The good news here? You may be able to avoid the trap. But the bad news? You may need to take steps in the next few days.
Accordingly, let me explain how this PPP tax trap works. And then let me point out the two gambits you may have for sidestepping trouble.
Finally, a clarification: I’m not sure if this PPP tax trap is something real or just theoretical. But, gosh, for some borrowers, the dollars could be big.
So, let’s be careful…
PPP Tax Rules: A Quick Review
The new PPP tax laws say the PPP loan money isn’t taxable. The same laws say PPP borrowers can take a tax deduction for the spending. And the laws also say the PPP borrowers get basis for the forgiveness.
In a perfect world, this combination of favorable tax laws should mean you avoid any federal income taxes on the PPP money.
But a PPP tax trap exists in theory. Accordingly, if you can, you probably want to take steps to sidestep the trap.
A Simple Example of the PPP Tax Trap
A simple example shows how the PPP tax trap blindsides the unwary.
Say a business got a $1,000,000 PPP loan. Assume the business broke even for the year. (Taxable income, in other words, equals zero for the year.)
Assume the $1,000,000 of PPP money still sits there, in the partnership or corporation bank account.
And a final critical assumption: Say the business owner has $100,000 of basis in the business. That’s the dollar amount the owner has invested in the firm either through original capital contributions or reinvested profits.
The PPP tax trap here? If the PPP borrower distributes the PPP money to its owner before the PPP loan gets forgiven, the owner lacks the basis to get the distribution tax free.
With $100,000 of basis in her or his ownership interest, if the business pays out the $1,000,000 of leftover PPP money to the owner, the business owner pays long-term capital gains taxes on a $900,000 distribution in excess of her or his basis.
The tax rate runs either 15 or 20 percent on this gain. So, the tax equals $135,000 to $180,000.
Avoiding the PPP Tax Trap: Method #1
A first way to avoid the tax trap? Delay taking the distribution until the year of forgiveness.
In an example like that provided earlier, the business can just leave the leftover PPP money in the bank account until the year of forgiveness.
After the PPP lender grants forgiveness, the PPP borrower gets basis. And that’ll mean a tax-free distribution.
So that’s one way to sidestep trouble.
Note: If you return a “PPP” distribution to the business before the year ends, that should also fix the excess distribution problem.
Avoiding the PPP Tax Trap: Method #2:
The second way to avoid the tax trap? A PPP borrower may be able to treat funds paid out to a shareholder as a shareholder loan. This accounting method then shows the payments as a shareholder receivable instead of a distribution.
Accounting for a disbursement of PPP funds as a shareholder receivable complicates your bookkeeping.
You’ll want a formal shareholder receivable “note payable” with standard terms and conditions.
Probably you’ll want to ask your accountant for detailed advice and help on this. Maybe your attorney too.
But delaying the distribution until both official forgiveness occurs and until the IRS specifies how the tax accounting works? That seems like something many PPP borrowers will want to consider if they lack basis.
Other Resources You May Find Helpful
Tony Nitti’s nice, detailed discussion of this whole basis problem: Congress Agreed to Make PPP Expenses Deduction. Note that basis may also delay when you get deductions for PPP spending–though that seems like less of a problem to me.
Finally, a brief overview of how PPP tax accounting works at our CPA firm’s website.