I’m concerned that the tax consequences of the Paycheck Protection Program are not clearly understood and want to repeat two consequences and discuss a third issue that I think is equally important.
I have in the past written that the cancellation of a note is almost always a taxable event. As a result, the amount canceled is typically taxable income. However, a special exception was made with PPP to allow borrowers whose notes are canceled do so without this income tax consequence. As a result, forgiveness of the PPP loan is not taxable.
Just like any other expense, if the money is used to pay ordinary and necessary business expenses, it can be deducted by the borrower. Deductions are not typically tied to the source of funds, so whether you borrowed that money, were given money or contributed your own money to the business really doesn’t matter.
One would normally think that the entity that made the payment would be able to take the deduction. That is typically the case. When a C corporation or a sole proprietorship pays an ordinary and necessary business expense, that business would normally get the deduction.
The problem arises where, and I have not seen anyone address this issue, a pass-through entity makes the payment. A large number of businesses are S corporations or general or limited partnerships. Typically, the gains and losses of these entities pass through to the individuals who owned the stock in the S corporation or the interest in the partnership. However, those losses cannot be passed through without scrutiny. The owners must have sufficient basis in the partnership interest or the stock in the S corporation for the deduction to pass through from the business to them personally.
Here is a very simple example for our discussion purposes.
Normally, an S corporation or partnership earns income and pays its expenses. Your ownership basis (in the partnership or the S corporation) typically includes the excess of that income over its expenses.
When a loan is made to an S corporation or partnership, it does not increase the owner’s basis. When the business uses the money to pay an expense, there is a deduction to the business, but that deduction may not pass through to the owners personally (if they lack sufficient basis in their stock or partnership interest).
So, folks, here’s the deal.
It is very important that you contact your tax adviser and ask whether you have sufficient basis for the deductions generated by the PPP loan to the business to pass through to you as an individual owner. If not, there are lots of things that can be done to make sure this occurs, but they must be done before the end of the entity’s year. Otherwise, the deduction can be lost in the year the expense was paid. Typically, it will carry over until you do have sufficient basis to use the deduction.
Again, there are several ways to fix this problem if you plan for them in advance of the business entity’s year end.