Did the PPP Loan Drive Up Your Taxable Income?
Surprises, A Business Owner’s Foe
We know this year has been chock full of surprises, but our hope is that you will NOT be surprised by your tax burden when it comes time to file and settle up in March and April (depending on your business entity). As such, we want to walk you through what you can expect when it is time to file your tax return if you received a disaster recovery loan. Let’s first quickly reintroduce the PPP Loan for clarity’s sake.
The Paycheck Protection Program
The Paycheck Protection Program (PPP) offered a loan to small business owners as a way to inject cash flow into their businesses while the world dealt with the repercussions of a global pandemic. The loans provided by the Small Business Administration (SBA) must be used to cover payroll, mortgage interest payments, utilities, and rent. Beyond the huge need for this cash, the loans had the potential to be forgiven, essentially releasing business owners from the loan’s debt.
Loan Forgiveness & Your Tax Impact
Since most business owners set out with the intention to have their loan forgiven, it is highly likely you will find yourself in the scenario of trying to determine how loan forgiveness fits into your tax obligations. The best way to explain this is to walk through an example.
Let’s say your business received a $100,000 PPP loan. Let’s also say that you made $0 of net profit according to your books (not negative, simply $0 profit), given that the current IRS ruling is that PPP related expenditures are not tax-deductible, you will have to add all of the expenses you paid with the PPP loan to your net profit when determining your total taxable profit.
Thus, the net taxable profit in this example becomes $100,000. The government taxes on profit and, depending on your business entity, you will have to pay a percentage of this net profit as part of your 2020 federal tax return. If you are a Sole Proprietor, an LLC, or an S Corp, then this net profit gets included in your personal taxable income. You can see how this situation can quickly become tricky for a business owner, especially one who did not make any profit in 2020.
Tax Deductions Outside of COVID
In the past, business owners have been able to write off a lot of their expenses like payroll, rent, and utilities, but 2020 proves again to be a highly unique situation. Since the SBA required that PPP loans were to be spent on payroll, mortgage interest payments, utilities, and rent, the tax deductions business owners are ordinarily used to have now been taken off the table leaving business owners open to higher than normal taxable income.
How Can You Affect Your Taxable Income Now?
You’re probably wondering what is left to do now that your taxable income may be much higher than you anticipated based on the intricacies of PPP loan forgiveness. First, let’s start with an outline of the 2020 business tax rates for each entity type, so you can begin to get a better picture of what you will owe in federal taxes come March and April.
2020 Business Tax Rates
- C-corporations owe a flat 21% on their net business income and are taxed on the corporate and the individual level.
- S-corporations, Sole-proprietors, and LLCs owe between 10% and 37% depending on their filing status and other/non-business-related income. Sole proprietors, LLCs, and S Corps may have the option of deducting up to 20% of taxable qualified business income before calculating their tax rate (if their personal income does not exceed the IRS threshold). Additionally, S-corporations can divide their net income into a “reasonable” salary and the remainder recorded as distributions. This avoids self-employment taxes on the distribution portion.
Time is of the Essence
If you complete your taxes on a cash basis (if you’re unsure, speak to your tax accountant or book a call with us) then there is still time to take some actions in your business to mitigate your tax burden. HOWEVER, time is of the essence, because you only have until 12/31 to spend your tax-deductible expenditures, and 12/31 is only a few short weeks away.
Now a quick caveat, we are not advocating to start throwing money around in order to reduce your taxable income but rather to consider whether now is a good time to not only front-load expenses that would happen in 2021 anyway but also negotiate a better deal on these expenses by paying upfront.
Let’s look at some examples.
3 Ways to Bring Your Taxable Income Down
- Prepaid Expenses
- The first option is that you can prepay your rent. Now we know this one may sound weird, but the world will open up again and if you get creative with the scheduling your team can take a much-needed break from their makeshift home office.
- Second, you can prepay contractors and vendors. Maybe you are planning to implement a whole new service and a fancy marketing campaign to go with it. It is likely your marketing vendor will accept prepayment for their services and offer you a discount for paying early. This option does come with some service agreement/performance risk, as you will have limited recourse should the vendor not provide the return you were anticipating.
- Fixed Assets and Depreciation
- You can purchase additional assets for your business. Maybe you’ve been waiting to replace some older machinery or your team could use a fleet of new computers. This can be a great way to outlay cash on something more than useful for your business.
- Retirement Accounts / 401ks
- Finally, we would advise getting together with your investment advisor and maxing out your retirement contributions.
The AICPA & Congress
If you haven’t taken any action to limit your taxable income just yet, there is still hope that Congress will pass legislation to ensure the receipt and forgiveness of PPP loans does not result in unexpected and burdensome tax costs. The American Institute of CPAs (AICPA) along with 560 other organizations have been urging Congress to take action and make it clear that expenses related to a forgiven PPP loan are tax-deductible.
In a letter written to Congress, it was stated that without this legislation there is “…the specter of a surprise tax increase of up to 37% on small businesses when they file their taxes for 2020.” The AICPA is optimistic that the deductibility issue will be resolved because there is support on both sides of the aisle. In fact, Congress is currently considering a PPP2 that currently has terminology confirming the deductibility of expenses paid with PPP2 funds, as well as retroactively confirming deductibility of expenses paid with PPP1 loans.
Here’s to Hoping
So where does all of this tax talk leave business owners? You can still delay the filing of your tax returns as much as possible, and, of course, there is the option to file an extension as well. Hopefully, the world cuts us one break this year and Congress returns a favorable result in their upcoming sessions (#fingerscrossed). However, if Congress does not make a decision before the looming tax deadlines in March and April, you can still work with your tax accountant to amend your tax return if congress does allow for the deductibility after filing your return.
Our hope in sharing this information with you was not to make a crazy year feel even more weighty, it was meant to cut down on any surprises come tax time. If you have yet to engage a tax accountant or are ready to make a final few spending decisions to cut your taxable income, we invite you to book a call with one of our tax experts and we can sort out the best plan for your business taxes together.