On March 18, 2021, the Iowa Department of Revenue revised guidance addressing the nuances of the state’s conformity to the Coronavirus Aid, Relief, & Economic Security (CARES) Act. As part of these revisions, the department advised business and individual taxpayers that the state is in full conformity with the federal Employee Retention Credit (ERC) provisions. Full conformity in this instance means that a taxpayer who elects to claim the ERC and is required to forgo income tax expense deduction for related wages for federal purposes, also loses the wage expense deduction for Iowa purposes even though the state does not offer its own credit program equivalent to the ERC. In coming to this conclusion, the department relied upon the mechanics of the state’s individual and business income tax returns, which start with federal adjusted gross income for individuals and federal taxable income before net operating losses for businesses, and provide no modification to allow wage expense deductions disallowed because of the ERC.
The Employee Retention Credit was one of the flagship employment and liquidity stabilization measures in the CARES Act. Subject to certain limitations, it allows individual or business taxpayers to take a 50% refundable credit against federal payroll taxes for qualifying wages paid. Taxpayers electing to take the credit are not allowed a federal income tax expense deduction for related wages. Because the federal tax value of the deduction depends on the taxpayer’s applicable rate and other tax attributes, the overall impact of electing into the credit varies. For the sake of simplicity, assuming a taxpayer is in an income position and the tax value of the wage deduction is 25% of the deductible amount, electing into the credit creates a 25-point swing in the taxpayer’s favor at the federal level without considering any other costs.
However, this simple calculation ignores the impact of state income taxes. If the taxpayer is in a state like Iowa, which follows federal in denying ERC related wage deductions, the state tax implications of taking the ERC may be significant. For example, assume the taxpayer above is subject to tax on 100% of their income in a state that follows the federal ERC provisions and has a 10% tax rate. In this instance, the benefit of taking the ERC, without adjusting for timing and without considering any other costs, is reduced from 25 points to 15 points. While there is certainly, still a benefit to be had from the ERC for taxpayers in these circumstances, the impact of layering on state taxes make be significant, particularly for distressed businesses. Accordingly, it is important for taxpayers to review the state tax implications in the states where they file, model the impact, and respond accordingly.