What is the "ERTC" on a Business Tax Return?
We often receive questions via the Bukers Hotline from analysts who notice a book/tax adjustment on Schedule M-1 called “ERTC”, which stands for the Employee Retention Tax Credit. Their question is usually something along the lines of, “can you explain what this ERTC is, and how should I treat it in my analysis?” On this week’s newsletter, let’s explore this topic and answer the analyst’s question.
What is the ERTC?
Let’s start off with a brief refresher on what the ERTC is in the first place. Back during the COVID pandemic, the IRS wanted to provide relief to certain, qualifying businesses whose operations were struggling due to the pandemic. So, they enacted a refundable tax credit (the ERTC) for companies who continued to pay their employees’ wages during that period of economic uncertainty. The ERTC reduces the company’s payroll taxes during that time, dollar-for-dollar based on the employee wages paid. The credit applies to the 2020 and 2021 tax years, but it has been eligible to be applied retroactively until recently when the IRS cut off any further ERTC applications. So, analysts may see its effects on tax returns from the past few years while conducting historical business tax return analysis.
How Does the ERTC Appear on a Business Tax Return?
The application of the employee retention tax credit itself does not appear on a business tax return. That is processed on a separate form – generally Form 941-X. The specific information included on Form 941-X is outside the scope of our analysis. There is, however, an adjustment made on a business tax return related to the ERTC that is important for our analysis, especially as we convert the business tax return to a GAAP-equivalent set of financial statements.
Why the Adjustment Exists
With refundable credits like the ERTC, the IRS often requires the business claiming the tax credit to make an adjustment on its income tax return to disallow tax deductions related to the credit claimed. In this instance, the IRS requires the business to disallow the tax deduction for employee wages that was included in the calculation of the ERTC. Since the business receives a tax credit on those wages paid via the ERTC, the IRS stipulates that the business cannot also receive the benefit of tax deductions from those same wages. If the employer would rather forgo the ERTC to claim tax deductions on wages paid, they can do so, but they must choose one option or the other. Either claim the ERTC and add back applicable wages or avoid the ERTC and deduct wages as normal. Usually, the benefit to the business from the credit outweighs the tax deduction taken from those expenses, so the company will add back the expenses on the tax return in order to qualify for the refundable tax credit.
How the Company Reports the ERTC
The company initiates this addback of employee wages on Schedule M-1, for the line representing expenses recorded per books this year not deducted on the tax return. The statement detail for this line on Schedule M-1 will usually contain a description that alludes to the ERTC in some way. It is important in our business spread to properly classify this book/tax adjustment so that it resembles salaries and wages on our book Income Statement output.
How to Treat the ERTC in the Business Spread
Those wages that were disallowed for tax purposes should be included as book expenses for our analysis. Based on the size of the company and number of eligible employees, this disallowed deduction could be material, so it is important that we understand the proper way to spread the adjustment. If we ignored it, we could have misstated cash flow figures and underestimated the true total wages paid during that period.
Example
Let’s illustrate this with a very quick example.
ABC Company is eligible for the ERTC because it still paid its employees during the economic downturn resulting from the COVID pandemic. Out of the total $400,000 in wages paid during the period, the company is eligible to claim a $50,000 refundable tax credit for that period, but it cannot deduct those expenses on its business tax return, per IRS rules and regulations. Even though the ERTC relates to the 2020 and 2021 tax years, ABC Company is applying for this credit retroactively and reports this information on its 2023 tax return.
On its 2023 tax return, the company reports deductible wages of $350,000 on Page 1 of the tax return. Upon examining the statement detail for Schedule M-1 (expenses recorded per books, not deducted on the tax return), the analyst notices a line item that says “ERTC” with a corresponding amount of $50,000. As such, the analyst spreads the adjustment as an item related to salaries and wages. After spreading the return, the resulting GAAP-equivalent Income Statement shows total salaries and wages of $400,000 ($350,000 per Page 1 plus $50,000 per Schedule M-1). The analyst has now properly stated wages paid during the period and has a business spread that properly reflects the company’s internal books and records.
Key Takeaway for Lenders
When reviewing a business tax return, lenders should not overlook an ERTC-related Schedule M-1 adjustment. The adjustment represents wages that were recorded on the company’s books but disallowed as a tax deduction, so it should be classified with salaries and wages in the business spread. Failing to make that adjustment can understate actual wage expense and distort the lender’s analysis of historical cash flow and operating performance.
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