Tax Implications of PPP Funds Finally Align with Congressional Intent
December 21, 2020
On December 20, 2020, Congress agreed to terms of the Emergency COVID Relief Act of 2020 (the Act). The Act, which will provide an additional $900 billion of funds to stimulate the economy, includes significant changes to the Paycheck Protection Program (PPP). President Trump signed a one-day extension of government funding to prevent a government shutdown, enabling lawmakers to write the final text for the relief package.
To the satisfaction of many, three notable clarifications from prior guidance are included in the Act regarding the tax implications of PPP funds:
1) PPP loan forgiveness
2) PPP covered expenses
3) Owners’ basis for flow-thru entities
PPP Loan Forgiveness
The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) implies that forgiveness of a PPP loan is non-taxable. While the terminology was inconsistent at times, wavering from forgiveness of indebtedness to excluded from gross income, the CARES Act and subsequent guidance reiterated that forgiveness will not create a taxable event. This Act reaffirms this position.
PPP Covered Expenses
Much of the PPP tax conversation has been focused on the treatment of covered expenses – payroll, utilities, rent and interest as defined by Section 1106(b) of the CARES Act. Internal Revenue Service (IRS) Notice 2020-32 indicated that a borrower cannot deduct expenses paid with funds that create non-taxable income. The IRS then doubled down with the issuance of Revenue Ruling 2020-27 affirming their position that a taxpayer may not deduct those expenses in the taxable year in which the expenses were paid or incurred if, at the end of such taxable year, the taxpayer reasonably expects to receive forgiveness of the covered loan, even if the taxpayer has not applied for forgiveness of the covered loan by the end of such taxable year.
The Act significantly changes course for year-end tax planning. When referencing the covered expenses under the PPP, the Act states “no deductions shall be denied or reduced…by reason of the exclusion from gross income,” meaning the expenses ARE deductible.
Owners’ Basis for Flow-Thru Entities
Many of the tax implications questions were focused on the deductibility of expenses. The Act addressed such and also provided a welcomed clarification for owners of flow-thru entities (S corporations and LLCs/partnerships), especially after the additional limitations of PPP funds placed on owner compensation. The Act states “no basis increase shall be denied, by reason of the exclusion from gross income,” meaning PPP forgiveness will INCREASE basis.
A Closer Look
Considering the clarifications and trusting that the IRS will not impede the legislation, we have provided an example of how the changes could affect your loan forgiveness tax impact.
|Expenses||$ 6 million|
|Net Loss||($1 million)|
|Add: PPP forgiveness amount||$1 million|
|Net Income||$ -0-|
|Less: non-taxable PPP forgiveness amount||$1 million|
|Taxable Loss||($1 million)|
|Additional assumptions for LLC/partnership/S corporation:|
|Tax basis of owner as of January 1, 2020||$-0-|
|Owner distributions paid in 2020||$-0-|
Corporations will have non-taxable income to the extent the PPP loan is forgiven and accounted for as such. All expenses paid will be fully deductible and all wages will count toward the computation of federal and state R&D tax credits.
This loss can now be carried back five years or carried forward indefinitely.
Depending on the previous taxable position of the company, this change could result in a big win for some corporations. Five years ago, income tax rates were much higher than they are today. If five years ago the company was in a 34% tax bracket and today at 21%, the result of this law is a 47% higher tax benefit
S corporations and LLCs/partnerships:
The big question since March related to flow-thru entities was whether an owner’s basis would increase or not. The clarified forgiveness amount, while not taxable, will increase basis.
To accompany the example above, consider an S corporation with one shareholder. The tax loss of $1 million might not have been allowed since the taxpayer is being allocated a $1 million tax loss and their basis was zero. However, since the law indicates that you will get basis for the forgiveness of the PPP loan, the taxpayer’s basis is now $1 million before the loss and the owner can use this basis on their individual income tax return, allowing them to deduct the $1 million loss against other income.
The challenge many flow-thru entities will have will relate to buy-out clauses. There could be unintended consequences from M&A transactions or when partners enter and leave an entity.
Self-employed individuals and farmers:
Similar to flow-thru entities, this legislation will allow individuals and farmers to claim the losses. There is a specific question on IRS Forms Schedules C and F which ask a question each taxpayer must answer: is ‘all or some’ investment at risk? Taxpayers can take the position that the forgiveness amount gives them basis to claim these losses now and can check the box in the affirmative.
Over the last few months we have been busy tax planning with our clients who expected to have their PPP loans forgiven, and each conversation hinged on a variable – what will taxable income be if the IRS and/or Congress react? We debated ordering rules, the impact on IRS Section 199A, R&D credits and the impact to owners of flow-thru entities.
The changes regarding deductibility provide answers to many of the questions and concerns we, along with borrowers and other practitioners, had. More importantly, these changes correct the unintended tax consequences of PPP funds and keep cash in the hands of the small businesses, magnifying the PPP impact.
Flow-thru entities should review their Operating Agreements and Shareholder Agreements to fully understand the impact PPP forgiveness may have on their business.
While significant, the clarification on the tax implications of PPP funds is just a small piece of the Act. For more updates and guidance on all things COVID-19, visit our blog.
Let Us Help
Aprio has established a dedicated PPP loan forgiveness team that is continuously monitoring new guidance from the SBA, as well as the Treasury, Congress and the IRS, to ensure we have the latest information when advising our clients.
Aprio’s tax advisors can assist companies in reviewing their Operating Agreements and Shareholder Agreements to ensure there are no unintended consequences as a result of PPP forgiveness.
To discuss your tax situation, contact your Aprio advisor or Aprio’s dedicated PPP loan forgiveness team.
Disclaimer for services provided relative to SBA programs and the CARES Act
Aprio’s goal is to provide the most up to date information, along with our insights and current understanding of these programs and regulations to help you navigate your business response to COVID-19.
The rules regarding SBA programs are constantly being refined and clarified by the SBA and other agencies In certain instances, the guidance being provided by the agencies and/or the financial institutions is in direct conflict with other competing guidance, regulations and/or existing laws.
Due to the evolving nature of the situation and the lack of final published rules, Aprio cannot guarantee that additional changes or updates won’t be needed or forthcoming and the original advice given by Aprio may be affected by the evolving nature of the situation.
You need to evaluate and draw your own conclusions and determine your Company’s best approach relative to participation within these programs based on your Company’s specific circumstances, cash flow forecast and business strategy.
In situations where resources are provided by third parties, those services should be covered under a separate agreement directly with that service provider. Aprio is not responsible for the actions of any other third party.
Aprio encourages you to contact your legal counsel to address the legal implications of the impact of the CARES Act and specifically your participation in any of the SBA programs.
About the Author
Mitchell is the partner-in-charge of Aprio’s Tax practice as well as the Technology & Biosciences group. He has been a partner since 1990 with Aprio, which is the largest Georgia-based tax, accounting and consulting firm. Mitchell works with companies in the software, gaming, clean tech, financial technology (FinTech), health care IT, processing, biosciences (biotech and medical device) and manufacturing industries. Whether a company is pre-revenue, starting up, growing or preparing for a liquidity event, Mitchell works with them to maximize their potential at each stage. He is known for promoting research, innovation and entrepreneurship by enabling companies to be successful, regardless of where they are in their business lifecycle.