The IRS updated its Employee Retention Credit FAQs on March 20 to indicate that taxpayers will be permitted to adjust their wage expense in the year an employee retention credit (ERC) claim is paid or denied rather than amending a prior year income tax return. The FAQs note that the ability to utilize these procedures stems from the tax benefit rule and statutory rules under the ERC.
The new guidance may be helpful for many employers with wage expense improperly deducted on a prior year return. Employers that had an ERC paid or denied in 2024 should assess prior treatment of wages and review the opportunity to correct the treatment on their 2024 income tax return.
The ERC provides a refundable tax credit against payroll taxes for certain wages paid in 2020 and 2021 by eligible employers while the business was subject to a suspension order or after a significant decline in gross receipts. The credit has been a target of significant IRS enforcement and many taxpayers have seen significant delays in processing of their claims.
Taxpayers must generally reduce their deduction for wage expense by the amount of the credit in the year in which the qualified wages were paid or incurred. See Notice 2021-49. Employers may have mismatched wage expense for a variety of reasons. Employers who filed an ERC claim after filing their income tax return, for example, may have included their entire wage expense as a deduction on their income tax return before deciding to file an ERC claim. Employers that reduced their deduction for wage expense based on an anticipated ERC claim may have understated their deduction if the claim was later denied.
Procedures for Correcting Wage Expense Under Updated ERC FAQs
The IRS added new FAQs to its website (see questions 1 through 3 under the “Income Tax and ERC” section of the FAQs) providing that taxpayers that did not properly reduce their wage expense will not be required to address this issue on an amended return or an administrative adjustment request (AAR). Taxpayers can instead include the overstated wage expense as gross income on the return for the tax year in which the ERC was received.
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.
Similarly, taxpayers who reduced their wage expense for an ERC claim that was denied may increase their wage expense in the year the disallowance is final.
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.
Taxpayers retain the option of filing an amended return or AAR to address these situations, but the new approach contained in the updated FAQs may provide a much simpler option, particularly for partnerships. Taxpayers whose credit was paid, or disallowed, during 2023 do not appear to be eligible under these procedures, which are limited to the year in which the credit was paid or the disallowance was final.
BDO Insight
Taxpayers that had an ERC paid or denied in 2024 should assess prior treatment of wages on appropriate return(s) and review the opportunity to correct the treatment, if appropriate, on their 2024 return to avoid having to amend prior year returns. BDO can assist with these reviews and has extensive experience assisting taxpayers of all industries and sizes with the various aspects and requirements of ERC claims.
Stay up to date on the latest ERC guidance with BDO’s Employment Credits & Incentives Hub.