS suggestion that the tax benefit rule might apply to delay the tax consequences of an ERC until the year the funds were actually received).
2. The IRS alone is responsible for the delays in processing and paying the ERC.
3. The IRS knows whether the employer filed an amended income tax return. It is surprising (to say the least) that the IRS simply paid the ERC to employers that had not filed amended income tax returns without first checking their own records. Presumably, before the statute of limitations expired, the IRS could have issued to these employers a letter describing how the IRS was processing the ERC claim, attaching a statute of limitations extension agreement. Alternatively, the IRS may have been able to deny the portion of the ERC claim equal to the unpaid income tax.
4. The employer played by the rules and fairness requires expecting the same from the IRS.