IRS Changes Course on Income Tax Impact of Employee Retention Credit

On March 20, 2025, the IRS updated the FAQs on the IRS website to provide updated guidance to employers that claimed the employee retention credit (ERC), creating a decision point for many ERC claimants. Specifically, the updated guidance materially differs from prior IRS guidance of how and when employers should report the income tax impact of the ERC. In the updated FAQs, the IRS describes how employers can report taxable income in the year the ERC payment is received. This position contradicts prior guidance, which the IRS states still applies, pursuant to which taxpayers must reduce their deduction for wage expenses in the year qualified wages for the ERC were paid, including by filing an amended return even if the ERC was not claimed or known about when the taxpayer filed the original return.

This new guidance (which also is not necessarily legally binding) is likely to create confusion for taxpayers who have not amended income tax returns for prior years to reduce their deduction for wages paid with the ERC. Further, unless they proceed carefully, taxpayers following the guidance may find themselves paying tax they do not owe.

Congress created the ERC as part of the CARES Act to provide much-needed relief for the COVID-19 pandemic. Over time, the ERC evolved into a key form of relief for many employers, and likely the relief measure with the longest tail. A detailed discussion of the ERC can be found in past legal alerts here, here, and here. For this alert, the material background is:

• For 2020, eligible employers could claim an ERC of up to $5,000 per employee and for 2021, eligible employers could claim an ERC of up to $21,000 per employee.
• Employers generally claimed the ERC on quarterly payroll tax returns (Form 941) with many, if not most, employers claiming the ERC on amended quarterly payroll tax returns (Form 941-X), which could be filed several years after the end of the applicable quarter.
• The IRS significantly delayed processing Forms 941-X claiming an ERC.

Ultimately, the ERC provided a means by which the federal government funded a portion of the wages paid to employees during the pandemic. This government funding raised the question: What is the income tax impact to employers of receipt of the ERC?

The IRS provided clear (but not necessarily legally binding) guidance for the income tax treatment in Notice 2021-20. In Q&A 61 of Notice 2021-20, the IRS stated that the employer does not include the ERC in income when the claim is filed or the credit received. Instead, as described in Q&A 60 of the notice, the ERC reduces the allowed deduction for wages. Further, in Notice 2021-49, 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.

No one can legitimately dispute the IRS’s position that an employer should not be entitled to a tax deduction for wages ultimately paid by the ERC because the employer did not bear the economic cost of such wages. Requiring an employer to file an amended income tax return imposed a significant burden on taxpayers and including the ERC in income for the year of receipt provided a simple remedy that ensured that the government collected the correct amount of taxes (but not the interest paid with an amended return). In a typical scenario, employers would claim the ERC months or years after filing income tax returns claiming a deduction for all wages (including those to be reimbursed with the ERC). The need to prepare and file amended federal income tax was quite onerous, even without taking into account the additional difficulties of state and other income tax returns. The IRS provided no relief to this taxpayer burden, presumably because the IRS interpreted applicable law to require adjustment to wages in anticipation of future government reimbursement–even though many taxpayers have waited for years and still have not even had their ERC claims processed, much less paid. Of course, when the IRS issued the notices in 2021, it probably anticipated that it would process ERC claims with more than enough time to audit employers that did not file amended income tax returns.

It appears, however, that this IRS rigidity in 2021 has now created an opportunity for some taxpayers. Generally, because of the above-described delays in processing ERC requests and because of concerns that the IRS would deny (even perfectly valid) claims, employers often did not file amended income tax returns until receiving the ERC. Indeed, based on the analysis in Notice 2021-20, it generally appeared that employers claiming the ERC were in the same position as any taxpayer that understated income from an unintentional overstatement of a deduction and could decide whether or not to amend their income tax return.

Of course, filing an amended income tax return shortly after receiving an ERC during the normal three-year statute of limitations for an assessment (if not sooner) made sense and was fair. The IRS presumably could easily determine whether the employer had filed an amended income tax return when paying the ERC. IRS processing delays, however, have pushed the payment of 2020 ERC claims past the three-year statute of limitations and we will soon pass the statute of limitations for 2021 ERC claims, complicating the decision of whether to file an amended income tax return.

Now that the IRS has begun making ERC payments after the expiration of the statute of limitations for an income tax assessment, the IRS has changed it guidance. In Q&A 2 under the heading, “Income Tax and ERC”, the IRS now explains:

“[Taxpayers that did not amend their prior tax returns are] not required to file an amended return or, if applicable, an administrative adjustment request (AAR) to address 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.”

In other words, the IRS seems to have finally recognized what tax advisors have been talking about for years: many ERC claimants were waiting to amend their prior year tax returns until they were more confident that they would actually receive the reimbursement. Given the IRS delays and unenacted Congressional bills to limit the ERC, it is easy to understand why many taxpayers chose not to amend prior year returns just because they applied for the ERC relating to prior tax years.

Now that the IRS is (finally) processing ERC claims, the IRS must have recognized that many, or most, of these ERC recipients might not have amended (or might not amend before the statute of limitations expired) their prior year tax returns, resulting in massive tax losses to the government and massive tax windfalls to many ERC claimants. Accordingly, the IRS now “offers” an alternative for employers that have not yet amended their prior tax returns to include the ERC as income in the year of receipt. To be clear, the IRS also confirmed the prior guidance about the need to file an amended return; “The amount of your ERC reduces the amount of your wage expense on your income tax return for the tax year in which you paid or incurred the qualified wages.”. In our experience, inclusion of income is not optional, where taxpayers “can” decide; a taxpayer either does not have a 2020 or 2021 deduction for wages ultimately paid with ERC funds or has income in the year of receipt, not either or both.

The IRS cites, without analysis, the tax benefit rule to support its new position that receipt of the ERC can result in income in the year of receipt. The tax benefit rule is a complicated tax principle and it is not clear that it should apply. Indeed, the IRS did not discuss, or even include a caveat about, the tax benefit rule when it stated without equivocation in Q&A 61 of Notice 2021-20: “An employer receiving a tax credit for qualified wages, including allocable qualified health plan expenses, does not include the credit in gross income for federal income tax purposes.” Stated differently, in 2021 the IRS did not believe the tax benefit rule applied to the ERC. In 2025, recognizing that its prior position was about to cost the government billions of dollars of lost tax revenue, the IRS has reversed itself, without really explaining why they could do that other than a reference to the tax benefit rule that they previously thought appropriate to ignore.

Taxpayers who receive an ERC after (or near) the expiration of the statute of limitations for the year to which the ERC relates should consult with a tax professional about whether to include the ERC in income for the year of receipt, including whether the tax benefit rule applies. The recent IRS guidance (Q&A#1 of the same section) provides that taxpayers who already amended their prior tax returns in accordance with prior IRS guidance may not use the more recent guidance as a justification to file another amendment to reverse the prior reduction in wage expenses. However, it is unclear how the IRS can argue that both of their guidance positions are correct. Taxpayers that followed prior IRS guidance arguably should not be placed in a worse tax position than taxpayers that ignored prior IRS guidance. Some taxpayers may elect to “re-amend” their prior amended returns. This, too, raises complicated issues for consideration that taxpayers should discuss with their tax advisors.

Attorneys in our Tax Group will continue to monitor these developments, and are available to help clients navigate these complex processes.