How should I report the Employee Retention Credit (ERC) on Form 1120S?

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The Employee Retention Credit (ERC) is a refundable tax credit introduced to encourage employers to retain employees during the COVID-19 pandemic. For S Corporations filing Form 1120S, accurate reporting of the ERC is essential to comply with IRS regulations. This involves adjusting wage expenses and correctly reflecting the credit on the tax return.

1. Understanding the ERC and Its Impact on Wage Expenses

Explanation:

  • The ERC reduces the employer’s deductible wage expenses by the amount of the credit received.
  • Although the ERC is a credit against employment taxes, it is considered a government grant, affecting the computation of taxable income.

Authoritative Sources:

  • IRS Notice 2021-20
    “An employer’s deduction for qualified wages, including qualified health plan expenses, is reduced by the amount of the employee retention credit.”
  • Internal Revenue Code (IRC) § 280C(a)
    “No deduction shall be allowed for that portion of the 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… section 3111(e)…” cornell Law School

2. Reducing Wage Expense on Form 1120S

Action Steps:

  1. Calculate Total Wage Expenses: Determine the total wages paid to employees during the tax year.
  2. Subtract ERC Amount: Reduce the wage expense by the amount of the ERC claimed.
  3. Report Adjusted Wage Expense: Enter the net wage expense on Form 1120S, specifically on Line 8 (Compensation of Officers) and Line 13 (Salaries and Wages).

Example:

  • Total Wages Paid: $500,000
  • ERC Received: $50,000
  • Adjusted Wage Expense: $500,000 – $50,000 = $450,000
  • Report $450,000 on the relevant wage expense lines.

Authoritative Sources:

  • Form 1120S Instructions
    “Enter on line 13 the amount of salaries and wages paid for the tax year, reduced by the amount of employment credits claimed.” IRS
  • IRS FAQs on ERC
    “An employer must reduce its deduction for qualified wages by the amount of the employee retention credit claimed.” IRS

3. Reporting the ERC on Schedule K and K-1

Explanation:

  • The ERC itself is not reported separately on Schedule K or Schedule K-1.
  • The impact of the ERC is reflected through the reduced wage expense, which affects Ordinary Business Income (Loss) reported on Form 1120S, Line 21.
  • Shareholders will see the effect in their distributive share of income or loss.

Authoritative Sources:

  • Form 1120S Instructions – Schedule K and K-1
    “The corporation must furnish each shareholder a Schedule K-1 showing the shareholder’s pro rata share of items reported on Schedule K.” IRS

4. Impact on Shareholder Basis

Explanation:

  • Since the ERC reduces deductible expenses, it increases the Ordinary Business Income, potentially affecting the shareholders’ basis in the S Corporation.
  • Shareholder Basis is adjusted annually for income, losses, deductions, and distributions.

Action Steps:

  • Increase Basis: Shareholders increase their basis by their share of the corporation’s income.
  • Decrease Basis: Shareholders decrease their basis by their share of losses and deductions.

Authoritative Sources:

  • IRS Publication 551 – Basis of Assets
    “Adjustments to the basis for S corporation shareholders are similar to those for partners.” IRS
  • IRC § 1367 – Adjustments to Basis of Stock of Shareholders
    “The basis of each shareholder’s stock in an S corporation… is increased for income items and decreased for distributions and loss or deduction items.” IRS

5. Amending Returns if Necessary

Explanation:

  • If the ERC is claimed retroactively for a prior year (e.g., via amended Form 941), you may need to amend Form 1120S for that year to adjust the wage expenses accordingly.
  • Amended returns affect shareholders’ K-1s and may require them to amend their individual returns.

Action Steps:

  • File Form 1120-SX (Amended Return): Use this form to amend the corporate tax return.
  • Issue Amended K-1s: Provide shareholders with corrected Schedule K-1s.

Authoritative Sources:

  • Instructions for Form 1120-SX (Amended Return):
    “Use Form 1120-SX to correct a previously filed Form 1120S.” IRS
  • IRS FAQ #57 on ERC and Amended Returns
    “If an employer filed its income tax return for a taxable year in which qualified wages were paid before filing an employment tax return to claim the employee retention credit, the employer should file an amended federal income tax return or administrative adjustment request (AAR).” IRS

6. Recording the ERC in Financial Statements

Explanation:

  • For bookkeeping purposes, the ERC is considered other income or a reduction of payroll expenses.
  • Consistency with tax reporting is essential to avoid discrepancies.

Action Steps:

  • Consult with an Accountant: Ensure that financial statements accurately reflect the ERC.

Authoritative Sources:

  • Financial Accounting Standards Board (FASB) ASC 958-605
    “Government grants to business entities are accounted for by analogy to IAS 20.” IRS

7. Key Considerations and Best Practices

  • Documentation: Maintain thorough records of how the ERC amount was calculated and how wage expenses were adjusted.
    Authoritative Sources:
    • IRS Recordkeeping Requirements
      “You must keep records sufficient to show that you are entitled to the credits.”

Disclaimer: The information provided is for general informational purposes and should not be considered legal or tax advice. Tax laws are complex and subject to change. For advice specific to your situation, consult a qualified tax professional or refer to official IRS resources.