Okay, sorry, but I’m worried you might stumble into a PPP tax trap.
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
A quick discussion of the two other important tweaks to the PPP loans: second draw loans and PPP original loan amount increases.
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.
Another workaround to this lack of basis problem would be to increase the tax basis in 2020 based on the likelihood that the PPP loan will be forgiven in 2021. Using the same logic the IRS used when they determined that expenses paid with PPP money were not deductible in 2020 even if the loan forgiveness would occur in 2021, based on the likelihood that it will eventually be forgiven. I find this approach more simple and has merits based on the IRS’s previous guidance on this matter.
Hi Fabian, so your thought was my first thought. And I kind of think IRS could (and maybe should) decide to do that. In some other blog posts about this, I said, “hey, let’s channel the logic of Rev. Ruling 2020-27.)
Stephen, don’t know how you keep up with all of this and make any money. But, thank you!
🙂
This doesn’t make sense. Most businesses would have used up the PPP funds paying for payroll, rent, utilities, or mortgage expenses. Therefore, there wouldn’t be any funds leftover. Needless to say, you aren’t even allowed to distribute it to an owner anyway.
Does the law say that the owner is allowed to both deduct the expenses AND get additional basis for the amount forgiven? This, again, isn’t logical as the business get the benefit of the deductions for the forgiven loan funds and the shareholder gets an increase in basis for a loan that no longer exists.
What am I missing here?
>Most businesses would have used up the PPP funds paying for payroll…
This may be true, but we see and hear about firms which got PPP loans fearing the worst given the terrible forecasts concerning the pandemic. And then, what some of these firms found was, business didn’t get sick. It stayed healthy. In that case, the business will have PPP leftover.
>Needless to say, you aren’t even allowed to distribute it to an owner anyway.
The above statement is incorrect. BTW, the PPP money was for payroll and other specifically forgivable expenses. But some of the PPP money was always earmarked for owner payments.
>What am I missing here?
Congress with the new law clearly says PPP borrower gets tax-free forgiveness, tax deductions for PPP-funded spending, and also an adjustment up in basis. That’s in the law. This will explain (and quote the statute):
https://nelson.cpa/how-taxes-work-for-ppp-loans/
Stephen,
next to last sentence —please explain “though that seems like less of a problem to me”
Thanks
Tony Nitti in that Forbes article pointed out that if folks didn’t get basis for the PPP forgiveness until 2021 (when lender and SBA approve forgiveness application) that means in 2020, the PPP borrower may lack enough basis to deduct losses and may inadvertently make distributions in excess of basis.
Nitti seems to worry the most about the lost deductions. But to me, that’s not that big a problem. A lack of basis in 2020 means deductions suspended until 2021 when forgiveness occurs. That’s a minor headache. But not that bad in my mind because things net out in a couple of years (hopefully).
I worry about someone who’s business didn’t get sick and so they indirectly use PPP funds to make a big distribution in 2020. Without the basis adjustment, that distribution may be long-term capital gain… and then, yes, in 2021 when they receive forgiveness, they’ll get a bump up in basis. But that may take decades to have impact. E.g., they’ll have a capital loss at sale.
Sorry for the long-winded explanation. I know you know all this. Just trying to explain why I said “seems like less of a problem”…
What about that rev-rul that says expectation of forgiveness equals forgiveness in 2020. do not have the specific number in front of me. Could not that apply here? Expectation of forgiveness equals basis increase? Or am I stretching to much?
Yeah, that was my first thought. The RR is 2020-27, and it said that in terms of deducting expenses, you couldn’t deduct if you weren’t going to end up paying because forgiveness was a near certainty. Like you, I hope IRS creates some similar grace with new tax law. My first thought on this issue, as documented at our CPA firm website was, “oh gosh surely we don’t need to worry about this…” E.g., see here: https://nelson.cpa/how-taxes-work-for-ppp-loans/
But I think taxpayers probably want to plan if possible as if the basis adjustment occurs in 2021. So, to plan as if RR 2020-27 doesn’t apply.