IRS Provides Helpful Instructions for Wage Expenses and ERC

Background

When the IRS issued guidance for the employee retention credit (ERC), it instructed taxpayers to reduce the wage expense on their business tax returns at the time they claimed the credit. See IRS Notice 2021-20.

IRS instructed taxpayers who followed the guidance but later had their ERC claim denied or reduced to amend the return for the year the wages were paid to deduct the corresponding wage expense. Taxpayers who did not reduce their wage expense when they filed their ERC claim were instructed to amend the return for the year the wages were paid to eliminate the corresponding wage expense once their ERC claim was paid. See IRS Notice 2021-49. Although laborious, this guidance was workable until the three-year limitations period began to run for amending business returns.

Taxpayers who received 2020 ERC refunds after the limitations period ran out in 2024, for example, could no longer amend returns or file an administrative adjustment request (AAR) to reduce their wage expense. Similarly, taxpayers who had reduced the wage expense when they filed their 2020 ERC claim were unsure how to proceed when their claim was denied after the limitations period had run. In anticipation of the statute running for 2021 returns in 2025, many taxpayers were considering filing protective claims.

New Instructions

On March 20, 2025, the IRS broke its silence on this issue by dropping three helpful frequently asked questions.

In response to Question 1, “Should I have reduced my wage expense on my income tax return when I filed for the ERC?” the IRS affirmed earlier guidance, reiterating that this was indeed an expectation. The IRS explained that a taxpayer can’t deduct an expense as an ordinary and necessary business expense if they have a right or reasonable expectation of reimbursement at the time they paid or incurred the expense. Taxpayers had a reasonable expectation of reimbursement when they filed their ERC claim.

The answers to Questions 2 and 3, however, explain how to resolve the issue if this wasn’t done or if it was done, but the ERC claim was disallowed.

In response the Question 2, “I claimed the ERC but didn’t reduce my wage expenses on my income tax return,” the IRS provides a practical solution:

You’re not required to file an amended return or, if applicable, an administrative adjustment request (AAR) to address the overstated wage expenses. Instead, you can include the overstated wage expense amount as gross income on your income tax return for the tax year when you received the ERC.

The IRS relied on the tax benefit rule to support this guidance, “Under the tax benefit rule, a taxpayer should include a previously deducted amount in income when a later event occurs that is fundamentally inconsistent with the premise on which the deduction is based.”

In response to Question 3, “What can I do if my ERC claim was disallowed and I’d already reduced my wage expense…?”, the IRS directs taxpayers to “increase your wage expense on your income tax return by the same amount that it was reduced when you made your claim." The IRS stated this should be done only if the ERC disallowance is final.

Alternatively, the IRS said that a taxpayer could (but is not required to) file an amended return, AAR, or protective claim for refund to deduct the wage expense for the year in which the ERC was claimed.

Bottom line, the IRS stated that taxpayers should treat the ERC as they would failure to receive any other reasonably expected reimbursement that prevented them from deducting a business expense in the year they paid or incurred the expense.

Penalty Relief

Within the answer to Question 1, IRS cites IR-2022-89, which explains to taxpayers how they may receive penalty relief if additional tax was not timely paid. This release was directed to those taxpayers who did not reduce their wage expense because they could not afford to pay the additional tax until after they received their ERC refund.

This release reminds taxpayers that, consistent with the relief from penalties for failure to timely pay noted in Notice 2021-49, they may be eligible for relief from penalties for failing to pay their taxes if they can show reasonable cause and not willful neglect for the failure to pay. In general, taxpayers may also qualify for administrative relief from penalties for failing to pay on time under the IRS's First Time Penalty Abatement program if the taxpayer:

• Did not previously have to file a return or had no penalties for the three prior tax years,
• Filed all currently required returns or filed an extension of time to file and
• Paid, or arranged to pay, any tax due.