IRS addresses ERC wage expense adjustments on tax returns

On March 20, 2025, the IRS released new Frequently Asked Questions (FAQs) that provide alternatives for adjusting wage expenses on income tax returns for employee retention credit (ERC) claims, which may eliminate the need to file amended returns and protective refund claims for prior years in certain scenarios (see FAQs 1-3 under the “Income tax and ERC” section).

The amount of the ERC reduces the amount the employer is allowed to deduct or capitalize for salaries and wages for federal income tax purposes.

Before the release of the new FAQs, employers generally reduced wage expenses in the tax year in which the qualified wages used to calculate ERC amount were paid or incurred (that is, the ERC claim year). If the ERC claim was made after the original federal income tax return for the ERC claim year had been filed, employers generally reduced wage expenses by filing an amended income tax return, or in the case of a partnership, an administrative adjustment request (AAR) for that prior tax year to reflect the reduced wage expenses.

Example 1 – Employer A claimed an ERC of $700 based on $1,000 of qualified wages paid for tax year 2021, but did not reduce its wage expense on its income tax return for 2021.

Before the new FAQs were released, Employer A generally would have filed an amended income tax return for the 2021 tax year to reflect reduced wage expenses of $700 for the amount of the ERC claimed for 2021.

In addition, if an employer reduced wage expenses for the amount of the ERC claimed on its income tax or partnership return, and the ERC claimed was subsequently disallowed, employers generally had to file an amended income tax return or AAR for that prior tax year to increase wage expenses by the amount of the disallowed ERC claim. However, employers have a limited amount of time to file amended returns or AARs — the period for filing a claim for refund or AAR generally is three years from the date the original return for the applicable tax year was filed.

The new FAQs provide additional alternatives for adjusting the wage deduction in certain situations. The FAQs address two specific scenarios:

• The employer did not reduce its wage deduction for the ERC claim year and the ERC was allowed in a subsequent year (that is, an “overstated wage deduction” scenario); and
• The employer did reduce its wage deduction for the ERC claim year, but the ERC was disallowed in a subsequent year (that is, an “understated wage deduction” scenario).

Overstated wage expenses

In an overstated wage expenses scenario, the new FAQs provide that an employer is not required to file an amended return (or AAR) for the tax year in which the wage expenses were paid or incurred to address the overstated wage expenses. Instead, an employer can include the overstated wage expense amount as gross income on its income tax or partnership return for the tax year in which the employer received the ERC.

Example 2 – The same facts as described in Example 1 above, except that the IRS paid the ERC claim to Employer A in 2024.

Based on the guidance provided in the new FAQs, Employer A does not have to amend its income tax return for the 2021 tax year. Employer A can account for the overstated wage expenses by including the $700 in gross income on its 2024 income tax return.

The FAQs also indicate that if an employer had capitalized wages (as opposed to deducting them) or did not otherwise experience a reduction in tax liability for the overstated wage expenses, the employer may not need to include the overstated wage expense amount in gross income on the income tax return for the tax year in which the employer received the ERC. Instead, the employer may need to make other adjustments, such as a reduction in basis for the capitalized wages.

Understated wage expenses

In an understated wage expenses scenario, the new FAQs provide that an employer may, in the tax year the claim disallowance is final, increase wage expenses on its income tax return by the same amount that it was reduced when it made its ERC claim. Alternatively, an employer may, but is not required to, file an amended return, AAR, or protective claim for a refund to deduct the wage expenses for the tax year in which the ERC was claimed.

For this purpose, the FAQs provide that the year in which a claim disallowance is final is the year in which the employer is not contesting the disallowance or has exhausted all remedies to argue against it.

Example 3 – Employer B claimed the ERC for tax year 2021 and reduced its wage expenses on its income tax return for tax year 2021 because it expected the credit would be allowed and paid. In 2024, the IRS disallowed Employer B’s ERC claim. Employer B does not challenge the denial of the ERC claim, and accordingly, the disallowance is final.

Based on the guidance provided in the new FAQs, Employer B does not need to amend its income tax return for tax year 2021. Instead, Employer B can address this adjustment on its 2024 income tax return by increasing its wage expenses by the amount of the previously reduced wage expenses from its 2021 income tax return.

The IRS noted in the FAQs that, because employers have a limited amount of time to file amended returns or AARs, these new alternatives prevent the need for employers to file protective claims for years in which the time to file an amended return or AAR is quickly coming to a close. The IRS also noted that these new alternatives provide relief to employers who previously reduced wage expenses in tax years for which the period of limitations has expired and the employer did not file a protective refund claim. 

Employer implications

These FAQs provide alternative approaches for employers that need to make adjustments to their wage expenses in connection with prior ERC claims. These new alternatives may eliminate the need to file amended returns, AARs, or protective refund claims for prior years in certain scenarios. 

Please note that FAQs are informal and nonbinding guidance — the IRS can change or withdraw the guidance at any time, including retroactively. Employers should understand the nature of the guidance so they can make fully informed decisions about how to adjust their wage expenses in these scenarios for federal income tax purposes. 

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