Employee Retention Credit – Timing of Qualified Wages Deduction Disallowance

By Steven N. Smith, CPA, JD

Initially, the employee retention credit (ERC), enacted by the CARES Act, was not available to paycheck protection program (PPP) borrowers. The passage of the Consolidated Appropriations Act 2021, on December 27, 2020, changed that and allowed PPP borrowers to claim the credit after all. This modification to the law allowed PPP borrowers to qualify for the ERC for 2020 retroactively by filing amended employment tax returns (on Forms 941-X) for the applicable quarters in 2020.

The ERC, a refundable credit, is not includible in gross income but, it is subject to expense disallowance rules which generally call for the reduction of deductible wage expenses by the amount of the ERC received. For taxpayers that claimed and received the ERC in 2020, the expense disallowance occurred in 2020 as would be expected.

Taxpayers that claimed the ERC during 2021 for 2020 by filing amended employment tax returns for the applicable quarters in 2020 must also properly reduce deductible wage expenses by the amount of the ERC received. When should that expense disallowance occur? On August 4, 2021, the IRS released Notice 2021-49 to provide additional guidance on the ERC in a number of areas, including the timing of the qualified wages deduction disallowance in Section IV. C.

The Notice indicates that the Treasury Department and the IRS were asked about the timing of the reduction, specifically in the circumstance in which a taxpayer files an adjusted employment tax return to claim the ERC for prior calendar quarters and has already filed a federal income tax return for the tax years in which the credit is claimed on the adjusted return. A reduction in the amount of the deduction allowed for qualified wages for the receipt of the ERC occurs for the tax year in which the qualified wages were paid or incurred.

When a taxpayer claims the ERC by filing an adjusted employment tax return, the taxpayer should file an amended federal income tax return for the taxable year in which the qualified wages were paid or incurred to correct any overstated deduction taken with respect to those same wages on the original federal tax return. This conclusion applies to taxpayers regardless of their overall method of accounting (cash basis or accrual basis). Thus, for taxpayers that claimed the credit in 2021 for wages paid in 2020, the 2020 return must be amended.

The significant delays by the IRS in processing ERC refunds raises the potential for cash flow issues for certain taxpayers obligated to amend and pay additional tax for 2020, while waiting for the ERC refund for 2020. Similar delays might exist for 2021 ERC refund claims with the result that 2021 income tax returns with the reduced wage deduction might be filed and tax due before the refund is received. Taxpayers with cash flow issues may wish to consider a delay in the filing of amended 2020 income tax returns or an extension of time to file 2021 returns, while awaiting ERC refunds. Taxpayers considering this option should carefully weigh any interest or penalty that might be incurred by an extension to file without paying the tax against the cost of borrowing funds to pay the 2021 tax.

If you have any questions regarding the ERC and the timing of the wages deduction disallowance or other matters discussed above, please contact your BMSS tax professional at (833) CPA-BMSS.