The Paycheck Protection Program (“PPP”) enacted through the Coronavirus Aid, Relief, and Economic Security (CARES) Act (P.L. 116-136) is the government relief program that provided loans to small businesses to cover payroll, rent or mortgage payments and utilities. The loan may be forgiven under certain prescribed circumstances. The issue for recipients now is how to account for the funds. There may also be tax planning opportunities.
In the absence of additional legislation, taxpayers in receipt of PPP loans that have been converted to grants should be aware that the taxpayer will not be able to claim a deduction for the expenses that were paid with the PPP funds. Thus, the taxpayer may have higher taxable income and greater tax liability than expected.
The PPP law and guidance are clear that if the recipient of the loan qualifies to have the loan forgiven, the resulting grant is not subject to Federal income tax. Presumably the states will follow suit and not tax those funds either, but that is not guaranteed. State law must be consulted to verify that there will be no unexpected forgiveness of indebtedness taxable income subject to tax in the state of residence of the taxpayer. However, although employee expenses, rent, mortgage payments and utilities are generally deductible as business expenses for tax purposes, the expenses paid with PPP funds will not qualify as business expense deductions. There is some glimmer of hope that Congress will rectify this situation and allow deductions for payments of these business expenses, but that has not happened to date. The Internal Revenue Service has indicated that it will enforce current law, which is that a business may only claim a business deduction if the expenses were paid with taxpayer revenue. The exception for this rule is, of course, if the funds are borrowed and the taxpayer is obligated to repay the debt.
In the absence of legislation, a small business in receipt of a PPP loan has some tax planning opportunities to consider before the end of the taxpayer’s 2020 tax year. One option is to leave the PPP funds as a loan into the 2021 tax year, thereby allowing deductions for the expenses that were paid using the PPP loan. That will defer payment of tax until such time as the loan is converted into a grant. At that time, an amended return will need to be filed restating taxable income, with the prior business deductions recharacterized as nondeductible. It is possible the IRS or Small Business Administration will issue guidance regarding this issue, but to date there is none. When the funds are converted into a grant, the PPP legislation is clear that there is no forgiveness of indebtedness income by reason of the loan/grant. However, by deferring the loss of deductions for a year, the taxpayer has deferred the tax liability on taxable income that was not reduced by the usual business expenses. That provides some relief from an otherwise dreadful 2020 for most, but unfortunately at this time it appears that it will be temporary. If the small business has losses or expenses that may be claimed in 2020 to absorb the revenue that was not offset by the usual employee and office expenses, then this planning technique will not be necessary. Numbers should be crunched and options explored before filing the paperwork with the business’ PPP bank to convert the loan into a grant. Free money is never really free.
This summary is not intended to contain legal advice or to be an exhaustive review. If you have any questions regarding this article, please contact the author Nancy Ortmeyer Kuhn or another member of Jackson & Campbell’s Tax Law Practice Group.