Did you claim the Employee Retention Tax Credit? In fact, the ERTC can create taxable income when you file your tax return. This makes it important to understand your tax filing obligations and best practices when claiming the ERTC.
In this article, we’ll cover everything you need to know about claiming the ERTC on your tax return, including the tax impact on different business types. If you have any questions after reading through this guide, reach out to Abdul Tax Consulting and Accounting Services right away.
How Does the ERTC Impact Your Tax Return?
The impact of the ERTC on your tax return depends on the following factors:
• The amount of ERTC claimed.
• The payroll expense deductions claimed during the year.
• The type of entity your business has.
• The year you claim and receive your refunds.
The ERTC might need to be taken into consideration for multiple tax years, especially if you operate on a cash basis of accounting. We’ll explore these items in more detail below.
Does the ERTC Result in Taxable Income?
Although the ERTC is not considered taxable income, it does impact the amount of payroll deductions you can claim on your tax return. The IRS does not allow you to double dip on payroll expenses. This means that employers must reduce wage and insurance accounts by the amount claimed on the ERTC.
For example, let’s say you used $100,000 of wage expenses and $10,000 of health insurance costs to claim the ERTC. Your total costs for the year were $150,000 and $15,000, respectively. Instead of claiming these full amounts, you would need to reduce them to $50,000 and $5,000, increasing your taxable income.
This legislation follows IRC Section 280C, which requires taxpayers to reduce deductible expenses by the amount of R&D credits claimed during the year. The same guidelines apply to the ERTC, preventing employers from double dipping on tax deductions.
When Should the ERTC Be Reported on the Tax Return?
Taxpayers that utilize the accrual basis of accounting are required to follow the matching principle under Generally Accepted Accounting Principles. The year that you claim the ERTC should be the year you reduce your payroll expenses.
This means that if you claim the credit in 2020, you will need to reduce payroll expenses on the 2020 return. The same is true for 2021. This matching principle might result in the need to amend already filed tax returns to increase taxable income.
It can take anywhere from six to nine months to receive your refunds. Taxpayers that file amended payroll returns in 2022 for 2021 quarters might not receive ERTC refunds until 2023. In the year you receive the ERTC refunds, the income will be tax-exempt since you already increased taxable income in prior years.
How Should the ERTC Be Reported on the Tax Return?
Reporting the ERTC can be tricky, especially if you claim and receive the credit in separate tax years. Here are the main sections of your tax return that will be impacted. Keep in mind that the reporting will differ if you are preparing a trust, corporation, or individual tax return. Contact an accounting professional to learn more.
Form 1120s and Form 1065
The face of Forms 1120s and 1065 will be impacted based on the amount of wages and health insurance costs used to claim the credit. This will impact Line 7 (compensation of officers), Line 8 (salaries and wages), and Line 19 (other deductions) of Form 1120s.
On Form 1065, you will need to adjust Line 9 (salaries and wages) and Line 20 (other deductions). Keep in mind that you might need to reduce direct labor claimed on the cost of goods schedule if your wages are broken out.
If your health insurance costs are reported as employee benefits in Line 18 of Form 1120s or Line 19 of Form 1065, you will not reduce any line items in the other deductions category.
If you are unable to precisely allocate wages and health insurance costs to these categories, allocate the ERTC amounts based on the total amount of expenses in each category. These adjustments will impact both ordinary and taxable income.
Schedule K and Schedule K-1
In the year you receive your ERTC funds, you will need to pick up the income as tax-exempt. You most likely categorized the income as “Other Income” on your financial statements. These amounts should not go to the “Other Income” line on the tax return but instead, be reported as “Other Tax-Exempt Income” on Schedule K.
For 1065s, this will be line 18b, while Form 1120s will show line 16b. These amounts will flow through to Schedule M-1 or Schedule M-3 and the K-1s issued. The IRS issues ERTC checks by quarter. If you only receive one refund check, you will only report that amount as tax-exempt income.
These amounts will flow through to the subsequent lines on Schedule K-1, which taxpayers use to report pass-through income on their individual tax returns. It’s important that you include these adjustments on the proper lines to stay in compliance with IRS regulations and avoid misreporting income.
Schedule M-1 or Schedule M-3
There will also need to be an adjustment to reconcile taxable income to book income. This will generally be found on Schedule M-1 unless you have over $10 million in assets and use Schedule M-3.
On Line 3 of Form 1120s or Line 4 of Form 1065, you will need to enter the full amount of the wage and health insurance deductions. This will lower your taxable income back down to your book income.
For tax years where you report your refunds as other tax-exempt income, these amounts will flow through to Schedule M-1 Line 5 for 1120s returns and Line 6 for 1065s.
AAA and OAA
Schedule M-2 of Form 1120s and 1065 tracks shareholder basis in the company. The ERTC does impact shareholder basis, requiring adjustments when filing the tax return. Since reducing wages and health insurance costs increases ordinary and taxable income, this will increase your basis in the company.
However, in the year the funds are received there will be a subsequent reduction in the Accumulated Adjustment Account (AAA), creating a net zero effect. In certain states, the ERTC income should be shown as an addition and a reduction in the Other Adjustment Account (OAA).
The shareholder basis reporting requirement can depend on your state, making it important to consult with a tax expert on proper reporting.
Not all states conform to the Federal treatment of ERTC expenditures and income reporting. Some states, like Massachusetts, New Jersey, and Pennsylvania, do follow Federal treatment of increasing taxable income.
Other states, like Wisconsin and Illinois, don’t require business owners to decrease wages and health insurance costs, resulting in the ERTC being tax-free. As a result, you may need to create an add-back to ordinary income to true-up expenses in the year the ERTC is claimed. Subsequently, a subtraction from ordinary income will be necessary in the year you receive the ERTC funds.
How Does the ERTC Impact Other Business Types?
Your company may be set up as a C-corporation, trust, or sole proprietorship. In these cases, the tax reporting of the credit will differ from S-corporations and partnerships. C-corporations will still reduce wages and health insurance costs and follow the timing of tax-exempt income. However, there will be no taxable impact on shareholders, as C-corporations pay all taxes at the entity level.
Sole proprietorships and single-member LLCs that file Schedule C on the individual tax return will also reduce wages and health insurance expenses, generating more taxable income. In the year the refunds are received, you will need to back out the income as tax-exempt.
What About Other Payroll Tax Credits?
The ERTC isn’t the only payroll tax credit that employers are able to claim. The Social Security and Medicare tax credits and the Work Opportunity Credit can also be reported on the business tax return. These amounts flow through to Line 13 of Schedule K-1.
Unlike the Employee Retention Tax Credit, these credits will impact the shareholder’s individual tax return. The ERTC is claimed through the business, with your company receiving refunds. However, the Social Security and Medicare tax credit and the Work Opportunity Credit are taken on the individual tax return.
The ERTC isn’t always as straightforward as business owners would hope. The complexity of tax reporting shouldn’t scare you away from claiming the credit, as extra cash flow can go a long way in helping your business grow.
One way to ensure that you are properly reporting the ERTC on your tax return is to work with a qualified tax preparer, like Abdul Tax Consulting and Accounting Services. Our team can walk you through the credit claiming process, bolstering compliance and making it simple to enjoy your newfound cash flow.
Reach out to a team member today to schedule your free consultation.