Sole proprietor and partnership PPP tax rules get complicated.
A sole proprietor who uses her or his PPP loan money to pay the owner probably avoids income taxes on the money. Unless someone goofs up.
Probably partners in a partnership don’t get that same tax break. Except maybe there’s a hack.
This blog post explains why these results occur… And how savvy borrowers and tax accountants can minimize taxes on their PPP loan forgiveness.
The Standard Rules for PPP Tax Accounting
The easiest way to think about PPP loans is that a business gets taxed on the loan. For example, if you receive a $100,000 loan, you want to assume for planning purposes that you’re taxed on that money.
In reality, however, the accounting works more complicated. First, you aren’t taxed on the actual loan. One never is.
Second, while usually cancellation of debt–which is what happens with most PPP loans–counts as taxable income, the PPP forgiveness statute specifically says that doesn’t occur with PPP loans.
Third, what does happen? A PPP borrower loses the deductions paid with borrowed, forgiven money. (The IRS explains why and how this works in a notice: IRS Notice 2020-32.)
Example: A small business borrows $100,000 and uses that money for $60,000 of payroll and then $40,000 of mortgage interest, rent and utilities. Because its use of the PPP funds matches what Congress wanted the firm to do, the small business doesn’t have to pay back the loan. However, the small business loses deductions for $60,000 of payroll and then the $40,000 of mortgage interest, rent and utilities.
How Sole Property PPP Tax Accounting Works
With a sole proprietor, though, the tax accounting works differently.
To keep things simple, assume a sole proprietor received a $20,000 PPP loan based on the sole proprietorship earning $100,000 in 2019.
In this case, the PPP accounting rules allow the sole proprietor to use all of the $20,000 for “owner compensation replacement.” And in fact, to get forgiveness, the business may need to use the entire PPP loan for that.
But the $20,000 isn’t taxable. The reason? The payments made by a sole proprietorship to the owner aren’t tax deductions. The payments are, well, just payments.
Accordingly, a sole proprietorship doesn’t “have” a tax deduction it can even lose when it uses PPP money for the payment.
How a Sole Proprietorship Can Goof Up PPP Tax Accounting
By the way, a sole proprietorship might goof up the tax accounting and so unnecessarily trigger income taxes.
For example, suppose a sole proprietor with no employees in 2019 received a $20,000 PPP loan. Further suppose that in 2020 the business hires some employees and so, trying to do things right, uses $12,000 of the PPP money to pay those employees their wages. And then that the business uses the remaining $8,000 of PPP money to pay mortgage interest, rent and utilities.
In this case, the sole proprietorship loses $20,000 of deductions. And as a result, in effect, the PPP loan money becomes taxable.
The Problem with Partnerships and the PPP Loans
With the preceding paragraphs as background, we’re now ready to talk about why partnerships may get taxed on their PPP loans.
Suppose, for example, a two partner partnership without employees gets a $40,000 loan on the basis of its 2019 profits.
You might assume that it can pay the $40,000 out to its partners ($20,000 per partner) and escape tax. And you might be right.
But payments a partnership makes to its partners sometimes do count as tax deductions. The chunk of tax law that says when they do count is Section 707.
More than one part of Section 707 creates problems for partnerships borrowing a PPP loan. But Section 707(c), which describes guaranteed payments, seems most problematic. It says:
To the extent determined without regard to the income of the partnership, payments to a partner for services or the use of capital shall be considered as made to one who is not a member of the partnership, but only for the purposes of section 61(a) (relating to gross income) and, subject to section 263, for purposes of section 162(a) (relating to trade or business expenses).
That language makes the guaranteed payment a tax deduction on the partnership’s tax return.
And then, the other thing you want to look at? The PPP loan forgiveness application instructions. Here’s the first part of what those instructions say about when a small business like a partnership gets forgiveness for “owner compensation replacement:”
Line 9: Enter any amounts paid to owners (owner-employees, a self-employed individual, or general partners)….
Does the Line 9 instruction make the payment to a partner a Section 707(c) guaranteed payment? I think it might.
The amounts a partnership pays to partners to get forgiveness on the PPP loan? They seem to me like they are “determined without regard to the income of the partnership.” And like they are “payments to a partner for services.”
A compulsive personality requires me to note this tax accounting treatment also means that similar taxpayers (small partnerships and small corporations) get treated similarly.
Two Final Comments to Close
A couple of comments to close.
First, the tax accountants who’ve thought about this? They have a hack they hope works to make payments to partners tax free. Treating the payments as distributions. That may work. But taxpayers and their accountants probably want to plan for the possibility it doesn’t.
Note: If you want to know how distributions and special allocations work, you might find this other blog post useful: Salvaging Partnership Section 199A Deductions.)
Second, you know what we really need? Some additional guidance from the IRS. And soon. Ideally before people start to apply for PPP loan forgiveness.