You may be able to avoid taxes on some or all of your PPP loan forgiveness.
The possibility exists for some small PPP loan borrowers. Specifically for sole proprietors and partnerships.
And the possibility exists in spite of the new revenue ruling and revenue procedure the IRS published a week or so ago.
The trick? You need to prepare the 3508 PPP loan forgiveness application in a specific way.
Interested? The paragraphs that follow explain how PPP loan forgiveness works. And then they explain why the way you prepare your forgiveness matters for your taxes.
The Logic of the 3508 Forgiveness Application
The PPP loan forgiveness applications (the 3508, the 3508EZ and the 3508S) document that PPP borrowers spent their loan proceeds on forgivable spending.
To make the math simple, a small business with $10,000 in monthly payroll costs should have gotten a loan equal to $25,000.
To get forgiveness for that $25,000 loan, a borrower needs to spend $25,000 on salary, wages, fringe benefits, mortgage interest, rent and utilities within a 24-week covered period, or “spending window.” A borrower also needs to spend at least 60 percent of the loan on payroll costs.
A borrower who spends $25,000 on payroll and fringe benefits gets full forgiveness on a $25,000 loan.
But a borrower might also spend $15,000 on payroll and fringe benefits and then another $10,000 of spending on mortgage interest, rent and utilities to get full forgiveness on a $25,000 loan. (That $15,000 represents 60 percent of $25,000.)
How the Tax Accounting Works
The PPP loan forgiveness triggers taxes, however. At least for many and maybe most borrowers. And in a backwards manner.
The forgiveness doesn’t create taxable income. But the borrower loses tax deductions for the forgivable spending funded with PPP loan proceeds.
Say a borrower receives forgiveness for a $25,000 PPP loan for spending $15,000 on payroll and $10,000 on rent. In that case, the borrower reduces the tax deductions shown on the income tax return. Specifically, the borrower reduces the payroll deductions by $15,000 and then the rent deductions by $10,000.
Note: Our last blog post at Evergreen Small Business digs deeper into the details and mechanics, in case you’re interested: PPP Loan Tax Returns.
But a wrinkle shows up for sole proprietors and probably for partners in partnerships too.
Amounts that a sole proprietor pays its owner as replacement compensation doesn’t count as a tax deduction. No line appears on a Schedule C form or Schedule F form to deduct proprietor draws.
Furthermore, done right neither do amounts a partnership pays its owners count as a tax deduction. (The partnership tax accounting for PPP loans can get a little tricky, as discussed here.)
A PPP loan borrower who uses a $25,000 PPP loan for $15,000 of owner compensation replacement and then $10,000 of rent may receive $25,000 of forgiveness. But this borrower only loses $10,000 of rent deduction.
Connecting the Dots
When you apply for forgiveness using the 3508 forgiveness application form, in most cases you look at your spending over the 24 weeks that follow you receiving the loan.
What a borrower wants to do? Load up the application with enough spending to receive full forgiveness.
But the tax planning opportunity you want to keep in mind?
If possible, you want to get forgiveness for the spending on owner compensation replacement that doesn’t typically create a tax deduction. That’s the spending you want to report first and foremost on the 3508 forgiveness application.
Return to the example of a borrower spending $10,000 a month on payroll and receiving a $25,000 PPP loan.
Further suppose, that $10,000 of monthly payroll includes $5,000 of owner compensation replacement and $5,000 of employee wages and benefits.
The borrower can ask for forgiveness for all or some of the spending:
The borrower might simply ask for forgiveness for 24 weeks of employee payroll spending, for example. That’ll run about $30,000. And that $30,000 of payroll spending will give the borrower full forgiveness on the $25,000 loan. But that approach also results in the borrower losing a $25,000 deduction.
Another approach? The borrower could ask for 2.5 months of owner compensation replacement (that’s the maximum), which in this example equals $12,500. And then the borrower could ask for forgiveness for $12,500 of the payroll costs of employees. This spending also leads to full forgiveness. But the borrower only loses $12,500 of deductions.
You see what you want to do: You want to first put any spending on the 3508 forgiveness application that doesn’t cause you to lose tax deductions. And then, after that, you want to pour just enough additional deductions onto the 3508 application form to receive full forgiveness.
A Worst Case Scenario
Let us also point out what might count as the possible worst case scenarios here. Because forewarned is forearmed.
Return to the example $25,000 PPP loan.
Earlier paragraphs say owner replacement compensation equals $12,500 and employee payroll and fringe benefits equal roughly $30,000.
Those earlier paragraphs also mentioned $10,000 of rent expense. And suppose the borrower also within the 24-week covered period “spending window” paid another $5,000 for mortgage interest and 5,000 for utilities.
In this case, the borrower spending on forgivable items totals $62,500, as shown below.
|Forgivable Spending Category||Amount Spent|
|Owner compensation replacement||$12,500|
|Employee payroll and fringe benefits||$30,000|
|Total potentially forgivable spending||$62,500|
So that $62,500 of forgivable spending? Notice that the owner replacement compensation equals $12,500. Or 20 percent of the total reported on the forgiveness application
In this case, the 3508 forgiveness application also could show another $50,000 of spending. So, the other 80 percent.
The $64 question is, what tax deduction amounts does the borrower remove from its income tax return if the borrower reports all $62,500 of this spending on the 3508 form.
Another way to frame the question: How much of the $25,000 of forgiveness stems from the $50,000 of spending on employee payroll, rent, mortgage interest and utilities. Because that amount equals the lost tax deduction.
One might see an auditor or the IRS using a percentage. For example, the auditor might say, “Well, look, 80 percent of the spending reported on the 3508 form? You need to adjust your tax return deductions by 80 percent of the $25,000 forgiveness.”
One might also see an auditor or the IRS using an “employees-first” rule. For example, the auditor might say, “Gosh, $25,000 of PPP loan? $30,000 of payroll? We want you to assume the entire $25,000 PPP loan went for employee payroll.”
Taxpayers and tax accountants may or may not get additional guidance from the IRS on how to handle this. Or at least not by the time accountants start filing returns in a few weeks.
Furthermore, you should have already spent your PPP money and need to prepare and submit your PPP loan forgiveness application now.
Accordingly, probably you do not want overload your 3508 with spending if you’re a sole proprietor or partnership. Rather, first put the owner compensation replacement on the 3508 form. You don’t lose a tax deduction for that spending. And then second pour just enough additional deductions onto your 3508 application form to receive full forgiveness.