What Is the Employee Retention Tax Credit?
The Employee Retention Tax Credit, commonly referred to as ERTC or ERC, is a refundable payroll tax credit created by the CARES Act in March 2020 and subsequently expanded by the Consolidated Appropriations Act of 2021 and the American Rescue Plan Act. The credit was designed to incentivize businesses to keep employees on payroll during periods of COVID-19-related economic disruption, rather than laying them off.
The ERTC is not a deduction -- it is a dollar-for-dollar credit against federal payroll tax liability, and any excess credit is refunded directly to the business. For eligible businesses, the credit can be substantial: up to $5,000 per employee for the 2020 tax year and up to $7,000 per employee per quarter for the first three quarters of 2021 (Q4 2021 eligibility was retroactively eliminated for most employers by the Infrastructure Investment and Jobs Act). The maximum total credit per employee across all qualifying periods is $26,000.
At Northstar Financial, we have helped businesses across multiple industries evaluate their ERTC eligibility, calculate their credit amounts, and prepare the documentation necessary to support their claims. This guide reflects our experience processing these claims and our understanding of the current IRS enforcement environment.
How Do You Determine If Your Business Is Eligible for the ERTC?
Eligibility for the ERTC is determined on a quarter-by-quarter basis using one of two tests. A business need only satisfy one test for a given quarter to be eligible for that quarter's credit.
The Government Order Test requires that the business experienced a full or partial suspension of operations due to a government order related to COVID-19. This is the test that generated the most confusion and, frankly, the most aggressive interpretation by ERTC promoters. A "full suspension" is straightforward -- if a government order required your business to completely shut down for a period, you qualify for that period. A "partial suspension" is where it gets nuanced. The IRS has clarified that a partial suspension exists when a government order limited your business operations in a meaningful way -- for example, capacity restrictions, indoor dining bans for restaurants, elective surgery moratoriums for medical practices, or mandated closures of specific business functions.
The critical point is that the government order must have had more than a "nominal effect" on your business operations. The IRS specifically states that a government order that applies to the general public (such as a stay-at-home order) does not automatically qualify a business unless that order actually impacted the business's specific operations. A software company whose employees worked from home during a stay-at-home order with no disruption to service delivery or revenue would have difficulty sustaining the argument that operations were partially suspended, even though the order technically applied to them.
The Gross Receipts Test is more objective and easier to substantiate. For 2020, a business is eligible for a quarter if gross receipts for that quarter declined by more than 50 percent compared to the same quarter in 2019. Eligibility continues until the quarter after the quarter in which gross receipts recover to more than 80 percent of the same quarter in 2019. For 2021, the threshold was lowered -- a business is eligible if gross receipts declined by more than 20 percent compared to the same quarter in 2019 (or the immediately preceding quarter, if the business did not exist in 2019).
The gross receipts comparison must use the same accounting method consistently. If you file taxes on a cash basis, use cash-basis gross receipts. If you use accrual, use accrual-basis gross receipts. Mixing methods to cherry-pick the most favorable comparison is not permissible and will not withstand IRS scrutiny.
Large employer versus small employer status affects which wages qualify. For 2020, a "large employer" is one that averaged more than 100 full-time employees in 2019. For 2021, the threshold increased to more than 500 full-time employees. For large employers, only wages paid to employees who were not providing services (essentially, paid not to work) qualify for the credit. For small employers -- which is the vast majority of businesses claiming the ERTC -- all wages paid to all employees during eligible quarters qualify, regardless of whether the employees were actively working.
How Do You Calculate the ERTC Credit Amount?
The calculation differs between 2020 and 2021, and understanding both is essential for determining your total credit.
For 2020 (Q2 through Q4), the credit equals 50 percent of qualified wages paid per employee, up to a maximum of $10,000 in qualified wages per employee for the entire year. This means the maximum credit per employee for 2020 is $5,000 (50 percent of $10,000). Qualified wages include both cash compensation and the employer's share of health plan costs allocable to the wages. If you paid an employee $12,000 in qualified wages during your eligible quarters in 2020 and allocated $3,000 in health plan costs, the qualified wages are capped at $10,000 and the credit is $5,000.
For 2021 (Q1 through Q3), the credit equals 70 percent of qualified wages per employee, up to a maximum of $10,000 in qualified wages per employee per quarter. This means the maximum credit per employee per quarter is $7,000 (70 percent of $10,000), and the maximum for all three qualifying quarters of 2021 is $21,000 per employee. The per-quarter cap is what makes 2021 significantly more generous than 2020 for most businesses.
Health plan costs are includable in qualified wages even if the employee received no cash wages during the period. This is relevant for businesses that furloughed employees but maintained their health insurance -- the employer-paid portion of health plan costs during the furlough period counts as qualified wages for ERTC purposes.
The interaction with PPP is a critical calculation consideration. The Consolidated Appropriations Act of 2021 retroactively allowed businesses to claim both PPP forgiveness and the ERTC, but not on the same wages. Wages used to justify PPP loan forgiveness cannot also be used to calculate the ERTC. This means you need to allocate your wages between the two programs in the most tax-advantageous way. Since PPP forgiveness covered payroll costs over an 8- or 24-week period, and PPP was not taxable (but the ERTC reduces the deductible wage expense), the optimization calculation requires careful analysis. In general, the strategy is to allocate the minimum wages necessary to achieve full PPP forgiveness and reserve the remaining wages for ERTC calculation.
A simplified calculation example illustrates the math. Suppose you are a small employer (under 100 full-time employees in 2019) who qualified for Q2 and Q3 of 2020 and Q1, Q2, and Q3 of 2021. You have 15 employees, each earning $50,000 per year ($4,167 per month). For 2020, each employee's qualified wages for Q2 and Q3 total $8,333 per month times two is $8,333 -- actually, let me walk through this more precisely. At $4,167 per month, two qualifying quarters of wages total $25,000 per employee, but the cap is $10,000 per employee for all of 2020. So qualified wages per employee are $10,000, and the credit is 50 percent times $10,000 equals $5,000 per employee. For 15 employees, the 2020 credit is $75,000.
For 2021, each employee earns approximately $12,500 per quarter. The cap is $10,000 per employee per quarter, so qualified wages are $10,000 per employee per quarter. The credit is 70 percent times $10,000 equals $7,000 per employee per quarter. For 15 employees over three quarters, the 2021 credit is $7,000 times 15 times 3 equals $315,000. The total ERTC across all periods is $390,000. This is real money that directly reduces your payroll tax liability (or is refunded to you if it exceeds your liability).
What Documentation Do You Need to Support Your ERTC Claim?
Given the IRS's current enforcement posture on ERTC claims, documentation is not optional -- it is the difference between keeping your credit and having to return it with penalties and interest.
For the Government Order Test, you must be able to produce the specific government order that you contend caused a full or partial suspension of your operations. This means the actual executive order, health department directive, or regulatory notice -- not a general news article about COVID restrictions. You must also document exactly how that order affected your specific business operations: what activities were suspended, what percentage of your operations were impacted, and for what specific dates. Contemporary evidence -- emails, memos, operational changes documented at the time -- is far more credible to the IRS than after-the-fact narratives constructed when filing the claim.
For the Gross Receipts Test, you need comparative gross receipts data by quarter for 2019 and the claiming period (2020 or 2021). This data should be pulled from your tax returns, financial statements, or accounting system and should be consistent with the accounting method used on your tax returns. Keep the underlying records that support the gross receipts figures in case the IRS requests verification.
For qualified wages, you need payroll records showing wages paid to each employee during each eligible quarter, documentation of the employer-paid health plan costs allocable to each employee, and evidence that the employees were not related to the business owner (wages paid to majority owners and their family members are generally not eligible for the credit). You also need documentation showing your full-time employee count for 2019 to establish whether you are a large or small employer.
For PPP coordination, maintain records showing which wages were allocated to PPP forgiveness and which were reserved for ERTC. This allocation should be documented in a memorandum prepared at the time the ERTC claim was filed, not reconstructed later.
What Is the Current Status of ERTC Claims with the IRS?
The IRS processing environment for ERTC claims has changed dramatically since the credit was first enacted, and understanding the current landscape is essential for any business that has filed or is considering filing a claim.
In September 2023, the IRS announced a moratorium on processing new ERTC claims filed via Form 941-X. This moratorium was imposed in response to a flood of fraudulent and ineligible claims, many driven by aggressive ERTC promoters who used misleading marketing to convince businesses they qualified when they did not. As of early 2025, the moratorium remains in effect for new claims, though the IRS has stated it is continuing to process claims that were filed before the moratorium.
The IRS has established multiple programs to address the ERTC backlog. The Voluntary Disclosure Program, which ran through March 2024 and was reopened in August 2024, allowed businesses that received ERTC payments but later determined they were ineligible to return 85 percent of the credit received (keeping 15 percent, presumably to cover promoter fees already paid). The IRS has also sent disallowance letters to claims it has determined are ineligible and has launched a withdrawal process for businesses that filed claims that have not yet been processed and wish to withdraw them without penalty.
Processing times for legitimate claims remain extremely long. Businesses that filed valid 941-X amendments are experiencing wait times of 12 to 24 months or longer for their refunds. The IRS has indicated that it is prioritizing claims with the lowest risk of error and working through higher-risk claims more slowly with additional verification. If you have filed a legitimate claim with solid documentation, patience is unfortunately required.
Audit activity on ERTC claims is increasing. The IRS has hired additional staff and engaged contractors specifically to review ERTC claims. If your claim is selected for examination, you will receive a letter requesting documentation to support your eligibility and calculation. Respond promptly and thoroughly. The documentation outlined in the previous section is exactly what the IRS will request, and having it organized and ready to produce will significantly streamline the examination process.
Should You File a New ERTC Claim in 2025?
This is a question we receive frequently, and the answer requires careful consideration of several factors.
The statute of limitations for filing ERTC claims is three years from the date the original Form 941 was filed or two years from the date the tax was paid, whichever is later. For most businesses, this means the deadline for 2020 claims has already passed (the deadline for Q4 2020 was April 15, 2024, or later depending on filing date), and 2021 claims have deadlines approaching in 2024 and 2025 depending on the quarter. However, the IRS moratorium on processing new claims creates practical uncertainty about whether a newly filed claim will be processed at all.
If you have a legitimate, well-documented claim that has not yet been filed, consult with a qualified tax professional (CPA or tax attorney, not an ERTC promoter) to assess whether filing makes sense given the current environment. A claim that is supported by clear government order documentation or an unambiguous gross receipts decline, with proper calculation and PPP coordination, is defensible and worth pursuing even in the current enforcement environment.
If you filed a claim based on aggressive advice from an ERTC promoter and are now uncertain about its validity, take this seriously. The IRS has made clear that it holds the taxpayer, not the promoter, responsible for the accuracy of the claim. If your claim was based on a tenuous government order argument, if you did not actually experience the claimed gross receipts decline, or if your calculation included wages that should have been allocated to PPP, you should consult with an independent tax professional about whether the Voluntary Disclosure Program or claim withdrawal is appropriate. The penalties for maintaining an invalid claim through audit can include a 20 percent accuracy penalty and interest from the date the credit was received.
Red flags that suggest your claim may be problematic include: you were told you qualify based solely on a "supply chain disruption" argument without specific documentation, your ERTC promoter charged a percentage-based fee (a sign of a promoter-driven rather than advice-driven engagement), you were told every business qualifies, or you cannot produce the specific government order that you claimed suspended your operations.
How Does the ERTC Affect Your Tax Returns?
The ERTC has tax return implications that many businesses and even some tax preparers have not properly addressed.
The ERTC reduces your deductible wage expense. This is a critical point that directly impacts your income tax liability. If you claimed $100,000 in ERTC, your deductible wages on your income tax return must be reduced by $100,000. For a business in a combined 30 percent federal and state income tax bracket, this means $30,000 of the $100,000 credit is effectively offset by higher income taxes. The net benefit is still $70,000 -- substantial, but not the full $100,000 that the credit amount might suggest.
If you claimed the ERTC on an amended payroll return (Form 941-X) but did not yet amend your income tax return to reduce the wage deduction, you need to do so. The IRS expects the income tax adjustment to correspond to the ERTC claim, and failing to make this adjustment can trigger a separate audit of your income tax return.
The timing of the income tax adjustment has been a source of confusion. The IRS has indicated that the wage deduction should be reduced in the year the ERTC was claimed for (the year the wages were paid), not the year the refund is received. This may require amending prior-year income tax returns, particularly for 2020 and 2021 ERTC claims that were filed on amended payroll returns in 2022 or 2023.
At Northstar Financial, we strongly recommend that any business with an ERTC claim -- whether pending, received, or under audit -- engage a qualified CPA to ensure that the income tax implications have been properly addressed. The intersection of the ERTC with PPP, income tax deductions, and the current IRS enforcement environment creates a complex situation that warrants professional guidance. If you need help evaluating your ERTC position or preparing documentation for an IRS examination, our team has extensive experience navigating these issues and can provide the support you need.