01/08/2021 Update: The new Federal COVID-19 bill passed and signed into law in late December overrules the IRS Notice that disallowed deductions used by a forgiven PPP loan. The new law specifically says that forgiven PPP loans will not be income and will not reduce expenses. This is good news for the business community and makes the below blog just about completely obsolete.
Executive Summary
- This information is urgent for businesses that received the PPP loan.
- IRS: PPP loans that are reasonably expected to be forgiven, must reduce expenses on the 2020 income tax return
- This will cause an inflated income tax liability in 2020
- For detailed information about how this may affect your business, continue reading below.
Last week the IRS issued guidance regarding the tax treatment of the expected forgivable amount of the Payroll Protection Program (PPP). The guidance given by the IRS is not what we wanted to hear as we begin our holiday season.
The CARES Act, passed in March, 2020, specifically said that any forgivable amount of the PPP was not to be included as income. That was good news.
The bad news now is that the IRS, while agreeing that the forgiven PPP will not be included in income, determined that the business cannot deduct expenses paid with the forgiven PPP. To illustrate, let’s say ABC Business, Inc. had a total of $200,000 in wages in 2020, received a PPP loan of $50,000, and used all the PPP funds correctly on wages. Normally, ABC Business, Inc would deduct $200,000 of wages on their tax return. In 2020, per the IRS guidance, this deduction must be reduced to $150,000. For a business in the 24% IRS income tax bracket, this means an increase in tax of $12,000.
Additionally, the IRS has given guidance on when (or, what tax year) this expense reduction is to take place. The tax community, including Prospect Financial Solutions, assumed that the expense reduction would take place in the year the loan forgiveness occurred, which for most businesses will be 2021. However, the IRS’ guidance states that since forgiveness is reasonably expected, regardless of the actual tax year of that forgiveness, the expense reduction must take place in 2020.
This is difficult news for the business community. The IRS formal guidance is coming late in the year, allowing very little time to react and plan.
Another difficulty is the actual expense reduction calculation. Referring back to ABC Business, Inc., let’s throw in these factors:
- They received the EIDL Grant
- They used some of their PPP on rent, payroll taxes, 401k and utilities
- They will not qualify for 100% forgiveness of the PPP due to their Full-Time Equivalent employee calculation
Given these additional factors, the expense reduction for the 2020 tax year is not going to be a simple reduction of wages.
What does this mean and what should you do?
Don’t panic!
Our optimistic side says Congress will include language in the next COVID legislation that overturns the IRS formal guidance.
Though we can hope that happens, let’s also come up with a game plan in the event this doesn’t happen:
- Begin applying for the PPP forgiveness as soon as possible. If you’ve hired Prospect Financial Solutions to track and apply for forgiveness, we will begin doing this the first weeks in December. If you haven’t hired us and want to, you know how to reach us.
- Prepare your income tax return as soon as possible with an estimated calculation of the expense reduction. If you are a client of Prospect Financial Solutions, you will receive correspondence from us early next week regarding the preparation of your income tax return. We are taking on new clients for the 2021 tax year.
- Be mentally and financially prepared to pay more income tax than expected with your 2020 tax return.
- Read and share what we send out! If anything changes, we will update you as soon as we can.
This doesn’t make the additional tax an easier pill to swallow, but please remember there was still an economic benefit for receiving the PPP. One last reference to ABC Business, Inc. They got the PPP for $50,000 and will pay $12,000 in taxes. This is a net cash flow of $38,000. Applying for and receiving the PPP was the right thing to do.
Finally, let’s reflect for a moment. Though we expected this to be a true ‘life-line’ for businesses and though we don’t need any more bad news in 2020, the PPP was a business-saver for many of us. We faced unprecedented economic uncertainty in March. Many of us were forced to turn away clients, shut our businesses, and do things differently. Clients of Prospect Financial Solutions are perfect examples of who the PPP was intended to help: small, local, private, family businesses that faced this uncertainty. We are proud of our clients’ ethical and proper use of the funds.
