Employee Retention Credit: Complete Guide for Small Business Owners
Did you know the U.S. government paid out over $283 billion in Employee Retention Credits—and over half a billion dollars worth of those claims are now under criminal investigation? The ERC is one of the most valuable COVID-era tax programs ever created, but it's also become one of the most misunderstood and misused.
Whether you already claimed the ERC, received a disallowance notice, or are just trying to understand what happened, this guide covers everything small business owners need to know in 2026.
What Is the Employee Retention Credit?
The Employee Retention Credit (ERC) is a refundable payroll tax credit created by the CARES Act in March 2020. Its purpose was to help businesses keep employees on payroll during the COVID-19 pandemic by offsetting a portion of qualified wages paid.
Unlike a deduction, the ERC is a credit that directly reduces payroll taxes owed. If the credit exceeds your tax liability, you can receive the difference as a refund. Credits were reported on Form 941 (quarterly payroll tax return) or claimed retroactively via Form 941-X.
The ERC filing window is now closed. The final deadline to file ERC claims for 2021 wages was April 15, 2025. No new ERC claims can be filed.
Who Was Eligible?
Eligibility rules differed between 2020 and 2021, and understanding these distinctions is critical—especially if you're facing an audit or disallowance notice.
2020 Eligibility
For wages paid between March 12 and December 31, 2020, a business qualified if it:
- Had 100 or fewer full-time W-2 employees in 2019, and
- Either experienced a full or partial suspension of operations due to a government COVID-19 order, or
- Showed a 50% or greater decline in gross receipts compared to the same quarter in 2019
2021 Eligibility
For wages paid between January 1 and December 31, 2021, a business qualified if it:
- Had 500 or fewer full-time employees in any quarter, and
- Either experienced a suspension of operations (Q1–Q3 only), or
- Showed a 20% or greater decline in gross receipts versus the same quarter in 2019
The gross receipts threshold dropped significantly from 50% in 2020 to just 20% in 2021, which dramatically expanded eligibility.
Recovery Startup Businesses
A special category applied for Q3 and Q4 of 2021: Recovery Startup Businesses (RSBs). These were businesses that:
- Started operations after February 15, 2020
- Had average annual gross receipts under $1 million for the preceding three tax years
- Were not otherwise eligible under the suspension or gross receipts tests
RSBs could claim up to $50,000 per quarter—a meaningful benefit for newly launched companies that might not have met the standard eligibility requirements.
PPP Loan Recipients
One of the most important expansions came when Congress clarified that businesses that received Paycheck Protection Program (PPP) loans could also claim the ERC. The catch: you cannot use the same wages for both PPP forgiveness and the ERC. Separate wage allocations are required.
How Much Was the Credit Worth?
2020
- 50% of qualified wages per employee
- Maximum of $10,000 in qualified wages per employee for the year
- Maximum credit: $5,000 per employee for all of 2020
2021
- 70% of qualified wages per employee
- Maximum of $10,000 in qualified wages per employee per quarter
- Maximum credit: $7,000 per employee per quarter, or $28,000 per employee for the full year
Total potential lifetime benefit: Up to $33,000 per employee ($5,000 from 2020 + $28,000 from 2021).
For a business with 10 employees who qualified in all eligible periods, that's up to $330,000 in total credits—explaining why this program attracted so much attention.
How to Claim (and the Critical Tax Consequence Many Missed)
ERC claims were filed using:
- Form 941 for the original quarterly payroll tax return
- Form 941-X to amend prior quarters and claim the credit retroactively
The Wage Deduction Trap
Here's the compliance issue that catches many businesses off guard: you cannot deduct wages on your income tax return that you used to claim the ERC.
If you claimed $50,000 in ERC credits, you must reduce your wage deductions by $50,000 on your business income tax return. This applies for the year the wages were paid, not the year you received the refund check.
If you filed your income tax return before claiming the ERC (common for retroactive claims), you likely need to amend your income tax return to reduce your wage deductions accordingly. The IRS confirmed this requirement in March 2025 guidance.
Failing to make this adjustment is one of the most common ERC compliance errors—and it's exactly the kind of detail that triggers an audit.
The ERC Fraud Problem: Why It Matters for Honest Businesses
The ERC became a massive target for fraud. Here's the scale:
- $283 billion in total ERC credits paid out
- 504 criminal investigations opened by the IRS Criminal Investigation division
- $5.5 billion under criminal investigation
- 27 convictions secured as of late 2025
- Largest case: Seven individuals indicted in January 2025 for over 8,000 fraudulent claims totaling $600 million
Fraudulent ERC promoters aggressively marketed their services, often claiming that any business could qualify and downplaying or ignoring the eligibility rules. The IRS issued repeated warnings about these "ERC mills" that charged large contingency fees—sometimes 20–25% of the refund—to file questionable claims.
Why This Matters Even If You Filed Legitimately
The flood of fraudulent claims created two problems for honest filers:
- IRS scrutiny increased dramatically. Even legitimate claims face longer processing times and a higher likelihood of audit.
- Disallowance notices are widespread. Over 28,000 disallowance notices have been issued, covering approximately $5 billion in claims. If you received one, you have appeal rights.
Common ERC Mistakes That Trigger Audits
Whether you filed yourself or used a third-party preparer, these are the most common errors the IRS looks for:
1. Not reducing wage deductions on your income tax return Claiming the ERC while keeping the full wage deduction on your income tax return is a double benefit the IRS will catch.
2. Using the same wages for PPP forgiveness and ERC You can claim both programs, but wages must be allocated between them. Using identical wages for both is prohibited.
3. Incorrect employee counts The 100-employee threshold (2020) and 500-employee threshold (2021) only count full-time W-2 employees. Part-time employees and contractors don't count toward the cap.
4. Overstating the gross receipts decline The 50% decline (2020) and 20% decline (2021) thresholds are specific. Quarter-over-quarter comparisons must use the correct prior year quarters.
5. Inflating qualified wages Only wages paid to employees count—and only wages within the per-employee limits ($10,000 annually in 2020; $10,000 per quarter in 2021).
6. Claiming the credit based on incorrect suspension reasoning A general economic slowdown does not constitute a partial suspension. The suspension must result from a specific government order that restricted your operations.
What Happened to the Voluntary Disclosure Program?
In early 2024, the IRS offered a Voluntary Disclosure Program (VDP) that allowed businesses with improper ERC claims to repay only 80% of what they received, with no penalties or interest. This was a significant opportunity for businesses that had filed questionable claims under the influence of aggressive promoters.
The VDP closed in March 2024. The IRS has indicated it may reopen with less favorable terms, but as of early 2026, no new program has been announced. If you suspect you claimed ERC improperly, consulting a tax professional about your options is the right move.
Receiving a Disallowance Notice: What to Do
If the IRS sent you a disallowance letter (typically CP2000 or a Letter 105C or 106C), you have options:
Request an appeal. You can appeal the disallowance within the timeframe stated in the notice—typically 30 days. The IRS Office of Appeals handles these cases independently.
Provide documentation. Gather evidence that supports your eligibility: government orders affecting your business, payroll records, gross receipts records by quarter, and any supporting calculations.
Consider professional help. An enrolled agent, CPA, or tax attorney experienced in ERC matters can represent you before the IRS.
Don't ignore the notice. If you don't respond, the disallowance becomes final and you may owe the full amount refunded plus interest.
Processing Delays: What's Still in the Pipeline
As of mid-2025, approximately 597,000 ERC claims remained unprocessed. The IRS closed all non-examined claims by December 31, 2025, and roughly 41,000 remain under examination or appeals.
If you filed a retroactive claim years ago and are still waiting, you're in a large group. The IRS processing backlog was complicated by the moratorium on new claims filed after September 14, 2023, and by the legislative provisions in the One, Big, Beautiful Bill that further restricted how and when the IRS could process certain late-filed claims.
What the ERC Means for Your Tax Records
Even though new claims can no longer be filed, the ERC has lasting implications for your business records:
- Amended income tax returns may still be needed to adjust wage deductions
- Documentation supporting your eligibility claim should be retained for at least the statute of limitations period
- Audit risk remains elevated for businesses that claimed large ERC credits
- Income tax timing is affected if you received a refund check in a year different from when you claimed the wages
Good bookkeeping records—payroll records, gross receipts documentation, government order records, and bank statements—are your best protection in an audit.
Keep Your Financial Records Audit-Ready
Whether you claimed the ERC or are simply running a small business navigating complex tax obligations, organized financial records are non-negotiable. Beancount.io provides plain-text accounting that gives you complete transparency and version-controlled history of every transaction—exactly the kind of documentation that holds up under IRS scrutiny. Get started for free and build the financial foundation your business needs.
