How does claiming the ERC affect your state income tax return? Here's a breakdown of the ERC taxation laws by state so you'll know exactly what to expect come tax time.
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While the Employee Retention Credit isn’t taxable at the federal level, many small business owners have been left wondering how claiming the ERC will affect their state income tax returns. In this post, we’re going to break down how states are handling ERC. Spoiler alert: It varies by state, and changes may still be on the horizon.
Table of Contents
Before diving into how the ERC is taxed at the state level, we need to explore the IRS guidelines for federal taxation of the ERC.
The ERC is a refundable tax credit that is not considered taxable income for federal tax purposes. However, claiming the credit will affect your federal income tax return.
Per Section 280C(a) of the Internal Revenue Code (IRC):
“No deduction shall be allowed for that portion of wages or salaries paid or incurred for the taxable year which is equal to the sum of the credits determined for the taxable year under sections 45A(a), 45P(a), 45S(a), 51(a), and 1396(a).”
A letter from the Department of Treasury further clarifies:
“Section 280C(a) generally disallows a deduction for the portion of wages or salaries paid or incurred equal to the sum of certain credits determined for the taxable year. Accordingly, a similar deduction disallowance applies to the ERC. This means that an employer’s deduction for qualified wages is reduced by the amount of the ERC.”
In other words, while the ERC is not taxable at the federal level, payroll deductions must be reduced by the amount of the ERC credit to prevent “double dipping.”
This is important to understand because states base their tax laws on the IRC.
State governments also use the IRC as the basis of their tax laws.
States may opt to fully conform to the IRC, meaning that they simply adopt federal laws surrounding taxation. This is a rarity, as most states make modifications as needed. They may also opt to conform to the IRC partially, making changes as needed. Other states may opt to create their own tax laws and not conform to the IRC.
There are further complications when it comes to how states are taxing the ERC. Fixed conformity states — that is, states that conform to the IRC on a fixed date — have to enact legislation if they opt to change the date of conforming to IRC Section 280C(a) in relation to the ERC. Even conforming states may opt to modify laws, for example, allowing a deduction for creditable expenses, similar to expenses for research or foreign tax credits.
Sound complicated? Like most tax-related laws, it is.
And unfortunately, these laws may continue to change in the months ahead. For now, though, we’ve compiled a list of how each state is treating the ERC for state tax purposes.
This list will continue to be updated as new laws and changes are implemented.
There are some states that conform with federal laws for the taxation of the Employee Retention Credit. Based on Section 280C(a) of the IRC, these states do not allow taxpayers to claim a deduction for wages claimed for ERC.
The states that conform to federal laws are:
Other states have their own laws when it comes to how the ERC is taxed for state income tax returns. Here’s a breakdown of how these states are treating the ERC for tax purposes.
There are several states that have no personal or corporate income tax. Therefore, IRC conformity and state income tax laws do not apply to the following states:
Because state laws may continue to change in the months ahead, consider working with a CPA or tax professional. These experts can help you stay on top of your current state laws surrounding ERC, ensuring that your return is calculated accurately to avoid costly penalties and interest. A professional can also help you claim other money-saving tax credits.
Still haven’t claimed the ERC? There’s still time! Even though the IRS has temporarily ERC claim processing, the best ERC companies are still hard at work to help you claim funds for employees you kept on payroll during the COVID-19 pandemic. Check if you qualify for ERC, learn how to apply for ERC, and submit your claim before the ERC deadline to get the funds owed to your business.
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