The Coronavirus Aid, Relief, and Economic Security (CARES) Act was passed by Congress with overwhelming support and was signed into law by President Trump on March 27th, 2020. CARES was far-reaching and included substantial stimulus for businesses, particularly small businesses. In this post, we’ll look at some possible blending of stimulus opportunities for better tax and fiscal advantage.
Paycheck Protection Program (PPP). The PPP is a forgivable loan from the SBA to help businesses sustain payroll. In general, businesses with less than 500 employees could get a loan for 2.5 months of certain expenses. After several false starts and quite a few rule changes (43 at last count), and even a new statute (the PPPFA), the PPP was used by many businesses, including about 700,000 that received loans of $150,000 or more. The SBA published the list of loan recipients. Provided the borrower meets certain criteria on the use of the funds for qualifying expenses within a 24-week period, the loan is partially or fully forgiven.
Loan forgiveness is tax-free. However, the expenses associated with the forgiveness are not deductible pursuant to an IRS Notice 2020-32. As of mid-August 2020, there is movement in DC for prospective legislation to remedy that. To some, it appears that the non-deductibility makes the PPP taxable. Here’s how it works: Dr. Garcia get a PPP loan for $100,000 and uses it to pay payroll and other qualifying expenses of $100,000, resulting in full forgiveness. If she has no other income, she receives $100,000 tax-free and pays $100,000 of nondeductible expenses. Net result = zero. However, if she has any other income, the PPP is additive. So, if her practice makes $40,000 during the forgiveness period, she’d have $40,000 of taxable income, $100,000 of tax-free forgiveness, and $100,000 or nondeductible expenses. She’s still up $40,000, versus being down $60,000.
An interesting question arises when a fiscal-year taxpayer has a PPP loan. If Dr. Garcia has an August year-end, then she paid the expenses before the loan was forgiven. Presuming she is a cash-basis taxpayer, she’d have expenses that would theoretically be deductible in her fiscal year. In the year of forgiveness, she’d have forgiveness income, which is statutorily tax-free. I talked to Sarah Daya of the IRS Office of Associate Chief Counsel (and a co-author of the Notice). Ms. Daya indicated, “If the taxpayer has a reasonable expectation that the loan would be forgiven, then we (the Service) suggest they not deduct it in the fiscal year. If the loan proceeds subsequently become not fully forgiven, the taxpayer can deduct the unforgiven portion the next fiscal year.”
PPP and NOL combo. An interesting interface is the PPP and Net Operating Loss (NOL) rules. The Tax Cuts and Jobs Act (TCJA) eliminated NOL carry-back and limited the carry-forward to effectively 80% of the NOL. The CARES Act eliminated that restriction until the end of 2020, effectively creating a ‘hidden stimulus’ in the form of a five-year carryback. The NOL offers a potential arbitrage opportunity, when the 2015-17 tax rates are higher than 2020. For example, the highest marginal individual rate in 2015-2017 was 39.6%, versus 37% for 2020. The maximum corporate income tax rate was 35% in 2015-17, versus 21% in 2020.
The application might look something like this: a businessowner who had high income in 2015-17 can use a loss in 2020 to get an immediate income tax refund. If Jim is a dentist and received a $150,000 PPP loan, and used it for expenses, but didn’t have an offsetting loss of total revenue, he’d have a $150,000 tax-free infusion of cash. If he used that to purchase equipment for the dental practice, he could prospectively write those purchases off under the bonus deprecation rules. If this created a loss, he could carry it back 5 years and get an immediate refund.
Qualified Improvement Property (QIP). Alternatively, if Jim the dentist owned the building that houses his practice, he might take advantage of another CARES Act correction on Qualified Improvement Property (QIP). QIP was conspicuously missing from the TCJA but allows a real estate owner to deduct certain improvements, like interior construction or alarm systems. The QIP is eligible for bonus deprecation. A normal method of maximizing the QIP deduction is a cost segregation study. In this scenario, a professional engineer sorts out the QIP property from the actual structure, and the QIP is used to maximize the deduction.
Qualified Business Income (QBI) and PPP. Another interface presented by the CARES Act is with the QBI deduction, or the 20% pass-through deduction. There is a taxable income limitation for pass-through owners in a Specified Service Trade or Business (SSTB). SSTBs include most professionals who have a service business, like lawyers, doctors, CPAs, veterinarians, among others. For a married couple filing jointly, the SSTB taxable income limit for 2020 is $326,600. PPP is not included in taxable income, and bonus depreciation, qualified plans and charitable contributions can modify taxable income.
So, if Dr. Garcia and her husband made less than $326,600 in taxable income and all the income was pass-through income from the practice, they could deduct 20% of the pass-through income. The PPP forgiveness would not be included in taxable income. Dr. Garcia could actually benefit by potentially increasing her income up to the $326,600 threshold. If they made $300,000 for example and were making a pre-tax 401(k) contribution, they would benefit by switching their pre-tax contribution to an after-tax Roth contribution. Increasing income by $26,000 increases the QBI deduction by $5,200. This is a deduction versus a deferral situation. They pay effectively 19.2% tax on the income, plus build Roth tax-free assets.
Bottom Line: 2020 is a massive year for tax planning. Business owners need to look at options: What to do with the PPP? How do NOLs come into the fray? Is QIP useful? Can the PPP or other techniques maximize the QBI deduction? Tom Beard, CPA and partner at Cohen & Company in St Clair Shores, MI, observes: “We could have a client with a medical practice who might have a forgivable PPP loan, generate an NOL, and carry it back for a quick refund of prior taxes. Similarly, we could see how the reduction in activity in 2020 could be beneficial for owners of certain kinds of pass-through entities.” There are a lot of three-letter acronyms to involved, but the opportunities seem worth it. Get a sharp pencil (or a fast spreadsheet). Stay tuned for the possibility of another stimulus. I’m open for questions. My email is [email protected]