On March 20, 2025, the IRS revised its Employee Retention Credit (ERC) FAQs, providing critical guidance on income tax reporting. The updated section, 'Income tax and the ERC,' addresses scenarios where taxpayers failed to reduce prior-year wage deductions by the refunded ERC amount, either due to amended payroll tax returns or discrepancies between anticipated and actual refunds.

The Proper Handling of ERC Claims and Wage Deductions and the IRS Offer of a Simpler Reporting Option

The IRS, in the "Claiming the ERC" section of the March 20, 2025 update to their ERC website, explicitly states that the amount of the Employee Retention Credit (ERC) reduces the amount that taxpayers are allowed to report as wage expense on their income tax return for the tax year in which the qualified wages were paid or incurred. This fundamental principle is reiterated in Question 1 of the "Income tax and ERC" section, which was added on March 20, 2025, stating, "Yes. 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".

The IRS further clarifies that this reduction generally applies to wage expense claimed as a deduction. However, for some taxpayers, wage expense is properly capitalized to the basis of a particular asset or as an inventory cost. In these situations, the reduction should be applied accordingly, by reducing the prior amount capitalized and making any resulting adjustments, such as reducing a depreciation deduction.

In essence, the process taxpayers should have followed is to decrease their deductible wage expense (or the amount of wages capitalized) in the tax year the qualified wages were paid or incurred by the amount of the ERC they were claiming. The IRS emphasizes the reasoning behind this requirement by explaining that taxpayers eligible for the ERC have a "right or reasonable expectation of reimbursement for qualified wage expense in the amount of the ERC", and generally, an expense is not deductible if there’s a reasonable expectation of reimbursement. This is further detailed in Notice 2021-20.

Regarding a simpler alternative, the IRS acknowledges that situations may arise where taxpayers did not initially reduce their wage expense or where their claim was disallowed after a reduction. In the "Claiming the ERC" section, under the heading "However, if you’re affected by either of the situations below, the simplest solution for you is to follow the instructions in the Income tax and ERC section," the IRS points to specific guidance based on whether the claim was allowed or disallowed. These "simpler solutions" are elaborated in the subsequent "Income tax and ERC" section and include:

If a taxpayer did not reduce their wage expense and their ERC claim was allowed and paid in a subsequent year: The IRS states that the taxpayer is not required to file an amended return. Instead, they can include the overstated wage expense amount (i.e., the amount of the ERC received) as gross income on their income tax return for the tax year when they received the ERC.
If a taxpayer reduced their wage expense but their claim was disallowed: The taxpayer may, in the year their claim disallowance is final, increase their wage expense on their income tax return by the same amount that it was reduced. Alternatively, they have the option, but are not required, to file an amended return, AAR, or protective claim. This later-year adjustment is presented as a way to avoid the need for amended returns, especially when the statute of limitations is approaching.

Therefore, while the IRS clearly outlines the proper initial treatment of reducing wage expenses in the year the qualified wages were paid, it does provide "simpler solutions" in the "Income tax and ERC" section for specific scenarios where the initial guidance was not followed or where the ERC claim outcome differed from expectations. These alternative methods often involve adjustments in a later tax year rather than requiring amended returns for the original year.

Handling Income Tax Reporting When ERC is Received After Not Reducing Wage Expenses

CPAs may encounter clients who claimed the Employee Retention Credit (ERC) but did not reduce their wage expense deduction on their income tax return for the year the qualified wages were paid. When these taxpayers subsequently receive the ERC refund, an adjustment to their income tax liability is necessary. The IRS has provided specific guidance on how to handle this situation in the March 20, 2025 update’s “Income Tax and ERC” section of the FAQ.

According to Question 2 and Answer 2, if a taxpayer claimed the ERC but did not reduce their wage expenses on their income tax return, and the ERC claim was paid in a subsequent year, the taxpayer is not required to file an amended return or an administrative adjustment request (AAR) to address the overstated wage expenses. Instead, the IRS states that the taxpayer can include the overstated wage expense amount as gross income on their income tax return for the tax year when they received the ERC.

Example:

The IRS 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. In this scenario, 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.

Addressing Expired Statute of Limitations

This IRS guidance is particularly relevant when the statute of limitations to file an amended return or an AAR for the original tax year has expired. Because the correction is made in the tax year the ERC is received, taxpayers are not required to go back and amend prior-year returns that may now be closed due to the statute of limitations. This provides a clear path for addressing the overstatement of wage expense without needing to navigate the complexities of expired filing deadlines.

The IRS explains the rationale behind this approach by referencing the tax benefit rule. This rule states that a taxpayer should include a previously deducted amount in income when a later event occurs that is fundamentally inconsistent with the premise on which the deduction was based. In this case, receiving the ERC without reducing the wage expense creates such an inconsistency, leading to a potential unwarranted double benefit. Including the ERC amount in gross income in the year it is received rectifies this inconsistency.

Important Consideration:

The IRS does note an exception. If the taxpayer capitalized wages or did not otherwise experience a reduction in tax liability for the overstated wage expense, they might not need to include the overstated wage expense amount in gross income in the year they received the ERC. In such cases, other adjustments, such as a reduction in basis for capitalized wages, may be necessary. CPAs should carefully evaluate their clients’ specific situations to determine the appropriate treatment.

In summary, for taxpayers who claimed the ERC but did not reduce their wage expense and subsequently received the refund, the IRS directs them to include the amount of the ERC received in gross income in the tax year of receipt, even if the statute of limitations has expired for the original tax year. This approach simplifies the reporting process and aligns with the tax benefit rule. CPAs should advise their clients to follow this guidance and to carefully consider the exception related to capitalized wages or situations where no tax benefit was initially received from the overstated wage expense.

Handling Discrepancies Between Claimed and Received ERC Amounts After Wage Reduction

CPAs may encounter situations where a taxpayer claimed the Employee Retention Credit (ERC) and, in anticipation of receiving the full amount, reduced their wage expense deduction on their income tax return for the applicable year. However, if the taxpayer subsequently receives an ERC refund that is less than the amount used to reduce their wage expense, an income tax reporting issue arises. While the IRS guidance in the March 20, 2025 update doesn’t directly address the scenario of receiving a lesser ERC refund after reducing wages, we can draw inferences from the principles outlined for disallowed claims.

In cases where an ERC claim is entirely disallowed and the taxpayer had previously reduced their wage expense, the IRS provides a mechanism to rectify this in a later tax year. According to Question 3, if an ERC claim is disallowed and the wage expense was reduced, the taxpayer may, in the year the disallowance is final, increase their wage expense on their income tax return by the same amount that it was reduced. Alternatively, the taxpayer has the option, but is not required, to file an amended return, AAR, or protective claim for refund to deduct the wage expense for the year the ERC was originally claimed.

By analogy, if a taxpayer receives a lesser ERC refund than expected after reducing their wage expense, the initial wage reduction was overstated by the difference. In the year the final amount of the ERC is received and the discrepancy is known, it would be reasonable to increase the wage expense in that year by the amount of the initial reduction that was not ultimately offset by the ERC received. This approach aligns with the principle that the wage expense deduction should only be reduced by the actual amount of the ERC the taxpayer has a right to retain.

Addressing Expired Statute of Limitations

A significant concern arises when the statute of limitations to file an amended return or an Administrative Adjustment Request (AAR) for the year the wages were originally paid has expired. In the context of a completely disallowed ERC claim, the IRS explicitly states that the process of adjusting the wage expense in a later year 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. It also offers relief to taxpayers who previously reduced wage expenses in tax years for which the assessment period has expired and did not file a protective refund claim.

Applying this logic to the scenario of a lesser-than-expected ERC refund, if the statute of limitations has expired for the original tax year, the IRS’s guidance on disallowed claims suggests that the taxpayer can likely adjust their wage expense in the year the final, lesser ERC amount is determined. This would involve increasing the wage expense in the later year by the portion of the initial reduction that was not covered by the actual ERC received.

Example:

Consider a business that paid $100,000 in qualified wages in 2021 and claimed a $70,000 ERC, reducing its 2021 wage expense by $70,000. In 2024, the business only received a $50,000 ERC refund. The statute of limitations to amend the 2021 return has now expired. Following the principles for disallowed claims, the business could increase its 2024 wage expense by $20,000 (the initial $70,000 reduction minus the $50,000 received).

Important Considerations:

While the IRS guidance doesn’t explicitly cover the "lesser refund" scenario, the logic behind the treatment of disallowed claims provides a reasonable framework for addressing this issue.
Taxpayers should maintain thorough documentation of their ERC claim, the initial wage reduction, and the actual amount of the refund received.
It’s important to note the IRS’s emphasis on the fact that taxpayers cannot deduct an expense if they have a right or reasonable expectation of reimbursement. In the case of a lesser refund, the initial expectation of reimbursement was partially unmet.

In conclusion, for taxpayers who reduced their wage expense based on an ERC claim but received a smaller refund than anticipated, and the statute of limitations to amend the original return has expired, the IRS guidance on disallowed claims suggests that adjusting the wage expense in the year the final ERC amount is determined is the appropriate course of action. This involves increasing the wage expense in the later year by the difference between the initial reduction and the actual ERC received. CPAs should advise their clients accordingly, keeping abreast of any further clarifications or updates from the IRS on this specific scenario.

Source: IRS ERC FAQ

Prepared with the assistance of NotebookLM.