The Paycheck Protection Program offers small businesses in America a means to keep their employees on the payroll during the COVID-19 crisis, when many are forced to close their shop doors or ride out periods of lower-than-normal revenue. The goal of the loan program, as implied by the name, is to keep as many Americans employed as possible while the country recovers from the crisis.
The hallmarks of the loan program are:
- It’s based on your average payroll expenses and is intended to cover eight weeks of payroll, plus a little extra. The actual math is 2.5 x Average Monthly Payroll.
- If you spend the funds in certain areas, including over 75% on payroll, the loan may be forgiven.
- Forgiven loans are tax-free.
As more businesses have received the loan and are tracking their expenses against it, the “tax-free” line has come into question. Many expected to pay no taxes on these funds, while also being able to take their regular deductions for things like payroll and rent, but new guidance from the IRS proved this assumption was incorrect.
Last week, Secretary Mnuchin spoke on the topic, saying, “The money coming in the PPP is not taxable. So if the money that’s coming is not taxable, you can’t double dip. You can’t say you’re going to get deductions for workers that you didn’t pay for.”
If you’re a small business owner trying to use these funds to stay afloat, you probably don’t want to get into the intricacies of tax law. So we’re breaking down what you need to know here.
The Expectation: What Does Tax-Free Really Mean?
Many business owners, tax professionals, and even lawmakers expected business owners to face no tax burden for these loans.
There are two opportunities for these funds to be taxed—one when the funds are handed over and another when businesses pay their estimated quarterly taxes.
- The bill made clear that the forgiven loan amounts would be treated more like a grant and would not be taxed at the time that forgiveness was granted.
- However, the IRS guidance does state that, later, when businesses are preparing to make quarterly or annual tax payments, they are not allowed to deduct payroll and rent expenses that were used to get loan forgiveness. By not being able to deduct those expenses from their business income, those businesses have a higher taxable income, meaning they’ll have a higher tax burden later.
When Secretary Mnuchin said, “You can’t double dip,” this is what he meant. In other words, you have to pay taxes on this money at some point. It just won’t be up-front when the funds are issued.
As we said before, many have taken issue with this stance, including lawmakers from both political parties.
Senator Chuck Grassley said, “I’m disappointed by the IRS’ determination that these business expenses are not deductible, especially since this issue was discussed during the development of the Paycheck Protection Program.”
He went on to say that the IRS’ guidance went against the intent of the Paycheck Protection Program.
The Reality: How to Think About Your Tax Burden
Whether or not this was the original intention of the lawmakers, until they say otherwise, the IRS will move forward with expecting that businesses do not deduct payroll and rent expenses that fall under PPP loan forgiveness.
This makes tracking your spending even more important. Proving how you spent the funds is the first step of securing loan forgiveness. But as we’ve talked about before, if you are applying for one of these loans, you’re certifying that without it you wouldn’t be able to keep your team employed. So we know that cash is probably tight.
Tracking your spending with an eagle’s eye will help make sure that you can cover the tax burden when the time comes.
Let’s Do Some Math
The average PPP loan is for a little more than $200,000. Again, this is meant to cover an eight-week period. If you’re a pass-through entity and you’re taxed at a rate of 30%, a loan of this amount would mean about $60,000 in taxes.
Normally, if you brought in $200,000 in revenue, you’d be able to deduct your expenses like payroll and rent. Let’s say those usually run you $150,000. In that case, your taxable revenue would drop to only $50,000. If you’re taxed at 30% of $50,000, you’d pay $15,000 in taxes.
The expectation was that you’d be able to deduct your payroll and rent expenses, therefore bringing down your taxable income. The reality, however, is that taking a PPP loan likely means a higher tax burden than if you’d brought in that same amount through revenue alone.
This means that, as you begin to allocate those funds, you need to keep a close eye on cash flow to ensure that you have enough cash to cover the taxes you’ll be on the hook for.
Let’s Do Some Bookkeeping
That’s all well and good, but how do I do that? Glad you asked.
If you’re able to, set up a new bank account to keep your PPP funds. It’s a similar concept as creating a personal budget by putting cash into separate envelopes. One for groceries, one for the phone bill, etc. The reason to do this is to make sure that you avoid dipping into your PPP funds accidentally for expenses that don’t qualify for loan forgiveness. The easiest and simplest way to do this is to keep the funds 100% separate.
That said, we realize that it’s not always easy or feasible to open up a new business bank account. It’s just not as simple as a personal checking account.
Whether or not you open a new bank account, you should track the spending in your accounting. The way to do this is through creating a new account in your chart of accounts. Like many things in accounting, the fact that bank accounts and charts of accounts both use the term “accounts” is confusing—but they mean two different things.
Unlike a bank account, which holds your money, an account in your chart of accounts is a classification tool. When you log into your accounting software and select from a drop-down of categories to classify a transaction, you’re logging that transaction in a certain account.
As you log these expenses, you’ll be able to estimate the taxes you’ll need to pay. The only way to estimate it is to have clean, well-categorized books.
Estimating your payments might be as simple as looking at last year’s tax returns and finding your tax bracket, or it could be more complex. If you worked with a tax accountant to prepare your returns, now would be a good time to reach out and ask for confirmation that you’re using the right rate to make these estimations.
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Where Does Payroll Tax Fit In?
There’s another kind of tax we haven’t talked about yet: payroll taxes.
Payroll tax is usually handled by your payroll provider, if you’re using a company like Gusto, ADP, or QuickBooks to run payroll. Payroll taxes are paid by two sources—the business and the employees themselves through withholdings. So on top of what you pay the IRS as the business owner, you’re also responsible for withholding the right amounts from your employees’ paychecks and paying their portion of the taxes on their behalf.
If you have received PPP funds, you are allowed to use the money for both the salaries of your employees and the employee taxes that you would normally withhold and send to the IRS. You can’t, however, use these funds to cover the business’ portion of the taxes that go toward things like FICA and Medicare.
A Quick, Simplified Example
Let’s say that you’re about to run payroll and one of your employees will get a check for $1,000. If you withhold $150 from their paycheck for taxes, they’ll receive $850.* You can use the PPP funds to cover the total $1,000 expense.
However, you cannot use the funds to cover your portion of the payroll taxes, which are based on gross payroll for all employees.
It’s worth noting that the CARES Act also allows for some businesses to defer some of their payroll tax payments until the end of 2021. If you have received a PPP loan, you won’t be eligible to request deferred payroll tax due dates. But if you have requested that deferment before applying to the loan, those later due dates won’t change back.
*This tax rate is made up for the purpose of this example.
Will These Rules Change…Again?
As we mentioned earlier, lawmakers like Senator Grassley felt that this guidance from the IRS betrayed the original intent of the law. And yet, the IRS and Secretary Mnuchin have held firm in their stance.
Lawmakers may decide to pass new legislation that would overrule the IRS’ guidance, but it’s unclear right now whether they will take those steps. We’ll keep a close eye on the situation and will update this blog post if/when that step is taken.
Information is flowing fast and changing rapidly. We’re doing our best to cut through the noise and get you the information you need to run your business. Check out our full resources page for additional content relating to COVID-19 here.