Business owners who received Paycheck Protection Program loans should contact their tax advisors as soon as possible to discuss the tax effects they may be facing.
“A lot of people are unaware that your loan can be forgiven, so that’s tax-free, but you lose the deductions that generate that forgiveness,” said Jordan Empey, tax partner at Stockman Kast Ryan + Co.
The Internal Revenue Service has taken the position that, while the loan funds are not taxable, the expenses they were used for will be included in taxable income.
For example, an employer who obtained a $100,000 loan through the PPP program and gets full forgiveness does not pay tax on the $100,000. But if the business used the $100,000 on wages, the employer cannot deduct that $100,000 paid out in wages from taxable income, as would normally be done. The same rule would apply if the funds were used on other usually deductible expenses, such as mortgage interest, rent or utility payments.
The tax implications of PPP loans are the No. 1 issue that business owners need to keep in mind while doing year-end tax planning, Empey and other tax experts say. But there are also opportunities for businesses to generate additional cash and reduce their tax liability before the end of the year.
IRS Notice 2020-32, issued in May, provided guidance about the deductibility of otherwise deductible expenses when the taxpayer has received a PPP loan. It states in part:
“No deduction is allowed under the Internal Revenue Code … for an expense that is otherwise deductible if the payment of the expense results in forgiveness of a covered loan…, and the income associated with the forgiveness is excluded from gross income for purposes of the Code. …”
Employers who have already applied for and received forgiveness of PPP loans will not be able to take these deductions in 2020. As of Oct. 22, only 11 percent of PPP loan recipients had applied for forgiveness, Empey said.
For employers who have not applied for forgiveness, “I would advise them to talk to their tax advisor and come up with their own strategy, because this gets geeky in the details,” he said.
The rules in this area are still evolving, but the Treasury Department has made it clear that these expenses will be nondeductible, said Michael Schroeder, senior manager at BKD LLP.
In an IRS update issued Nov. 18, “they clarified their position a little bit,” Schroeder said.
“Although there are still some outstanding questions, ultimately their position is consistent with what we were expecting, which is that expenses are nondeductible in the year they are paid, even if the loan is forgiven in a subsequent year, if there is a reasonable expectation that the loan will be forgiven,” he said.
“This is the same whether or not the application for forgiveness is filed by the end of the year,” he said. “We are encouraging clients to consider extending returns for 2020 for as long as possible, in hopes there may be some legislative changes in a future stimulus bill.”
There may be an opportunity to transfer some of those nondeductible expenses into 2021, depending upon when a business received a PPP loan, Schroeder said.
“Taxpayers that received a paycheck protection loan late [in the year] might be able to use the 24-week alternative covered period to push back some of those expenses into next year,” Schroeder said.
In some cases, employers might want to include that taxable income in 2020 — for example, if they expect their income to go up significantly in 2021.
“It just depends on their own unique circumstances,” he said. “But before you apply for forgiveness, you should consult your adviser.”
FREEING UP CASH
Struggling businesses should also be aware that there may be COVID-related opportunities to generate cash or obtain tax relief that they can utilize before the end of the year.
“A lot of things that were limiting our ability to generate cash were changed” by the CARES Act, Empey said. “So you need to evaluate your past filings and whether the CARES Act would free up any cash for you because that was really their goal.”
An example is net operating loss. The Tax Cuts and Jobs Act of 2017 removed the option to carry back a net operating loss to the previous two years.
“With the CARES Act, they changed that so you could, but you have to look backward to get some of that cash,” he said. “Most people have probably evaluated this, but smaller clients maybe haven’t yet.”
In addition, some taxpayers who made real property improvements in 2017 or 2018 may be able to get tax refunds through another CARES Act provision.
“There was actually a fix for a drafting error within the Tax Cuts and Jobs Act of 2017,” Schroeder said. “They were intending for certain real property improvements to nonresidential real property to have been eligible for a 100 percent bonus depreciation, or it would be 100 percent deductible, and it was actually not written that way into the Tax Cuts and Jobs Act. So for 2018, and for a lot of people that filed early in 2019, they may have had real property improvements that weren’t eligible to be deducted as a 100 percent bonus.”
That error was corrected in the CARES Act, Schroeder said.
“So there may be some opportunity to go back and get some tax refunds by going back and amending a 2018 or 2019 return and picking up that additional bonus depreciation,” he said.
The payroll tax credit under the Families First Coronavirus Response Act, passed in March 2020, is another measure that may impact businesses now, Empey said.
“With that bill, until the end of the year, you get a payroll tax credit for basically letting people stay at home for two weeks, and basically up to 12 weeks if you have to care for children, with schools shutting down,” he said.
For businesses that meet the full threshold for the credit, “if I pay $500 for an employee to stay home because they’re quarantined, you can actually receive that money back from the government as a payroll tax credit,” Empey said. “So the employer is whole, the employee can stay safe, and the employer doesn’t lose that payroll expense.”
Under another provision of the CARES Act, employers also may be able to defer their portion of their fourth quarter Social Security tax payment.
“Certain employers may be able to defer their payment of that, half of it being paid by the end of 2021 and then half of it being paid by the end of 2022,” Schroeder said. “That would include self-employed taxpayers and taxpayers that received paycheck protection.”
Other tax changes for 2020 concern IRA withdrawals and charitable deductions.
“If you were impacted by COVID, and you had a COVID hardship, you can pull money out of your IRA in 2020 and not pay the 10 percent early withdrawal penalty, which would normally be applied,” said Judy Kaltenbacher, tax partner in charge at Stockman Kast Ryan + Co.
That withdrawal, however, would be taxable when pulled from a traditional IRA, she said.
In addition, taxpayers will get more tax benefit from charitable giving in 2020.
“There’s no limitation on the deduction you can get from your charitable giving,” she said. The benefit “depends on what tax bracket you’re in. If you’re in a top bracket, it could be around 40 percent with your federal and state income tax.”
Kaltenbacher notes that this deduction applies to people who itemize on their individual tax returns. Taxpayers who take the standard deduction are limited to deducting $300 in charitable contributions, and this deduction applies just for 2020.
YEAR-END TAX PLANNING
“Something we try to look at every year is making sure taxpayers are on the right accounting method for tax purposes,” Schroder said.
The Tax Cuts and Jobs Act added flexibility for some taxpayers to use the cash method of accounting, whereas they may have been required previously to use the accrual method. “Certain receivables-heavy businesses may be able to switch to the cash method by filing an accounting method change, which would allow them to defer recognizing that income until they actually receive it,” Schroeder said. “So any receivables they have on hand at Dec. 31 wouldn’t be required to be recognized into income until the year that they actually receive it, which would be presumably next year.”
Another item Schroeder looks at with his clients is the opportunity to accelerate the deduction of certain expenses.
An example is insurance that is prepaid in 2020, but the taxpayer does not get the benefit of the expense until the following tax year.
Tax planning this year is uniquely complicated, with the political situation compounding an already complex tax year, Kaltenbacher said.
‘Depending on people’s individual situations, their facts and circumstances, if they expect the tax rate to be lower in the future and they’re in a higher bracket, right now they want to do things like defer income, accelerate deductions, look at being more aggressive with their depreciation and maybe purchasing assets,” she said. “Those are the kinds of year-end tax planning that we’ve been doing for years and years. And if you expect your income tax to be higher
next year, then you basically want to do all of those things in reverse.”
But the political situation — particularly control of the U.S. Senate — makes it more difficult to anticipate what tax changes might occur next year.
“That’s why it’s so much more important to consult with your adviser,” Kaltenbacher said, “because we can help our clients look at their individual situations, discuss what their goals are and give them all of the tools to make informed decisions.”