1. Will claiming the Employee Retention Credit create taxable income (or reduce a loss)?
Yes. IRS Notice 2021-20 provides that an employer receiving an employee retention credit (“ERC”) refund should not include the credit in gross income for federal income tax purposes; however, under rules similar to IRC Section 280C (which also applies to other tax credits, such as R&D credits), such employer should reduce their wage expense by such amount in 2020 and/or 2021, as applicable.
If the company (or its owners in the case of an S-corporation, partnership or disregarded entity) was in a taxable loss position greater than the amount of the credit, a reduction of wage expense may only reduce their loss position for such year with no additional tax due because of the credit.
If the company was in a taxable income position in either 2020 and/or 2021 (or had a loss less than the credit), the reduction of wage expense related to the credit may result in an increase in federal taxable income for that year. The same would hold true to the extent that claiming the ERC shifted a company from a taxable loss to a taxable income position.
Note, however, ordinary and necessary business expense under IRC Section 162 at the time the fees are paid or accrued.
2. For which years should I adjust or amend my federal income tax return?
The IRS addressed this question in August 2021 via IRS Notice 2021-49. The guidance explains that the reduction in the amount of the deduction for qualified wages caused by receiving an ERC occurs for the tax year in which the qualified wages were paid or incurred.
3. Will I incur interest and/or penalties in connection with my ERC refund?
If the ERC does create additional taxable income due to a reduction in wage expense, the IRS will likely assess an interest charge on any additional tax due. However, because the IRS also pays interest on the ERC refunds based on the periods for which the credit is being claimed, the interest due to you (in connection to your ERC) should generally offset the interest due to the IRS (in connection with the additional income tax).
In general, an increase in the tax liability of a taxpayer on an amended return will result in a late payment penalty. However, provided certain conditions are satisfied, penalties may be waived in accordance with IRS News Release IR-2022-89, which, in part, provides as follows:
“This release reminds taxpayers that, consistent with the relief from penalties for failure to timely pay noted in IRS Notice 2021-49, they may be eligible for relief from penalties for failing to pay their taxes if they can show reasonable cause and not willful neglect for the failure to pay. In general, taxpayers may also qualify for administrative relief from penalties for failing to pay on time under the IRS’s First Time Penalty Abatement program if the taxpayer:
Further, during a June 7, 2022 Senate Finance Committee hearing, Janet Yellen, Secretary of the Treasury reiterated this by stating “…I think there will not be penalties for situations that arise where additional income tax may be owed, and the taxpayer is waiting for this refund payment to be able to pay taxes owed – penalties will be waived…”
4. When should I amend my federal income tax return(s)?
The first consideration is potential penalties. To that end, IR-2022-89 provides as follows:
“The Department of the Treasury and the Internal Revenue Service have received requests from taxpayers and their advisors for relief from penalties arising when additional income tax is owed because the deduction for qualified wages is reduced by the amount of a retroactively claimed [ERC], but the taxpayer is unable to pay the additional income tax because the ERTC refund payment has not yet been received.”
Accordingly, while not explicitly guaranteeing that the IRS will provide penalty relief to taxpayers that delay the amendment and payment of tax until they have received their IRS refund, the release of IR-2022-89, along with Secretary Yellen’s comments provide strong signals that the IRS will provide penalty relief on not only the “late” payment on incremental tax due at the time the ERC filing is submitted to the IRS, but also on incremental tax accrued between the date of the filing and the date on which the ERC is processed by the IRS (i.e., the date on which the taxpayer receives the refund).
Notwithstanding the foregoing, if a taxpayer has the opportunity to include the ERC adjustment on a timely filed return (i.e., 2021), it would be prudent to consider filing with the wages adjusted in accordance with the amount of ERC claimed (i.e., reducing the wage deduction by both the amount of the ERC received and the amount anticipated after the expiration of the due date). In this scenario, a taxpayer may consider paying an additional tax deposit at the time of filing, or, if they are unable to do so, wait until receipt of the ERC and assert the aforementioned penalty relief.
5. May I simply file my ERC refund on cash-basis in the year the refund was received?
Sagemont Tax, along with many other industry leaders, have called upon Congress to create a solution to solve the administrative burden associated with having to potentially amend one or more income tax returns as a result of claiming the ERC (see Sagemont Tax’s Letter to Congress found here). However, there have been no meaningful indications that any changes to alleviate this burden are on the horizon.
While contrary to the current treatment prescribed by the Internal Revenue Code, we have seen a number of taxpayers, and even tax preparers, take a cash-basis approach to the ERC, often discussing it as a “practical” approach and many times alluding to the approach merely creating a “timing difference” regarding when the tax is due. It is worth noting, however, that taxpayers often end up in different marginal tax brackets in different years and, because the IRS is paying interest on ERC refunds, it may be contrary to public policy and/or legislative intent for taxpayers to receive interest on ERC refunds but not have a corresponding, offsetting interest expense related to the income tax liability.
Sagemont Tax does not specifically condone the cash-basis approach, however, our team of tax professionals are happy to discuss the pros and cons associated with adopting such approach. Please reach out to your Sagemont Tax representative to request a discussion with one of our tax experts.
