The Employee Retention Tax Credit is not taxable income in the ordinary sense. The IRS does not treat the ERTC as revenue or business receipts, and it never appears as a line of income on your tax return. But receiving it still raises your tax bill, because federal law requires you to reduce your wage deduction by the amount of the credit for the year the wages were paid. Less deduction means more taxable income, and that adjustment traces back to 2020 or 2021 — not the year the refund check finally arrived.
Why the Credit Still Raises Your Tax Bill
The ERC was a refundable payroll tax credit. The IRS paid it out either as a reduction in employment taxes or as a direct refund, not as business income.1Internal Revenue Service. Employee Retention Credit The tax hit comes through a different door: your wage deduction shrinks by the credit amount.
Two statutory provisions require this. For qualified wages paid between March 13, 2020, and June 30, 2021, Section 2301(e) of the CARES Act controls. For wages paid between July 1, 2021, and December 31, 2021, IRC Section 3134(e) does the same job.2Internal Revenue Service. Frequently Asked Questions About the Employee Retention Credit – Section: Income Tax and ERC Both apply rules modeled on IRC Section 280C(a), the general anti-double-benefit rule that stops taxpayers from claiming a credit and a full deduction for the same expense.3Office of the Law Revision Counsel. 26 USC 3134 – Employee Retention Credit for Employers Subject to Closure Due to COVID-19
The math is simple. If your business received a $50,000 ERC based on $100,000 in qualified wages, you can only deduct $50,000 of those wages. The $50,000 of lost deduction pushes your taxable income up by the same amount. For a C-corporation, that lands directly on Form 1120. For an S-corporation or partnership, the increased income flows through to owners on Schedule K-1, and a large credit concentrated in one year can push an owner into a higher personal bracket.2Internal Revenue Service. Frequently Asked Questions About the Employee Retention Credit – Section: Income Tax and ERC
How to Make the Adjustment
The IRS gives you two ways to handle this, and which one applies turns on what you already did on your original return.
Amend the Original Wage Year
If you already reduced your wage deduction on the original return for 2020 or 2021 in anticipation of the credit, that return is correct and you don’t need to do anything else. If you didn’t reduce it, the standard path is to amend the return for the year the wages were paid so it reflects the smaller deduction.1Internal Revenue Service. Employee Retention Credit C-corporations use Form 1120-X.4Internal Revenue Service. About Form 1120-X, Amended US Corporation Income Tax Return S-corporations amend on Form 1120-S. Partnerships file Form 1065-X or an Administrative Adjustment Request.
Any additional tax the amended return produces is due for the original year, with interest running from that year’s original filing deadline.
Report It as Gross Income the Year You Received the Refund
In guidance the IRS added in March 2025, there is a simpler alternative. If you claimed the ERC but didn’t reduce your wage expense on your original income tax return, you are not required to amend. You can instead include the overstated wage amount as gross income on your income tax return for the year you actually received the refund.2Internal Revenue Service. Frequently Asked Questions About the Employee Retention Credit – Section: Income Tax and ERC
Say your business claimed a $7,000 credit tied to 2021 wages, never adjusted the 2021 deduction, and the IRS paid the claim in 2024. Rather than amend 2021, you report $7,000 of gross income on your 2024 return. The IRS calls this the tax benefit rule: a prior deduction gets reversed into income when a later event makes the original deduction inconsistent.2Internal Revenue Service. Frequently Asked Questions About the Employee Retention Credit – Section: Income Tax and ERC
The tradeoff is worth noticing. Under this method the ERC amount effectively does show up as income on the receipt-year return, so you skip amending but you accept the income hit in a later year. Net tax over time works out the same — you only get the wage deduction once.
Interest and Penalty Exposure
When an amended return produces additional tax for a prior year, the IRS charges interest on the underpayment from that year’s original due date. For the second quarter of 2026 the underpayment rate is 6 percent, compounded daily.5Internal Revenue Service. Internal Revenue Bulletin 2026-08 The rate resets quarterly at the federal short-term rate plus three percentage points, so it moves.6Internal Revenue Service. Quarterly Interest Rates With several years between the original deadline and the amendment, interest alone can be substantial.
On estimated taxes, there is good news. The IRS granted automatic relief from the IRC Section 6654 estimated-tax underpayment penalty for taxpayers who reduced their estimated payments because of a retroactive ERC claim. No form is required; the waiver applies on its own.7Internal Revenue Service. Frequently Asked Questions About the Employee Retention Credit
Failure-to-pay penalties are separate. If your amended return shows tax owed and you don’t pay promptly, standard late-payment penalties apply. The IRS has said taxpayers may be eligible for ERC-related penalty relief and points to News Release IR-2022-89, which generally requires showing reasonable cause.7Internal Revenue Service. Frequently Asked Questions About the Employee Retention Credit
If the IRS Disallows Your Claim
The IRS has been auditing ERC claims aggressively, and many businesses have been receiving disallowance notices. If you already reduced your wage deduction based on the expected credit and the IRS later disallows it, you can reverse the adjustment. Specifically, you can increase your wage expense on the return for the year the disallowance becomes final, restoring the deduction you gave up.2Internal Revenue Service. Frequently Asked Questions About the Employee Retention Credit – Section: Income Tax and ERC You can also amend the original wage year to add the deduction back, but the IRS doesn’t require it. The current-year route is simpler.
If the IRS already paid the credit and then disallows it, you have to repay the full amount, potentially with penalties and interest.7Internal Revenue Service. Frequently Asked Questions About the Employee Retention Credit A 20 percent accuracy-related penalty is a real risk for claims that lacked a reasonable basis. For businesses that recognize a bad claim before the IRS gets to them, the ERC claim withdrawal process was still open as of early 2026 for claims that haven’t been paid or where the refund check hasn’t been cashed.8Internal Revenue Service. Withdraw an Employee Retention Credit (ERC) Claim A withdrawn claim is treated as if it were never filed, with no penalties or interest.
Your State Return May Not Follow the Federal Rule
The federal wage deduction reduction does not automatically carry to your state income tax return. It depends on how closely your state conforms to the Internal Revenue Code.
Most states that impose an income tax use federal adjusted gross income or federal taxable income as the starting point for the state return, and those states generally pick up the reduced wage deduction along with everything else baked into that number. Some states conform selectively, or decouple from specific IRC provisions, which can mean your state allows the full wage deduction even though the federal return does not. The opposite can also happen: a state may require an additional adjustment the federal return doesn’t.
State conformity rules vary widely and change often, so your state result may not match your federal result on this issue. If you operate in multiple states, or your state has a history of decoupling from federal changes, confirm the state-level treatment before filing. Guessing wrong one way means overpaying; guessing wrong the other way means an underreporting notice.