IRS Releases ERC FAQs on Income Tax Effects

The IRS's new positions are contrary to prior guidance in some cases

The IRS now realizes the late processing of refund claims in many cases prohibits the required reduction in wage expense under §280C for tax years 2020 and 2021 because the assessment statute of limitations bars those assessments.

New IRS frequently asked questions (FAQs) issued on March 20, 2025 attempt to give the IRS a second attempt to collect those funds and address issues that should have been addressed years ago. However, one FAQ is contrary to a prior IRS notice, so the ERC confusion continues to plague practitioners.

Q&A 1: Wage Reduction on the Original Return

In new Q&A 1, the IRS claims taxpayers should have reduced the wage expense on the original income tax return per §280C regardless of receipt of the funds.

The IRS stated the following (which is generally correct as a matter of law):

Generally, 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.

It was questionable whether the IRS would pay the claims, especially in the last two years. Is there a reasonable expectation of reimbursement for a claim still unpaid in the IRS’s self-created moratorium backlog?

The IRS is not legally obligated to process a refund claim; the Taxpayer Advocate summarizes this issue and advocates for a statutory change:

Surprisingly, the IRC does not require the IRS to process a claim for credit or refund or even to respond to the taxpayer. The IRS can simply ignore the claim. This odd result is a poster child for non-responsive government.

Q&A 2: Taxpayer Got Late Claim and Did Not Reduce Wages

In new Q&A 2, the IRS claims the following:

You should address your overstated wage expense. Under these facts, 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 is correct. There is no requirement to file an amended tax return; the taxpayer can file one if they so choose. The Supreme Court in Badaracco v. Comm., 464 U.S. 386 (1984) stated that “an amended return is a creature of administrative origin and grace,” and there is no legal requirement to file one. Since the wage deduction should occur in the year the credit was earned under Treas. Reg. §1.280C-1, the IRS should have examined and issued notices of deficiency for taxpayers who neglected to make the reduction.

Since the IRS failed to do that, many periods are closed under the three-year assessment statute of limitations. The IRS’s new position is that the taxpayer increases gross income in the year of receipt to adjust for the previously overstated wage deduction and references the tax benefit rule as its justification:

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. If you received the ERC and did not reduce your wage expense on your income tax return for the year the wage expense was paid or incurred, your ERC claim and income tax return are inconsistent and you may be claiming an unwarranted double benefit. Application of this rule corrects a taxpayer’s excess wage expense on the income tax return for the year in which it received the ERC, rather than limiting corrections to income tax returns for the prior year in which the ERC was claimed.

The tax benefit rule is a judicially created doctrine. §111 partially codified the rule with respect to excluding items from gross income to the extent their prior deduction did not create a tax benefit.

In Frederick v. Comm., 101 T.C. 35 (1993), the Tax Court explained that an amount is included in gross income under the tax benefit rule if, and to the extent that:

1. The amount was deducted in a year before the current year,

2. The deduction resulted in a tax benefit,

3. An event occurs in the current year that is fundamentally inconsistent with the premises on which the deduction was originally based, and

4. A nonrecognition provision of the Code does not prevent the inclusion in gross income.

The Court also stated in Frederick that:

The exclusionary component of the tax-benefit rule, by contrast, eats away at the inclusionary component by limiting the income that must be recognized in the subsequent year to the amount of the tax benefit that resulted from the deduction.

While the IRS stated a taxpayer who did not experience a reduction in tax liability might not need to include the amount in gross income, the example it provides bypasses this necessary analysis and assumes, without stating it, a full tax benefit. This may not be the case for every taxpayer; an actual analysis is needed.

One essential item is that the tax benefit rule can be applied to a taxpayer different from the one that claimed the deduction. In Frederick, the Tax Court stated:

Petitioners argue, without citation, that a recovery does not constitute taxable income if the recovery of a prior deduction would be taxed to a person different than the person that originally took the deduction. We disagree.

Notice 2021-49, which had an entire section titled “Timing of Qualified Wages Deduction Disallowance,” never mentioned the tax benefit rule and took a position utterly contrary to this new FAQ:

When a taxpayer… files an adjusted employment tax return to claim the employee retention credit, the taxpayer should file an amended federal income tax return or administrative adjustment request (AAR), if applicable, for the taxable year in which the qualified wages were paid or incurred to correct any overstated deduction taken with respect to those same wages on the original federal tax return. Section 2301(e) generally provides, in relevant part, that rules similar to the rules of section 280C(a) of the Code shall apply. Section 280C(a) requires tracing to the specific wages generating the applicable credit. See, generally, Treas. Reg. § 1.280C-1. To satisfy this tracing requirement, the taxpayer must file an amended return or AAR, as applicable.

Q&A 3: ERC Disallowed and Wages Were Reduced

The IRS says that a taxpayer has two options in this situation:

…in the year your claim disallowance is final (meaning you are not contesting the disallowance or you have exhausted your remedies to argue against the disallowance), increase your wage expense on your income tax return by the same amount that it was reduced when you made your claim. Alternatively, you may, but are not required to, file an amended return, AAR, or protective claim for refund to deduct your wage expense for the year in which the ERC was claimed.

The IRS says this process will prevent the need for protective refund claims, and help taxpayers who reduced expenses in tax years that are closed under the refund statute of limitations.

The IRS said this treatment is allowed because:

The special statutory rules for the ERC treat a claimed ERC as a right or reasonable expectation of reimbursement for qualified wage expense… The “special statutory rules” referred to here are: Section 2301(e) of the CARES Act for qualified wages paid between March 13, 2020, and June 30, 2021. Section 3134(e) of the Internal Revenue Code for wages paid between July 1, 2021, and Dec. 31, 2021.

These sections say that rules similar to §51(i)(1) [attribution rules] and §280C(a) [wage expense reduction] apply to the ERC. It may be a stretch to claim that these rules “treat a claimed ERC as a right or reasonable expectation of reimbursement for qualified wage expense.”

Next Steps

The IRS continues mismanaging the ERC program by issuing late guidance through informal channels with questionable positions. Interestingly, the IRS released this important guidance AFTER the March 17, 2025, deadline for partnership and S corporation tax returns.

Ultimately, FAQs posted on the IRS website are not authority for positions (unless added as a Fact Sheet to a press release, which the IRS did NOT do in this case). If the practitioner believes the positions stated in the FAQ are reasonable and likely correct, they can apply them after discussing the matter with the taxpayer.

If the return in question has already been filed, Circular 230 §10.21 requires the practitioner to advise the taxpayer of the noncompliance, error, or omission and its consequences but does not require an amended return to be filed. As the IRS stated above, there is no legal requirement to file an amended tax return.

If the IRS and the taxpayer agree on a taxpayer-friendly position in an FAQ, no adverse party can challenge that position, so there is no reason not to take the benefits the IRS offers to the taxpayer.

Thank You

Thank you to Tara Hendrickson, EA, who alerted me this morning to these FAQs.

Join the Conversation

As a paid subscriber, you can discuss this topic in the comments section. Please keep the discussion related to this edition’s topic.

Learn More About Tom

Please take a look at my website to learn about the educational opportunities I offer the tax professional community.