Small business owners already struggling because of the COVID-19 pandemic and state-ordered shutdowns or capacity restrictions now face another hurdle to surviving 2020: an unexpected tax hit.
That’s because of a November ruling by the IRS for business owners who took out a forgivable loan earlier this year through the Paycheck Protection Program, or PPP. According to IRS Revenue Ruling 2020-27, taxpayers who expect that their PPP loans will be forgiven are not allowed to deduct expenses up to the loan forgiveness amount for the year in which expenses are incurred.
This ruling, if it stands, will have a big financial impact on businesses that took out forgivable PPP loans through the Coronavirus Aid, Relief and Economic Security Act, better known as the CARES Act. Because of the ruling, business owners can’t claim a deduction for any otherwise deductible expense if the payment of that expense results in the forgiveness of a PPP loan.
Basically, business owners aren’t allowed to deduct business expenses from their annual tax returns if those expenses were paid for with money from a PPP loan.
Business owners who are already struggling to keep their doors open, then, now face another financial hurdle.
James Lockhart, partner and national leader of the real estate practice for Minneapolis-based accounting and business consulting firm Wipfli, said that when the PPP loan program was first rolled out, small business owners reacted quickly, applying for the loans without really understanding the fine print of how they actually worked.
That’s understandable: Businesses in many parts of the country were being forced to shut down. Others saw their revenues plummet as customers stayed away. They needed financial help and they needed it quickly.
Now more than nine months into the pandemic, many business owners have been blindsided by the IRS ruling and the impact it will have on their bottom line for 2020, Lockhart said.
“The intent was that people got this assistance and if they spent it on the right things and followed the requirements, the loans would be forgiven. Nowhere did anyone think, ‘Hey. I’m going to get taxed on this,'” Lockhart said. “That wasn’t the intent behind this. I think people are shocked and amazed. The IRS doesn’t write legislation. Its duty is to collect revenue. But to collect from those who don’t have it doesn’t seem right.”
The PPP already came with plenty of restrictions that business owners had to follow if they wanted their loans to be forgiven. Business owners who wanted complete forgiveness had to spend their PPP dollars on payroll, rent, mortgage and utilities.
The goal was to provide business owners with loans that they could use to keep workers employed and their businesses open. Business owners who followed the rules, then, wouldn’t have to pay their loans back.
Now, though, business owners are discovering that even if they did follow the rules, they’ll face a financial hit, one that is unexpected for many: They won’t be able to lower their tax bill by as much as they expected because they won’t be able to claim deductions that they’d normally take.
Being able to write off operating costs is important for businesses. Many can’t afford to remain open if they can’t write off big portions of their operating costs and expenses. These expenses include rent, mortgage and utilities. Those business owners who used PPP loans to pay these expenses this year are now not allowed to write them off, which could force some to the financial brink.
Hannah Smolinski, chief executive officer and founder of Clara CFO Group, said that it’s not surprising business owners are confused or shocked by the IRS’ ruling. Congress when drafting the CARES Act said that it didn’t want forgiven business loans to be treated as taxable income.
“That was ringing in the heads of small business owners,” Smolinski said. “They heard, ‘free money,’ ‘free money.’ But there is still a tax affect. That is confusing to a lot of people.”
Smolinski gives this example: Say business owners have $100,000 of expenses forgiven after taking out a PPP loan. The IRS says that business owners can’t deduct this from their profits at the end of the year. This, in essence, treats that forgiven debt as being similar to taxable income.
“Business owners thought they were getting lower profits this year and were planning to pay taxes on lower profits, maybe even on a loss position this year,” Smolinski said. “With about half of business owners, they were expecting losses. This is instead flipping many of them into profitable positions that they didn’t expect.”
Smolinski said that the IRS’ decision isn’t unexpected to financial and accounting professionals. The problem, she says, has been getting this information to business owners.
“Not everyone is going to read the CARES Act,” she said. “Taxes are inherently confusing to begin with. And this is all something new, something that had never happened before. We knew back in May that the IRS was going to do this. The IRS just recently doubled down on its position. Even if you have not had your loan forgiven yet but you still believe it will be forgiven, you don’t get to take a deduction on those expenses.”
Clara CFO Group worked with its clients to provide them with a calculation of the tax impact they would face when taking out a PPP loan. But not all small business owners work with professional accounting firms. Those owners are the ones most likely to be blindsided by the IRS’ decision, Smolinski said.
Lockhart said there is hope, though, that the revenue ruling is reversed and that business owners won’t suffer the tax hit. His hope is that the next round of stimulus funding, when it is approved, includes a change stating that business owners will be able to deduct expenses that they paid for with a forgivable PPP loan.
If this happens? That would finally be some good financial news for small business owners.
“We’ve seen this before. When things get passed too quickly, the legislators don’t consider everything,” Lockhart said. “They get it out there fast for the general good. They have to come back later to clarify. We hope that this gets cleared up. I don’t know if it will get clarified by the end of this year. But by January or February, we hope it does. As long as it is clarified before tax returns are due to be filed, that will work.”
As Lockhart says, if business owners took out $100,000 PPP loans, they did so because they needed all $100,000. They didn’t expect to get hit with the 30 percent tax.
“They needed all $100,000, not $70,000,” Lockhart said. “That’s a hefty tax bill.”