If you received a PPP loan and have received or are planning to receive loan forgiveness, it is important to begin thinking about the tax implications of the loan you received. While Congress intended for the loan forgiveness to be non-taxable, the Internal Revenue Service took a different position, as outlined in Notice 2020-32.
Tax Implications for S-Corporations and C-Corporations
Although the IRS agreed that the loan forgiveness itself will not be taxable as outlined in the original bill passed, they issued guidance stating that the expenses that are paid using the loan proceeds will not be deductible from income. This is because the expenses were paid using tax-free dollars, and deducting them from income would essentially be double-dipping.
For S-Corporations and C-Corporations, this is an especially unfavorable decision. Let’s say your business received a $100,000 PPP loan. Once the loan is forgiven, you will reduce your payroll/rent/utilities expenses by $100,000, assuming the whole loan was forgiven. The net result of this is a $100,000 addition to your bottom line. It is the same exact net result as it would have been had the loan forgiveness just been taxable in the first place. This means that a C-Corporation would receive a net benefit of $79,000 ($100,000 – ($100,000 * 21% Corporate Tax Rate)) from the loan (ignoring state tax implications, which will likely also reduce the net benefit). The loan is still a great thing that helped many small businesses out of a tough situation, but the IRS decision goes against Congress’ intent.
Tax Implications for Partnerships and Sole-Proprietorships
The strangest part about the Internal Revenue Service’s guidance is that as of right now, partnerships and sole-proprietors may still receive a tax-free benefit from the PPP loan that is unavailable to S-Corporations and C-Corporations. When the original loan amounts were calculated, S-Corporations and C-Corporations were required to calculate their average monthly payroll costs using actual wages paid. This includes the wages paid to owners of these entities.
For partnerships and sole-proprietorships, owners are not paid wages. Instead, they are taxed on the net income of the business. This is determined without regard to how much money they actually take out of the company. So when partnerships and sole-proprietors calculated their average monthly payroll costs to receive the loan, they used the net profit from their 2019 tax return plus any wages paid to non-owner employees.
Once their loan is forgiven, the loan proceeds are not taxable and they cannot deduct any expenses paid with the loan proceeds. However, owner compensation for partnerships and sole-proprietors is not deductible in the first place. This essentially means that they would not have to add back the portion of the loan that was based off of the net profit of the business, which for many sole-proprietors may cover their entire loan. For example, if a sole-proprietor with no employees had $100,000 in net profit on their 2019 schedule C, they may have received a PPP loan for $20,833 ($100,000 / 12 months * 2.5 months). They should not have to use any additional rent/utility costs to get the loan forgiven. They could not deduct their compensation in the first place, so the disallowance of deductions for expenses paid for with the loan proceeds has no impact on their net benefit from the loan. If they had other employees they paid using the loan proceeds, that portion has to be added back to their income along with any rent/utility/interest costs that were used in calculating forgiveness.
There’s Still Hope...
As I’m writing this, talks of an additional stimulus bill are stalled with the election approaching. However, there is some hope that if an additional stimulus bill is passed, it will include language to correct the Internal Revenue Service’s interpretation of the prior bill, which would allow the deductions for these expenses. This would be a significantly favorable change for business owners, as many of them are still struggling to stay afloat due to the pandemic. But with the information we have now, business owners should plan for the worst and set some money aside for the 2020 tax year.
For more information about your specific situation and tax-planning needs, contact me for a free consultation.