Editor’s note: a stimulus bill finalized on December 20 includes a ruling on the deductibility of PPP expenses. With the passing of this bill, any expenses that were covered by a PPP loan will still be tax deductible. This article will be updated when more information is available.
Your 2020 taxes are likely going to look a little different than they normally do. There have been a lot of new programs created to help small businesses, which means you’re probably going to deal with situations that you’ve never seen before including forgiven loans, grants, and unemployment benefits.
In this article, we’ll walk through how these three things will come into play when calculating your 2020 taxes.
Further reading: The New Tax Deadlines for 2020
How the PPP loan affects taxes
The Paycheck Protection Program (PPP) is a lifeline for businesses who are currently struggling due to COVID-19. The PPP is a loan intended to provide cash flow help for eight weeks, backed by the SBA.
What makes the PPP even more enticing for business owners is the potential that the loan amount can be forgiven, as long the money was spent on payroll, mortgage interest, utilities, and rent (with the majority spent on payroll).
But with this new program came a question about the IRS will view the money. If you meet the criteria for getting the loan forgiven, will the government tax you on the free money you’re receiving?
Not directly, but it’s a little more complicated than that.
Will I be taxed for my forgiven PPP loan?
The CARES Act spells out that the forgiven loan amount won’t be included in taxable income. That means you don’t pay taxes on the money that you receive. The aim of this loan is to provide businesses with the money to keep running and continue paying employees, not to create a tax burden for businesses receiving the funds.
But, there’s a catch. The IRS later released a notice clarifying how the forgiven loan amount would be treated when it comes to 2020 taxes:
“This notice clarifies that no deduction is allowed under the Internal Revenue Code (Code) for an expense that is otherwise deductible if the payment of the expense results in forgiveness of a covered loan pursuant to section 1106(b) of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), Public Law 116-136, 134 Stat. 281, 286-93 (March 27, 2020) and the income associated with the forgiveness is excluded from gross income for purposes of the Code pursuant to section 1106(i) of the CARES Act.”
Put simply: if the forgiven loan isn’t included in a business’s taxable income, the expenses paid for with the forgiven loan aren’t able to be included as a tax deduction. That may sound like a small detail, but it can potentially have a big impact on your final tax bill at the end of the year.
On November 18, the IRS released guidance clarifying that if you reasonably believe your PPP loan will be forgiven—regardless of whether it’s 2020 or later—any expenses you used your PPP loan to cover are not deductible.
What does this look like on your tax return?
Normally if a business has payroll, rent, mortgage interest, or utility expenses, these are deductible from taxable income. That deduction lowers your taxable income. Without that deduction, you’d owe the government more in taxes.
And that’s what is going to happen in this situation: you lose out on some tax deductions, so you may have to pay more when it comes time to file your taxes.
For example, let’s say your business is a C corporation that received $100,000 in a PPP loan. You used that money entirely on payroll expenses and qualified for loan forgiveness. The $100,000 that you receive won’t be included in taxable income at the end of the year.
But you won’t get a $100,000 tax deduction for the expenses you incurred. That means you could have an extra $21,000 tax liability at the end of the year ($100,000 * 21% corporate tax rate) that you wouldn’t have if you were allowed to take the deductions as normal.
While the PPP did provide you with an extra $100,000, you’re losing $21,000 in tax deductions that you’d normally get. In this example, you’re still going to have a net benefit of $79,000 from the program—money that you probably wouldn’t have otherwise. But for some business owners, this could be a big tax surprise that could be waiting for you at the end of the year from a program that is supposed to help your business stay afloat.
Further reading: How the Paycheck Protection Program Affects 2020 Taxes
Waiting for 2021 to apply for forgiveness
Don’t want to worry about how your PPP loan will affect your 2020 taxes? You can wait until the dust settles and the forgiveness processes are all decided. You don’t have to apply for forgiveness until your loan maturity date (2 or 5 years after receiving the funds). This means you can wait until 2021 or later to apply for forgiveness and focus on your upcoming tax season.
Things still could change
While this is a frustrating (and expensive) update to the loan program, it may not be the final decision. Rules are still being written and plenty of people are unhappy that the IRS has taken a position that would negatively impact businesses that are struggling.
The American Institute of Certified Public Accountants (AICPA) is challenging the IRS decision that these expenses aren’t deductible, saying that this goes against Congress’s intent when they created the PPP.
There is also a potential update to the law that could be passed. The recent stimulus proposal, the HEROES Act, reverses the decision that these expenses can’t be deductible. While the HEROES Act is still just a proposal and hasn’t been signed into law, it’s clear that some lawmakers want to change the tax treatment of forgiven PPP loans.
There is a chance things could change in the future, but for now, it’s a good idea to assume that you won’t be able to deduct these expenses and you may have a higher tax bill as a result.
How the EIDL advance affects taxes
The Economic Injury Disaster Loan (EIDL) is a loan option available through the SBA to help businesses struggling with financial hardship due to COVID-19. While it is a loan and doesn’t have any special treatment when it comes to taxes, there is one thing that may affect your taxes: the EIDL advance.
The EIDL advance is technically a grant for small businesses of up to $10,000. Because it’s a grant, it’s not part of the loan that needs to be repaid. That means it’s going to be treated differently than a loan on your financial statements and your tax return at the end of the year.
Unlike the PPP loan forgiveness, this grant will probably need to be included in taxable income. This isn’t definitive because the IRS hasn’t specifically said that this advance should be included in taxable income, but previously they’ve been pretty clear that any forgiven SBA loan amounts need to be included in income.
If you received an EIDL advance for the maximum amount of $10,000, that money will need to be added to your taxable income at the end of the year. But if it’s added to your taxable income, you’ll be able to deduct any expenses that you use to pay for this grant.
For example, say you received an EIDL advance of $10,000. You’ll increase your taxable income for the year by that amount. But you also used all of that money to pay for some of your business expenses, like inventory and rent. You’ll get to take that $10,000 that you spent as a deduction against your taxable income, which means you won’t pay taxes on the money you received.
How the Employee Retention Credit affects taxes
You might find that the total amount of tax you owe has been reduced thanks to the Employee Retention Credit. This credit is eligible for business with fewer than 500 employees who either suspended or partially suspended their business due to COVID-19 because of a government order or they experienced a 50% decline in gross receipts when compared with the same quarter in the previous year. The catch is that you can’t have a PPP Loan and receive the Employee Retention Credit
Tax credits are incredibly valuable because unlike a deduction, which reduces your taxable income, tax credits reduce your tax liability on a dollar for dollar basis. So if you have a $10,000 tax liability and a $3,000 tax credit, the amount of tax you owe is now $7,000.
The credit is calculated per employee and is 50% of up to $10,000 in qualified wages paid per quarter. If you qualify for the credit and paid three employees $8,000 in qualified wages during a quarter, you’d be eligible for a credit of $12,000.
Because the government knows you need this money now, you won’t need to wait until the end of the year to claim the credit. It can be claimed on your quarterly form 941.
How unemployment affects taxes
One thing that can sometimes take unemployment recipients by surprise is finding out that yes—unemployment benefits are considered taxable income. That means you will have to pay state and federal taxes on the amount of money you receive, though you won’t have to pay medicare or social security taxes on it.
You can pay these taxes in two different ways. One option is to fill out form W-4V, and request that the taxes are automatically withheld from your unemployment benefits payments. If you don’t request to have taxes automatically withheld, you’ll need to make estimated tax payments during the year. Beware of this to avoid an unexpected tax bill.
When you’re filing your 2020 tax return, you’ll need to report the income you received from unemployment compensation. You’ll get a 1099-G slip from your state labor office that details how much you received and how much, if anything, you had withheld for taxes.
There is still some uncertainty when it comes to 2020 taxes and how new programs like the PPP loan forgiveness will affect them. While lawmakers consider updates, the best thing to do is to stay organized and keep good records of your expenses, so you’re able to take full advantage of deductions if they’re allowed in the future.