The Paycheck Protection Program was created by section 1106 of the Coronavirus Aid, Relief, and Economic Security (CARES) Act. It provided much-needed relief to small business owners who were crippled by the COVID-19 outbreak. The loan program was attractive because eligible recipients could qualify for forgiveness (partial or full) if certain criteria was met. The funds forgiven under the program rules would then be considered non-taxable income. Although this may seem like a win-win, small business owners should prepare for potential PPP loan tax consequences resulting from PPP forgiveness.
PPP Loan Tax Consequences – Reduced Deductions
Earlier this year, the Internal Revenue Service (IRS) released Notice 2020-32, which provided additional guidance on the relationship between PPP loans and tax deductions. Essentially, it stipulates that business expenses paid with PPP funds are not deductible due to Section 265 of the Internal Revenue Code. This is because ordinary and necessary business expenses paid with tax-exempt income (forgiven PPP loan proceeds) would result in a double tax benefit.
So what does this mean for business owners? The following business tax deductions will not be allowed if paid for with PPP money:
- Mortgage interest
- Rental payments for office space
- Utility payments
The consequences of losing these deductions cannot be overstated. It could indirectly result in a federal tax of about 21% to 35% on the amount of PPP loan forgiven. This is why Congress introduced Senate Bill 3612, the Small Business Expense Protection Act of 2020. If passed, the PPP forgiven loan proceeds would remain tax-free and allow business owners to deduct expenses that were covered by PPP loan funding. Unfortunately, there has been no movement on the bill since it was introduced on May 5, 2020. To avoid an unexpected surprise at tax time, business owners should review their deductions from 2019 and estimate the additional tax liability they may incur due to PPP loan forgiveness.
State Income Tax Complications
States that have an income tax do not necessarily follow the IRS when it comes to revenue codes. This lack of conformity could become a real problem for business owners who received a PPP loan and need to file multiple returns. States must not only decide if the forgiven loan proceeds are tax-exempt, but also whether to allow deductions for expenses paid with loan proceeds. California, for example, has already declared that it will tax forgiven PPP loan proceeds. Even if the IRS decides to allow deductions for expenses paid with PPP funds, cash-strapped states may still disallow them. It’s important that business owners check with their state’s tax authority to verify how PPP funding will be handled and plan accordingly.
Payroll Tax Deferral
Business owners who deferred the employer portion of Social Security tax will not be able to deduct these expenses on their tax returns. Furthermore, if they do not set aside enough money to cover the required payment in 2021 and 2022, they could also be facing additional penalties and interest on those unpaid amounts.
If proceeds from a PPP loan are used for payroll taxes, the forgiveness application could also be declined. The business owner would then be responsible for repaying those funds under the loan terms.
PPP Tax Help
The Paycheck Protection Program was meant to help small business owners stay afloat during the pandemic. Although the funds provided much-needed relief, many business owners are now realizing that their taxes may be much higher than in previous years due to current IRS and state tax rules. Things may get even more complicated for those who do not receive forgiveness approval prior to the 2020 tax deadline. In some cases, 2019 tax returns could be affected due to PPP proceeds being used to cover expenses that were deducted on returns filed in July. For this reason, we strongly recommend working with a seasoned tax professional who can review your previous business returns and estimate your tax liability for 2020. Don’t get hit with an unexpected tax bill that you can’t pay. Protect your business and plan ahead. Contact Tax Defense Network today for a free consultation and learn more about our affordable PPP tax help.