By Robbin E. Caruso & Ariel Weiner
Recently, the Internal Revenue Service updated their Frequently asked questions about the Employee Retention Credit, otherwise called ERC. They added a new section called, “Income tax and ERC,” which provides updated procedures. We recommend that you speak with your tax professional about these changes, particularly if you have a pending ERC claim, have had an ERC claim disallowed, or received an ERC claim (i.e., refund) in a subsequent tax year. As a result of these changes, taxpayers waiting to hear whether their ERC claim will be approved or disallowed may no longer need to file a protective claim for refund.
These revisions offer simpler solutions for Taxpayers who either (a) did not already reduce the wage expense on their income tax return and the ERC claim was allowed or (b) reduced the wage expense but the ERC claim was disallowed.
The “Income tax and ERC” section provides guidance on the reporting of the ERC on income tax returns. When a taxpayer claims the ERC, they are required to reduce the wage expense by the amount of the ERC for that same tax year. This is because a taxpayer should not deduct an expense, when it is expected to be reimbursed at the time incurred. However, as has often been the case, many taxpayers have filed amended Forms 941-X to claim the ERC and these claims have then been allowed and paid (i.e., refunded) in a later tax year. Likewise, there are Taxpayers who claimed the ERC and reduced wage expense pursuant to Sec. 280C on that same tax year’s income tax returns, only to find in a later year that their ERC claims have been disallowed.
For those taxpayers who claimed the ERC without reducing the wage expense and then the ERC claim was paid in a subsequent year, the IRS advises in Q2 of this section that, although they should address the prior year’s overstated wage expense, they are not required to amend the tax return or file an administrative adjustment request (“AAR”) for that prior year. Rather, they can include the amount as gross income on the income tax return for the tax year in which the ERC claim was received consistent with the tax benefit rule.
Here is the example that the IRS included in their answer to Q2 of this section:
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.
On the other hand, if a Taxpayer already reduced their wage expense, paid taxes on the higher resulting net income, and their ERC claim was later disallowed, then they may file an amended return, AAR, or protective claim for refund to deduct the wage expense in the original ERC claim tax year. However, these actions are not required as there is now a simpler option available. Instead, the taxpayer may increase the wage expense by the disallowed ERC claim amount on the income tax return for the year in which the claim disallowance is final (i.e., not being contested or appeals remedies exhausted).
Note that this option is particularly helpful for taxpayers whose ERC claims are still pending (i.e., a contingent claim) and the statute of limitations to claim a refund is about to expire. Without this option, such a Taxpayer would have no choice but to file a protective claim for refund before the statute expires as a precaution should the claim be disallowed. If the pending claim is received, the Taxpayer would have nothing more to file and, if they chose to follow this new option, they will have avoided filing a potentially unnecessary protective claim for refund. Again, we recommend that you speak with your tax professional.
Here is the example that the IRS included in their answer to Q3 of this section:
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.
In the FAQs, the IRS refers to special statutory rules that allow Taxpayers to treat a disallowed previously claimed ERC as wage expense in a later tax year when the claim disallowance is final. This treatment is similar to how taxpayers should handle not receiving any other reasonably expected expense reimbursement, which prevented them from deducting a business expense in the year paid or incurred.
Please note that the “ERC Scams” section has an updated mailing address.
Please reach out to your Prager Metis tax advisor for further guidance.
