For the Employee Retention Credit, qualified wages are compensation subject to Social Security taxes under Internal Revenue Code Section 3121(a), plus certain employer-paid health plan costs, capped at $10,000 per employee for all of 2020 and $10,000 per employee per quarter for the first three quarters of 2021. That is the core of the ERC qualified wages definition, but the number that actually generates a credit depends on employer size, who the employee is related to, and whether the same dollars were used for another COVID-era program.
Wages Subject to Social Security Tax
The statutory backbone is Section 3121(a), which defines wages for FICA purposes. If a payment to an employee triggers Social Security withholding, it generally counts toward the ERC. That covers hourly pay, salaries, commissions, bonuses, and most other cash compensation reported on Form 941.1Office of the Law Revision Counsel. 26 USC 3121 – Definitions
Employee cash tips also qualify when they are treated as FICA wages under Section 3121(q), which is standard in food service and hospitality. Tips that meet the FICA threshold count toward the per-employee cap the same way regular pay does. Employers in tipped industries sometimes miss this and understate the credit.
Compensation outside Section 3121(a) does not count. That excludes certain fringe benefits that are not FICA wages, payments to independent contractors (who are not employees at all), and any amount above the Social Security wage base that escapes the 6.2% tax. Because the IRS compares ERC claims against Form 941 and W-2 data, payroll records need to line up.
Employer-Paid Health Plan Expenses
Qualified wages are not limited to cash. The CARES Act includes amounts an employer pays to maintain a group health plan under Section 5000(b)(1), to the extent excluded from employee income under Section 106(a).2Internal Revenue Service. Notice 2021-20 – Guidance on the Employee Retention Credit Under Section 2301 of the CARES Act Both the employer-paid share of premiums and the employee’s share paid through pre-tax salary reductions count.
This matters most for furloughed workers. Even when an employee received no cash during a quarter, the cost of keeping their health coverage active still counts as a qualified wage. For employers that kept benefits running through shutdowns, that can be a meaningful piece of the credit.
Health plan costs are allocated based on the period of coverage, not the date the premium was paid. A quarterly premium paid in advance gets spread across the weeks of coverage rather than dumped into the payment date.3Internal Revenue Service. Determining the Amount of Allocable Qualified Health Plan Expenses Pull premium statements and payroll deduction records for each eligible quarter and match them to the correct coverage weeks.
How Employer Size Changes Which Wages Count
The 2019 full-time employee count determines whether all wages qualify or only wages paid for time the employee was not working. This is where a lot of claims break.
For 2020, the line is 100 full-time employees. Employers at or below 100 can treat wages paid to any employee during an eligible quarter as qualified wages, whether the employee was working or not. Employers above 100 can only count wages paid for time the employee was not providing services.4Internal Revenue Service. Employee Retention Credit – 2020 vs 2021 Comparison Chart
For 2021, the threshold moves up to 500 full-time employees. Employers with 500 or fewer can claim on all employee pay during eligible quarters. Above 500, the credit is again limited to wages for non-working time.4Internal Revenue Service. Employee Retention Credit – 2020 vs 2021 Comparison Chart
A full-time employee is one averaging at least 30 hours per week or 130 hours in a calendar month.5Internal Revenue Service. Identifying Full-Time Employees The count uses 2019 as the baseline, so pandemic-era staffing changes do not move the threshold.
Aggregating Related Entities
Businesses under common ownership cannot split themselves into smaller entities to slip under the 100 or 500 employee lines. Under IRC Sections 52(a) and 52(b), related companies combine their employee counts and are treated as a single employer for ERC purposes. This reaches parent-subsidiary controlled groups, brother-sister groups where the same five or fewer individuals own at least 80% of each entity, and affiliated service groups under Section 414(m).6Internal Revenue Service. FAQs Regarding the Aggregation Rules Under Section 448(c)(2) That Apply to the Section 163(j) Small Business Exemption
Aggregation reaches beyond headcount. Related entities also combine gross receipts for the decline test, and a PPP loan taken by one member of the group can affect the entire group’s ERC. A restaurant group holding each location in its own LLC has to add every entity’s employees together.
Dollar Caps on Qualified Wages
The credit has hard per-employee ceilings that limit how much any one worker’s pay can generate.
- 2020: qualified wages are capped at $10,000 per employee for the entire year. At the 50% credit rate, the maximum credit is $5,000 per employee for all of 2020.
- 2021 (Q1 through Q3): the $10,000 cap resets each quarter. At the 70% credit rate, the maximum is $7,000 per employee per quarter, or up to $21,000 per employee across the first three quarters.
The caps include health plan expenses, not just cash. An employee earning $8,000 in a 2021 quarter with $3,000 in allocable health plan costs has $11,000 in combined compensation, but only $10,000 counts toward the credit that quarter.4Internal Revenue Service. Employee Retention Credit – 2020 vs 2021 Comparison Chart
For most employers, wages paid after September 30, 2021 do not qualify. The Infrastructure Investment and Jobs Act retroactively ended the program after the third quarter of 2021 for everyone except recovery startup businesses.4Internal Revenue Service. Employee Retention Credit – 2020 vs 2021 Comparison Chart
Wages That Never Qualify
Several categories of payments and people are excluded no matter how the size and cap rules come out. The IRS looks hard at these exclusions on audit.
Wages Paid to Owners and Their Relatives
Wages paid to anyone related to a majority owner are excluded. Under Section 51(i)(1), an employee who bears a family relationship to someone who owns more than 50% of the business does not generate qualified wages. Disqualified relationships include children, siblings, parents, stepchildren, in-laws, and other relatives listed in Section 152(d)(2).7Office of the Law Revision Counsel. 26 USC 51 – Amount of Credit Ownership is measured using the constructive ownership rules of Section 267(c), so interests held by family members or through partnerships and trusts get attributed to the owner.8Office of the Law Revision Counsel. 26 USC 267 – Losses, Expenses, and Interest With Respect to Transactions Between Related Taxpayers
In practice, wages of a business owner, their spouse, their children, and their siblings are almost always out. A family business where the founder holds 51% and employs three of their kids cannot count any of those four people’s pay.
Severance and Post-Termination Pay
Payments made after an employee’s termination do not qualify. This covers severance, final bonuses, and any other compensation tied to the end of the employment relationship. The IRS treats those payments as attached to a past relationship rather than as wages paid to a current employee during an eligible period.2Internal Revenue Service. Notice 2021-20 – Guidance on the Employee Retention Credit Under Section 2301 of the CARES Act Whether the relationship has actually ended is a facts-and-circumstances question; an employer that keeps paying wages but treats the person as terminated for every other purpose cannot then claim those payments went to a current employee.
Wages Allocated to PPP Forgiveness
The same payroll dollars cannot be used for both PPP loan forgiveness and the ERC. Congress eventually allowed employers to claim both programs, but required a clean separation: any wages specifically allocated to PPP forgiveness are excluded from the ERC calculation.2Internal Revenue Service. Notice 2021-20 – Guidance on the Employee Retention Credit Under Section 2301 of the CARES Act Employers with PPP loans need detailed schedules identifying which payroll dollars went to forgiveness and which remain available for the credit. Loose recordkeeping here is one of the fastest routes to an IRS adjustment.
Wages Claimed Under FFCRA Leave Credits
Wages used for the Families First Coronavirus Response Act paid leave credits under Sections 7001 and 7003 also cannot double as ERC qualified wages. One dollar of wages, one credit.
Recovery Startup Businesses
A narrow category of employer can claim the credit without meeting the government-order or gross-receipts tests. A recovery startup business is one that began operating after February 15, 2020, and averaged $1 million or less in annual gross receipts over the three years before the quarter being claimed.9Internal Revenue Service. Frequently Asked Questions About the Employee Retention Credit
Recovery startups can only claim for the third and fourth quarters of 2021, and the credit is capped at $50,000 per quarter total, not per employee. A startup with 20 employees hits the $50,000 ceiling well before reaching the standard $7,000-per-employee-per-quarter maximum.9Internal Revenue Service. Frequently Asked Questions About the Employee Retention Credit Recovery startup status is only available to employers who do not otherwise qualify; if the business also meets the suspension test or the gross-receipts decline test, it claims under the standard rules instead.
Documentation the IRS Will Ask For
The filing window for new ERC claims closed on April 15, 2025, and the One Big Beautiful Bill Act, signed in July 2025, extended the IRS audit window for ERC claims to six years from the later of the original return filing date or the date the ERC claim was made. Accuracy-related penalties of 20% can apply to underpayments caused by negligence or a substantial understatement of tax.10Internal Revenue Service. Accuracy-Related Penalty
For any claim already filed, keep the records that tie every dollar of qualified wages back to the statute:
- Payroll registers and Form 941 filings for each eligible quarter, matched to the wage amounts claimed.
- Health plan premium statements and salary reduction records, allocated by coverage period rather than payment date.
- The 2019 full-time employee count used to determine whether the 100 or 500 threshold applies, including any aggregation of related entities.
- Ownership records showing who is a majority owner and identifying wages of related individuals that were excluded.
- PPP forgiveness schedules identifying which specific payroll dollars were allocated to forgiveness and are therefore excluded from the ERC.
- Any FFCRA leave credit calculations showing wages excluded on that basis.
Employers with a pending claim can still request a withdrawal if the claim has not been paid or if a refund check has not been cashed. A withdrawn claim is treated as if it was never filed, with no penalties or interest.11Internal Revenue Service. Withdraw an Employee Retention Credit (ERC) Claim With a six-year audit window running against many claims into the early 2030s, the wage documentation is what will decide whether the credit survives review.