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.
Thank you for the continual updates and valuable information. It saves hours of research.
Thanks you for the update.
Thank you so much for the information in your article it’s very necessary
Need advice on solepropeitor with no employee . never applied.
Hi Chon, so my first piece of advice is this. As soon as they reopen the PPP program (sometime after Congress gets back into session), you HAVE to really bird dog this PPP thing. Top priority. The next round of money, assuming there is a next round, will go really fast in my opinion.
Second, your situation should be straightforward. You should be able to get a PPP loan equal to 2.5 months of your 2019 profits. If your business is WAY down in 2020, you may even be able to get two loans for this amount.
Hello morning my I file under C Corp and I can’t get the PPP Forgiveness approved but I have weeks oof and I’m still trying to do my best why don’t they see that I am running my business have my business license and prove me for a PPP forgiveness still trucking in this pandemic time
I don’t know why lender didn’t apply your PPP loan application. But the banks were just overrun with loan applications. And they did a pretty poor job in many cases. It’s been a while since I’ve mentioned this story, but I know of a large bank that rejected a PPP application from a customer they’d banked for three decades… the store down the street from the branch. Their reason? They couldn’t verify the identity of the applicant! Is that crazy or what?
What I would say is this: If you have payroll for 2019, you need to talk to you bank, any community banks in your area, and then the online financial technology (aka “fintech”) companies like Paypal and Kabbage as soon as the PPP restarts. Hopefully shortly after Labor Day weekend.
BTW, while you’re waiting, you might also want to look at this blog post: How You Should Have Handled Your PPP Loans.
Being a small business owner since 2014 Never filed bankruptcy.. But when they say there’s PPP LOANS for small businesses like mines .I have not been able to find a company that reflects the help that you interpret. I’ve. been surviving off of monies that I saved. When there was suppose to be a program for me as well.. But they seem to get you ready without response..I’d love to get a PPP LOAN like others but where do you go. If the ones you’ve dealt with have yet to return a call or email…
Mocha, so your experience, sadly, isn’t unusual. Smallest businesses often got overlooked in the PPP. And right now? The program is temporarily over. However, hopefully when Congress gets back into session after holiday weekend, they restart the program. And at that point, you want to be ready to go with your PPP application… and maybe even with an application for a second draw loan.
So, bottomline, don’t give up.
Hi, This question is about QSBS. I would have loved to comment on an older post, but am leaving this here per the site directions to comment on a recent post with open comments.
My 1 man S-corporation did some consulting work for a C corp startup and as part of my compensation, I accepted a convertible note, which has since become preferred equity shares.
I saw that one of the Section 1202 rules for being able to avoid capital gains taxes is that “the investor must not be a corporation.” I’m wondering whether I messed up by having the shares issued to my S corp instead of to me personally, or if as a 1 man S corp any gains after 5 years would still get favorable QSBS treatment?
I may have answered my own question. While researching, I found the following:
“As a practical matter, the benefits of QSBS are available to any taxpayer other than a C corporation. QSBS can be issued to a limited liability company, other partnerships, trusts or S corporations. IRC § 1202 has rules that address the handling of QSBS’ benefits among a pass-through entity’s owners.”
So it seems that I am in the clear as long as I make sure that my S corporation is the one that claims the exclusion and then passes through the benefits to me as a shareholder.
Thank you for your article very informative. My question is do you have any advice on how to return the loan. I received mine June 30 . I have spoke to my bank they said it needs to be requested back but kabbage won’t answer calls or emails..
You need to talk with the bank, but can I suggest you first talk with your accountant? She or he can help you determine whether you can get bank and SBA to just give you forgiveness on the basis of your payroll expenses during the 24 weeks that followed you getting the loan.
Hi, I recently received a PPP loan of $20000 as a Sole Proprietor in August 2020. I went to my bank to withdraw $10000. The Bank refused to give me the money, & have since withhold my accounts, claiming that I should bring a letter from an Attorney or a CPA indicating how long I’ve been in business & what does the business do.
What exactly do the Bank wants from the CPA or from me?
I think you do what the bank wants. It sounds like they have some worry about whether or not you’re really in business.
Hi Steve, I realize that your expertise is with business owners. I found you while trying to locate answers for my situation and I’m hoping you might point me in the right direction. I am an employee of a small business who brought us back on a PPP loan. After the program was complete, I asked when I would receive a check for back commissions (a significant amount), all were earned/generated long before our 8 week PPP. I was advised that they were paid to me via the PPP weekly checks. This doesn’t seem right but I don’t know who to speak to to confirm or deny this. Do you know someone or agency I might contact to confirm if I should pursue or not?
Thank you very much,
S. Owens
Sorry for the conflict with your employer and the miscommunications/misunderstandings regarding pay. Let me say that first…
Second, the accounting you describe isn’t completely “out of tune” with the way the PPP works/worked. It’s very possible employer used PPP money to pay you the past-due commissions you were due… and that he or she thought they needed to do so as a weekly payroll amount. Without getting into gritty details, the “bookkeeping advice” and ‘instructions” the SBA provided PPP borrowers was pretty skimpy. Lots of PPP borrowers tried to do their accounting of payroll costs so the amounts were very “regular” and “uniform.”
I think the only suggestion I have would be to discuss with your employer this issue. It does seem like if she or he had you work during the covered period that you deserve pay for that. And then if you were owed money for before the covered period that you’re owed additional amounts for that.
Good luck!
Hi Steve, as always, thank you for the updated information. I think the very last sentence is the most important, especially for sole proprietorships. I’ve been telling my clients to expect these loans will be counted as taxable income for Schedule C filers. I just wish the IRS would clarify this area, and SOON!