ERC & Your Taxes: How the Employee Retention Credit Affects Your Tax Returns

From wage deduction adjustments to amended return requirements, the ERC has lasting effects on your federal — and in some cases, state — tax returns.

And for businesses that had claims disallowed, withdrew claims, or are facing repayment demands, the tax picture is even more complex. In this guide, we’ll break down everything you need to know about how the ERC affects your taxes.

Who Was Eligible For The Employee Retention Credit?

Understanding whether your business was eligible for the ERC is still relevant, particularly if you’re facing an audit, a disallowance letter, or questions about whether your claim was legitimate.

To qualify, businesses had to meet one of the following conditions for each quarter claimed:

• Business operations were fully or partially suspended as a result of a government mandate, or
• The business had a significant decline in gross receipts

Additionally, the business must have paid qualified wages to employees. Wages paid to relatives of majority owners were not eligible for the credit.

If you’re unsure whether your original claim was valid, the IRS ERC Eligibility Checklist is a useful starting point for assessing your exposure.

Is ERC Taxable Income?

The ERC is not included in your gross income for federal tax purposes, but that doesn’t mean it has no impact on your tax return.

Because the ERC is tied to wages paid, receiving the credit reduces the amount you can deduct for wages and salaries on your income tax return. This means your taxable income will be higher than it would have been without the credit, even though you never added the ERC amount to your gross income.

Here’s a simple example:

• Business A paid $200,000 in wages in 2020 and received a $50,000 ERC refund. On its federal return, Business A can only deduct $150,000 in wages and salaries.
• Business B paid $200,000 in wages in 2020 and received no ERC refund. Business B can deduct the full $200,000.

If both businesses had identical income and expenses otherwise, Business A will have higher taxable income due to the reduced wage deduction.

How To Record The ERC In Financial Statements

If your business received the ERC, you’ll need to record it correctly in your financial statements. How you record it depends on where things stand with your claim.

Under ASC 958-605 (nonprofits) or IAS 20 (IFRS), the ERC may be recorded as a grant or contribution rather than a tax credit. Consult your CPA to determine the appropriate treatment for your organization.

If your claim was disallowed or you repaid the ERC: In addition to reversing the entries above, see the March 2025 IRS guidance below for how to handle the income tax implications on your current year return.

How The March 2025 IRS Guidance Affects Your Tax Returns

In March 2025, the IRS released updated guidance significantly changing how businesses should handle the income tax impact of ERC claims. This guidance is directly relevant to your 2024 and 2025 tax returns. Here’s what you need to know based on your situation.

If you received an ERC refund but did not reduce your wage expense on your original income tax return, the IRS does not require you to amend prior year returns. While the technically correct treatment remains reducing wages in the year the qualified wages were paid, IRS guidance allows businesses to instead include the overstated wage expense amount as gross income in the year the ERC refund was received.

If your ERC claim was disallowed after you already reduced your wage deduction, the IRS does not require you to file an amended return. Instead, in the year the disallowance becomes final — meaning you are no longer contesting the decision — IRS guidance permits you to increase your wage expense on that year’s return by the amount previously reduced.

If you already filed an amended return following prior IRS guidance, the new guidance does not allow you to file another amendment to reverse what you did. This has drawn criticism from tax professionals since businesses that followed the original rules may be in a worse position than those who didn’t. Consult a tax attorney if this applies to your situation.

Important note: This guidance is not legally binding. It was issued as FAQ updates rather than formal regulations. Some tax professionals have raised concerns about its legal basis. When in doubt, consult a CPA or tax attorney before acting on it.

Amended Return Requirements When ERC Is Repaid

If your business received an ERC refund and is now required to repay it, there are specific steps you need to take on both your employment tax returns and your income tax returns.

Step 1: Address your employment tax return.

To repay the ERC, you’ll need to file an amended employment tax return on Form 941-X for each quarter in which the credit was originally claimed. This reduces the credit amount on your payroll tax records and establishes the amount owed to the IRS.

Step 2: Restore your wage deduction on your income tax return.

When you originally claimed the ERC, you were required to reduce your wage deduction by the amount of the credit. When you repay the ERC, that reduction needs to be reversed. Under the March 2025 IRS guidance, you can do this in the year the repayment is made rather than filing amended returns for the original year, but the adjustment must be made.

Step 3: Understand interest and penalties.

If you are repaying an improper ERC claim, the IRS will typically assess:

• Interest accruing from the date the original refund was issued, calculated at the federal short-term rate plus 3%
• A 20% accuracy-related penalty if the IRS determines the claim was filed negligently or without reasonable basis
• A 75% civil fraud penalty if the IRS determines the claim was fraudulent

Interest accrues daily. Interest abatement is generally limited and typically applies only in cases involving unreasonable IRS error or delay rather than taxpayer reasonable cause. Penalties, however, may be reduced or eliminated through first-time penalty abatement or reasonable cause relief if you can demonstrate you relied on professional advice in good faith.

If you already filed amended income tax returns to reduce your wage deduction and are now repaying the ERC, you may need to file a second amended return to restore those deductions. Document the full sequence carefully for audit purposes.

State Tax Implications Of The ERC

The federal tax treatment of the ERC is complicated enough, but state tax implications add another layer of complexity that many businesses overlook.

Because state conformity rules vary widely — and frequently change — businesses should verify ERC treatment directly with their state tax authority or a SALT specialist.

Some states conform closely to federal treatment, while others allow modifications that effectively restore wage deductions disallowed at the federal level. For example, New York permits a state adjustment that may allow wages reduced for ERC purposes to be deducted for New York taxable income.

The Bottom Line On ERC & Your Taxes

The March 2025 IRS guidance changed the rules on how businesses handle ERC on their income tax returns, and state tax treatment varies significantly depending on where your business operates. Getting this wrong can trigger additional scrutiny, penalties, and interest on top of what you may already owe.

Whether you’re still waiting on a refund, navigating a disallowance, or trying to make sure your books and tax returns are in order, the smartest move is to work with a qualified CPA or tax attorney who is familiar with ERC compliance. The rules are complex, they’ve changed multiple times, and the stakes are high enough that this isn’t an area to navigate alone.