Receiving the ERC sounds ideal from a cash flow perspective, but when it comes to filing your taxes post-receipt of the ERC, headaches can start to occur.
While it technically isn’t classed as taxable income, it does alter your payroll deductions, thus impacting your taxable profits.
Confused yet? Join us as we delve further into where you need to declare your ERTC on relevant forms, such as 1120-S and 1065.
How does employee retention credit affect the tax return
How much the employee retention credit will affect your tax returns will depend primarily on three factors: (1) how much you claim under the credit; (2) how much payroll expense deductions you take during the year; and (3) what type of business entity you run.
But in order to know the answers to these factors, we need to explore the relationship between the ERC and “taxable income”...
So, is the employee retention credit taxable income?
While the ERC is technically not taxable income in and of itself, the ERC will still affect your payroll deductions. As an employer or business that receives the employee retention credit, you must reduce your payroll expense deduction by the amount of the ERC claimed.
To understand this better, we need to first unpack the law surrounding employment credits generally.
Under IRC Section 280C, taxpayers are required to reduce their deductible expenses by the amount of the R&D credit for the tax years that the credit has been taken.
R&D tax credits and ERC tax credits are separate categories, and the IRS has stated that any credits claimed under the ERC cannot also be claimed under R&D and vice versa. This rule is to prevent businesses from “double-dipping.”
For your business to have better cash flow, you need to take specific steps when claiming both federal tax credits.
Expenses that aren't considered qualified research expenses can be applied toward the ERC credit to reduce the negative impact on the R&D tax credit. The maximum benefit can be derived from when each credit is generated in this way.
Your payroll deductions are wages withheld from your total taxable earnings for the purposes of paying taxes and benefits.
So, by claiming ERC, you will effectively increase the amount of taxable income, thereby increasing the overall amount of taxes owed.
How to report ERC on a tax return
The employment retention credit is reported on the tax return on different forms depending on the type of business that you run, namely an S-corporation, partnership, cooperative, estate or trust.
If you’re a corporation or, more specifically, an S-corporation (“S-corp”), and you are a shareholder, then you will have to fill out the Form 1120-S. On the Form 1120-S, line 13g is the section used to report the income, gains, losses, deductions and credits that go into calculating a business’s income tax liability.
If you are a partner of a partnership, whether that be a general partnership, limited liability partnership or a limited partnership, you will have to fill out the Form 1065.
Additionally, with each of these forms, you will have to fill out an accompanying Schedule K-1, which will vary in its informational requirements depending, again, on the type of business that you run.
Finally, if you’re a partnership, S-corporation, cooperative, estate, or trust, you must file the Form 5884-A for any employee retention credit claims.
(Additional reading: employee retention credit and nonprofits)
How to report ERC on tax return 1120-S
The way to report the employee retention credit is straightforward, but nevertheless crucial to scrutinize and ensure the proper fields are completed. In this section, we will discuss the following forms and their relevant sections:
1. Form 1120-S
At its core, Form 1120-S is an income tax return that is filed by S-corporations. This tax return reports all gains, losses, credits, deductibles and other elements of the corporation’s tax liability.
The short definition of an S-corporation is that it is a “type of business entity that has the capacity to pass corporate income, losses, deductions, credits, etc. through to their shareholders for federal tax purposes.”
In other words, the business does not have to deal with the issue of “double taxation” on corporate income–it simply pushes those taxes to the shareholders, placing the onus on them to fill out the requisite forms.
The form itself is due alongside all other S-corp filings, which are submitted by day 15 of the 3rd month after the end of the tax year.
2. Line 13g
Line 13g falls under the category of “Other Credits” when reporting on the Form 1120-S. The following groups encompass the category of what can be entered into Line 13g:
Undistributed capital gains credits
These are credits that have taxes paid on undistributed capital gains by either a regulated investment company or a real estate investment trust. These credits must be included in proportion to the gross income of the shareholders.
Additionally, the capital gain tax that the company or corporation pays is treated by the IRS as being paid for by the individual shareholders. In turn, the shareholders are allowed a corresponding tax credit.
Work opportunity credit
This is a tax credit under federal law that is available specifically to employers that hire and employ individuals from certain targeted groups that have consistently faced barriers to employment.
Examples of targeted groups have included:
Qualified summer youth employees
Individuals who receive qualified supplemental nutrition assistance program benefits (SNAP)
Long-term unemployment recipients
Social security and Medicare tax credits
Generally, under this category of tax credits, the credit comes from the amount of employer social security and Medicare taxes paid by the employer as a result of tips that the employee receives.
This is usually relevant to food and beverage establishments that hire servers who earn tips from customers.
Corporations’ withholdings on dividends, interests, and other types of income fall under this category.
Code P / other credits
Lastly, Code P credits encompass a broad range of credits that have not been reported elsewhere on Form 1120-S.
Credits filed under this category require an additional statement identifying the amount and the type of credits.
The employee retention credit falls under the Code P category, as the IRS instructions clearly states “Employee retention credit for employers” as an applicable credit that further requires the filing of the Form 5884.
3. Form 5884-A
Form 5884-A is used to claim the employee retention credit for employers affected by qualified disasters.
According to the IRS, several types of businesses may fill out the form 5884 including partnerships, S-corporations, cooperatives, estates, and trusts.
To qualify, you must continue to pay an employee's wages even if your business is unable to operate due to damage caused by a disaster. An employee can receive a 40% credit on up to $6,000 of qualifying wages. Credits are limited to $2,400 per employee.
4. Schedule K-1
An entity, such as a business partnership or a S-corporation, is required to file a Schedule K-1 that shows the amounts that are passed through to each participant, such as partners or shareholders individually.
Each party prepares its own tax returns based on the information on the K-1, but the form is complex in that it requires information about the business, including:
There are different versions of the Schedule K-1 depending on the type of business filing for taxes. For example, the Schedule K-1 for a partnership is reported on the 1065 tax form and includes in pertinent part each partner’s share of income, losses and tax credits.
Next, there are Schedule K-1’s for S-corporations, which require the reporting of each shareholder’s share of income. These Schedule K-1’s are reported with the Form 1120S, discussed above.
Since we have already discussed Form 1120S, which is filed alongside its own Schedule K-1, the following section will delve into greater detail on the reporting techniques used to file the Schedule K-1 form for partnerships, also known as Form 1065.
How to report ERC on tax return 1065
Form 1065, also known as the Schedule K-1 form of business partnerships, is a form used to report income, gains, credits, etc. of the partnership. All domestic business partnerships headquarters in the United States must file Form 1065.
A partnership is a type of business entity that is created through a formal agreement between two or more parties to manage and operate the business and share in its profits.
And, depending on the type of partnership, each partner has a role in overseeing the day-to-day activities of the business and takes on some form of liability.
This means that each partner must file Form 1065 separately. For instance, if a business partnership earns a total of $500,000 in taxable income in the 2023 fiscal year and it has two partners, each partner receives their own Form K-1/Form 1065 with $250,000 of income on those forms.
To unpack this discussion further, we will break down the steps to filling out the Form 1065 as follows:
Form 1065 preliminary instructions
Navigate to Box 15 “Credits”
Enter employee retention credit under “Other Credits”
1. Instructions for pages 1-3 of Form 1065
The partner filling out the form is required to include their share of profits, including the amount of loss and deduction that the partner may claim on their tax return.
The form highlights that it is the partner’s responsibility and onus to apply all necessary limitations on losses, deductions and credits such that the amount reported on the Schedule K-1 is accurate and up to date.
Most recently, there has been an update to the form due to the Inflation Reduction Act of 2022. The update includes:
Advanced manufacturing investment credits
Excise taxes on repurchase of corporate stock
Increase in energy credit for solar and wind facilities
Extension of incentives for biodiesel or renewable diesel
Deductions for qualified retrofit for energy efficient commercial buildings
Credits against payroll taxes for small businesses for increase in research for tax years beginning after 2022
Further, payroll credits for COVID-related paid sick leave continues to be listed on the Form K-1 as part of the 2021 American Rescue Plan Act, allowing employers to take credits against payroll taxes owed for amounts paid for qualified sick or family leave. The eligible period is for April 1, 2020 to September 30, 2021.
However, the form explicitly states that the payroll credit will not allow for a double tax benefit, so other amounts claimed under different credits, such as the employee retention credit, must be claimed separately.
2. Navigate to Box 15 Credits
The pertinent section of Form 1065 is “Box 15. Credits”, which is where the partner must report credits for passive activity or any of the credits identified in the form.
The employee retention credit is listed and named explicitly as “Employee retention credit for employers affected by qualified disasters.”
3. Enter employee retention credit
The last step is filling out the accurate amount.
Be sure to list the employee retention credit on the form by recording the accurate amount and subtracting that amount from the payroll expense deduction.
Ultimately, as a fully refundable tax credit, the ERC is neither a loan nor something that must be paid back. The refundable credit is “in excess” of the taxes from payroll generated within the credit period (2020-2021).
Nevertheless, it’s incredibly important to accurately record the amount and calculate the amount of payroll expense deduction claimed, such that it is accurate given the amount of credit claimed.
Each type of business entity has its own form, whether it be Form 1120S for the S-corporation or Form 1065 for the partnership. Therefore, it’s crucial to keep track of the forms submitted and consult us if you need assistance with your ERC affairs.
Additional reading: will the IRS audit the ERC credit?