3 Things to Know About Disaster Recovery Loans & Your Business Taxes
The Changing Tax Landscape
Keeping a close eye on the tax implications incurred by your business is an integral piece of sound financial management. But when the new normal for business owners is that there is no normal, it can be difficult to come up with definitive answers to your questions. We’ve had a lot of conversations with clients questioning their disaster recovery loan tax implications and how they can prepare for the impact on their business. To help bring some clarity to the discussion, we’re addressing 3 things you should know about how disaster recovery loans like the PPP and EIDL are affecting your taxes.
With any business advice in relation to the COVID 19 situation, it’s important to remember that even the best advice may not be evergreen, so it’s always a great idea to consult your favorite tax professional with your specific questions.
#1. A PPP loan that has been forgiven is tax-exempt.
The Paycheck Protection Program (PPP) has been imperative to many small businesses’ survival over the past few months, helping provide much needed cash flow to business owners at their exact time of need. Further still the loan, provided by the Small Business Administration, comes with the exciting possibility of being forgiven or in layman’s terms, it will not need to be paid back (#thankyou). Of course, the SBA put in key factors for forgiveness like the loan funds had to be spent on payroll, mortgage interest, utilities, and rent – which is all in the name of ensuring loan funds are well spent.
So the question becomes, “Will business owners be taxed on PPP loans?” The answer is no, if the PPP loan was forgiven, but it’s a little more complex than that. The CARES Act which explains the full terms of the PPP Loan says that forgiven loans, will be considered “canceled indebtedness” and further that “Canceled indebtedness under section 1105 shall be excluded from gross income for purposes of the Internal Revenue Code of 1986.”
This being said, the Internal Revenue Service does clarify that deductible expenses – expenses that a business can subtract from their adjusted gross income – that were paid for using the PPP loan cannot be claimed as a deduction on 2020 tax forms. The reasoning here is most likely to shore up any double dipping on the benefits a business has received. So to conclude a forgiven PPP loan is tax-exempt, however, using the PPP loan can reduce expected tax deductions, which brings us to the second thing you should know.
#2. Typical tax deductions you normally claim may be affected by your PPP loan.
In the past, entrepreneurs often wrote off business expenses like payroll, office or warehouse rent, and utilities as business expenses. But since business owners are required to use the funds they received from their PPP loan for many of these same businesses expenses, they can’t write them off for the same reason as above. The IRS does not want to encourage double dipping since forgiven PPP funds do not count towards taxable income, so anything paid off by those funds was essentially a tax credit to begin with. This is important to note for many business owners, so they can prepare for a higher taxable income in 2020.
But one tax credit that shouldn’t be affected by the use of your PPP Loan are the family and sick leave tax credits explained in the Families First Coronavirus Response Act (FFCRA). As long as the sick and family leave wages were not paid for with PPP funds then you can claim this tax credit on your tax return (#phew).
#3. An Economic Injury Disaster Loan may be included in your taxable income with a caveat.
We already know that if you receive forgiveness for your PPP loan, the funds will not count towards your taxable income, but what about the Economic Injury Disaster Loan or EIDL? There are two parts to the EIDL loan, which is also provided through the SBA. The first part is the provision of a grant of $1,000 per employee with a maximum of $10K. The second part, beyond employee grants, is a low-interest SBA loan.
Though it has not been addressed by the IRS yet, it’s assumed that since the EIDL’s $1,000 per employee is a grant, and not a forgivable loan, that it will be treated differently than the PPP loan and WILL be considered taxable income. BUT, in a reversal from what we’re seeing with PPP funds, EIDL grant funds used to pay off typically tax deductible business expenses like rent or utilities, CAN be claimed as a deduction against your taxable income.
All funds received through EIDL beyond the per employee grants are considered a loan that must be repaid. So, just like any other loan, these funds are not taxable. Furthermore, also like any other loan, the interest paid on the loan is a tax deductible expense.
Side Note on Federal v. State Taxes
The above “3 things you should know” relates to the completion of your federal tax return. This information may not hold true regarding your state tax return. The CARES Act does not require states to follow suit regarding the same taxation practices that they have set at the federal level, but it is the assumption that states will keep in line with the federal regulations.
Change is the Only Constant
Remember when we said earlier that the, “New normal for business owners is that there is no normal.” I want to call your attention back to that, because the tax implications of your disaster recovery loans could still change. Yes, that is frustrating to hear. But it also means that things can change in your favor, new tax credits may be developed, and more favorable regulations could be created too. The best way to approach this evolving situation is to focus on making sound financial decisions for your business, conserve cash, and consult with a tax advisor.
Owning a business comes with enough of its own challenges, add to that the compounding stress of the unknown, and we know you’ve got a lot on your mind! Let us take one thing off your to do list – figuring out your business taxes – so you can focus on more fun stuff like innovative strategy, serving customers, and changing the world.