ERC Income Tax Return Amendments Present Tough Choices for Employers

By Jeffrey M. Glassman on July 17, 2024

According to IRS published guidance, when an employer claims the employee retention credit (“ERC”), the employer is supposed to make a corresponding amendment to its income tax return to reduce its wage expense deduction by the amount of the employee retention credit. See IRS Notice 2021-20 at Q&A 60. The IRS’ published guidance also says that the tax year to be amended is the year in which the applicable wages were paid or incurred. See IRS Notice 2021-34 at IV.C.

Specifically, IRS Notice 2021-34 says:

Under section III.L. of Notice 2021-20, a reduction in the amount of the deduction allowed for qualified wages, including qualified health plan expenses, caused by receipt of the employee retention credit occurs for the tax year in which the qualified wages were paid or incurred. When a taxpayer claims the employee retention credit because of the retroactive amendment of section 2301 of the CARES Act by section 206(c) of the Relief Act (relating to eligibility of PPP borrowers to claim the employee retention credit) or otherwise files an adjusted employment tax return to claim the employee retention credit, the taxpayer should file an amended federal income tax return or administrative adjustment request (AAR), if applicable, 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. Section 2301(e) generally provides, in relevant part, that rules similar to the rules of section 280C(a) of the Code shall apply.

Consistent with Notice 2021-34, on the IRS’ FAQs about the ERC, in the section titled “Claiming the ERC” (link) the IRS states the following:

Q1. How do I claim the ERC? (updated September 14, 2023)

A1. Eligible employers that didn't claim the credit when they filed their original employment tax return can claim the credit by filing an amended employment tax return. For example, businesses that file quarterly employment tax returns can file Form 941-X, Adjusted Employer's Quarterly Federal Tax Return or Claim for Refund PDF, to claim the credit for prior 2020 and 2021 quarters.

Reminder: If you file Form 941-X to claim the Employee Retention Credit, you must reduce your deduction for wages by the amount of the credit for that same tax period. Therefore, you may need to amend your income tax return (for example, Forms 1040, 1065, 1120, etc.) to reflect that reduced deduction.

Q7. Does the ERC affect my income tax return? (updated September 14, 2023)

A7. Yes.

The amount of your ERC reduces the amount that you are allowed to report as wage expense on your income tax return for the tax year in which the qualified wages were paid or incurred.

Generally, most taxpayers claim wage expense as a deduction on their income tax returns. However, for some taxpayers, wage expense is properly capitalized to the basis of a particular asset or as an inventory cost.

You should amend your income tax return to reduce the amount of your original wage expense if that adjustment has not yet been made by:

- reducing the prior wage deduction, or
- reducing the prior amount capitalized (and making any resulting adjustment, such as reducing a depreciation deduction).

It is reasonable to conclude that the IRS prefers an income tax return amendment occurring at the same time an ERC claim is made. Whether or not this is an actual requirement is not completely clear from the IRS published guidance. Requiring employers to reduce a deduction—and therefore pay more tax—before they receive an ERC refund is arguably contrary to Congress’ intent and desire to send money to businesses in enacting various COVID-19 relief provisions, including the ERC. Had Congress known that the IRS would take years to process most ERC claims, it may have made it clear that the income tax return amendment was not an immediate requirement.

The IRS recently commented that it believes around 70-90% of pending ERC claims have either “an unacceptable level of risk” or “show clear signs of being erroneous claims.” The IRS also commented that even those claims with a “low-level of risk” will be processed judiciously. We previously wrote about the IRS comments here. In short, the IRS statements indicate that the IRS will still take considerable time to process ERC claims. And even after they process the claims, will the IRS even allow the claims? Or will the employers need to challenge IRS denials to prove eligibility? There is simply no way to know. So, with that said, the decision whether to amend an income tax return while waiting for the IRS to act is an even tougher decision.

Ultimately, the decision of what an employer should do with respect to the income tax return amendment could come down to economic realities. Can the employer spare the amount of funds needed to make an income tax return amendment and pay the corresponding tax? If not, what should they do? Will the IRS deny an otherwise valid claim because the employer has not yet amended the income tax return? Does the employer need to amend their income tax return within any particular statute of limitations? If they amend, should the employer file a protective claim for refund to protect themselves if the IRS does not pay an ERC refund?

The income tax return amendment issue comes with many different considerations. The only thing that is clear is that employers should talk with a reputable tax practitioner before making any decisions.

If you have any questions about this article, an employee retention credit matter, or any other civil or criminal tax matter, please contact me at jglassman@meadowscollier.com or 214-749-2417.