Tax

Tax

Q&A: Are PPP Loan Forgiveness Expenses Deductible?

Q&A: Are PPP Loan Forgiveness Expenses Deductible?

Question

If I obtain Paycheck Protection Program (PPP) loan forgiveness, can I still deduct the business expenses I paid with the loan forgiveness proceeds?

Answer

We have bad news—the IRS just released Notice 2020-32 telling us the answer is no. Quick

Review

As we discuss in COVID-19: New SBA Loans for Small Businesses – Maybe a Great Deal:

  • Your maximum PPP loan amount is 250 percent of your average monthly payroll expenses, up to $10 million.
  • PPP loan amounts used for payroll, mortgage interest, rent, and utility payments during the eight-week period starting with the loan origination date will be forgiven and excluded from your taxable income.

IRS Position

The IRS says the payments you make during that eight-week period to get the non-taxable loan forgiveness are non-deductible up to the aggregate amount forgiven, for two reasons:

  1. The payments are allocable to tax-exempt income, making them non-deductible.
  2. Deductions for otherwise deductible payments are non-deductible if you receive a reimbursement for those payments.

Neither the CARES Act nor the Joint Committee on Taxation’s explanation of the CARES Act addresses the deductibility issue.

Takeaways

The IRS says you can’t take a tax deduction for the business expenses you used to qualify for PPP loan forgiveness.

The key benefit of the PPP loan is that you can have the loan forgiven—essentially putting free cash in your pocket.

Your inability to deduct the expenses that created that non-taxable loan forgiveness takes away some cash due to loss of tax deductions, but you are still well ahead with the PPP loan from a cash-in-hand perspective.

This IRS position generates at least one question we’ll need to answer in the coming weeks or months: does this affect the wage amount you use to calculate your Section 199A deduction if you are over the Section 199A taxable income threshold?

Tax

COVID-19 Crisis Creates Silver Lining for Roth IRA Conversions

COVID-19 Crisis Creates Silver Lining for Roth IRA Conversions

For years, financial and tax advisors have lectured about the wonderfulness of Roth IRAs and why you should convert traditional IRAs into Roth accounts.

But, of course, you didn’t get around to it. In hindsight, maybe that was a good thing.

For many, the financial fallout from the COVID-19 crisis creates a once-in-a-lifetime opportunity to do Roth conversions at an affordable tax cost and also gain insurance against future tax rate increases.

Roth IRAs Have Two Big Tax Advantages

Let’s quickly review them.

Tax-Free Withdrawals

Unlike withdrawals from a traditional IRA, qualified Roth IRA withdrawals are federal-income-tax-free and usually state-income-tax-free, too.

What is a qualified withdrawal? In general, the tax-free qualified withdrawal is one taken after you meet both of the following requirements:

  1. 1. You had at least one Roth IRA open for over five years.
  2. 2. You reached age 59½, became disabled, or died.

To meet the five-year requirement, start the clock ticking on the first day of the tax year for which you make your initial contribution to any Roth account. That initial contribution can be a regular annual contribution, or it can be a contribution from converting a traditional IRA into a Roth account.

Example: Five-Year Rule.

You opened your first Roth IRA by making a regular annual contribution on April 15, 2017, for your 2016 tax year. The five-year clock started ticking on January 1, 2016 (the first day of your 2016 tax year), even though you did not actually make your initial Roth contribution until April 15, 2017.

You meet the five-year requirement on January 1, 2021. From that date forward, as long as you are age 59½ or older on the withdrawal date, you can take federal-income-tax-free Roth IRA withdrawals—including withdrawals from a new Roth IRA established with a 2020 conversion of a traditional IRA.

Exemption from RMD Rules

Unlike with the traditional IRA, you as the original owner of the Roth account don’t have to take annual required minimum distributions (RMDs) from the Roth account after reaching age 72. That’s good, because RMDs taken from a traditional IRA are taxable.

Under those rules, if your surviving spouse is the sole account beneficiary of your Roth IRA, he or she can treat the inherited account as his or her own Roth IRA. That means your surviving spouse can leave the account untouched for as long as he or she lives.

If a non-spouse beneficiary inherits your Roth IRA, he or she can leave it untouched for at least 10 years. As long as an inherited Roth account is kept open, it can keep earning tax-free income and gains. Nice!

Silver Lining for Roth Conversions

A Roth conversion is treated as a taxable distribution from your traditional IRA, because you’re deemed to receive a payout from the traditional account with the money then going into the new Roth account.

So, doing a conversion will trigger a bigger federal income tax bill for the conversion year, and maybe a bigger state income tax bill, too. That said, right now might be the best time ever to convert a traditional IRA into a Roth IRA. Here are three reasons why.

1. Current tax rates are low thanks to the TCJA.

Today’s federal income tax rates might be the lowest you’ll see for the rest of your life.

Thanks to the Tax Cuts and Jobs Act (TCJA), rates for 2018-2025 were reduced. The top rate was reduced from 39.6 percent in 2017 to 37 percent for 2018-2025.

But the rates that were in effect before the TCJA are scheduled to come back into play for 2026 and beyond.

And rates could get jacked up much sooner than 2026, depending on politics and the need to recover some of the trillions of dollars the federal government is dishing out in response to the COVID-19 pandemic.

Believing that rates will only go back to the 2017 levels in the aftermath of the COVID-19 mess might be way too optimistic.

2. Your tax rate this year might be lower due to your COVID-19 fallout.

You won’t be alone if your 2020 income takes a hit from the COVID-19 crisis.

If that happens, your marginal federal income tax rate for this year might be lower than what you expected just a short time ago—maybe way lower. A lower marginal rate translates into a lower tax bill if you convert your traditional IRA into a Roth account this year.

But watch out if you convert a traditional IRA with a large balance—say, several hundred thousand dollars or more. Such a conversion would trigger lots of extra taxable income, and you could wind up paying federal income tax at rates of 32, 35, and 37 percent on a big chunk of that extra income.

3. A lower IRA balance due to the stock market decline means a lower conversion tax bill.

Just a short time ago, the U.S. stock market averages were at all-time highs.

Then the COVID-19 crisis happened, and the averages dropped big-time.

Depending on how the money in your traditional IRA was invested, your account might have taken a substantial hit. Nobody likes seeing their IRA balance go south, but a lower balance means a lower tax bill when (if) you convert your traditional IRA into a Roth account.

When the investments in your Roth account recover, you can eventually withdraw the increased account value in the form of federal-income-tax-free qualified Roth IRA withdrawals. If you leave your Roth IRA to your heirs, they can do the same thing.

In contrast, if you keep your account in traditional IRA status, any account value recovery and increase will be treated as high-taxed ordinary income when it is eventually withdrawn.

As mentioned earlier, the current maximum federal income tax rate is “only” 37 percent. What will it be five years from now? 39.6 percent? 45 percent? 50 percent? 55 percent? Nobody knows, but we would bet it won’t be lower than 37 percent.      

The Bottom Line

If you do a Roth conversion this year, you will be taxed at today’s “low” rates on the extra income triggered by the conversion.

On the (far bigger) upside, you avoid the potential for higher future tax rates (maybe much higher) on all the post-conversion recovery and future income and gains that will accumulate in your new Roth account.

That’s because qualified Roth withdrawals taken after age 59½ are totally federal-income-tax-free, as long as you’ve had at least one Roth account open for more than five years when withdrawals are taken.

If you leave your Roth IRA to an heir, he or she can take tax-free qualified withdrawals from the inherited account—as long as at least one of your Roth IRAs has been open for more than five years when withdrawals are taken.

If you want my help thinking this through or executing on the Roth conversion, I’m here to help. Call me on my direct line at 408-778-9651.

Sincerely,

The Financial Dream Team, USA

Tax

COVID-19: Tax Benefits for S Corporation Owners

COVID-19: Tax Benefits for S Corporation Owners

To help your small business, Congress created a lot of new tax-saving provisions due to the COVID-19 pandemic.

Many of you own and operate S corporations and expect the tax law to treat you differently, as it does with your health insurance deduction.

You’ve been asking us to help clarify which of the COVID-19 tax benefits the S corporation owner can use to put cash in his or her pocket.

We’ll go over the most important COVID-19 tax provisions and tell you what we know about how they apply to you.

Payroll Tax Deferral

You can defer payment of your S corporation’s employer share of Social Security tax on federal tax deposits you would otherwise have to make during the period beginning on March 27, 2020, and ending

Your S corporation’s deferred Social Security taxes are due in two installments. You must pay 50 percent

If you are an S corporation owner, the S corporation can defer the employer portion of Social Security tax on your salary just as it can on any other employee.

PPP Exception

If your S corporation receives a Paycheck Protection Program (PPP) loan, and it obtains loan forgiveness, it does not qualify for the payroll tax deferral provision.

PPP exception loophole. The PPP loan forgiveness prohibition doesn’t apply until your S corporation receives a decision from your lender on PPP loan forgiveness. Before that date, you can defer payroll

Example 1. You operate as an S corporation and have three employees, including yourself. Your S corporation’s April payroll is $10,000, including your W-2 salary or wages.

The employer Social Security tax on this payroll is $620. Your S corporation doesn’t have to pay it with its federal tax deposit. Instead, it will pay $310 by December 31, 2021, and the other $310 by December 31, 2022.

Employee Retention Credit

Your S corporation gets a refundable payroll tax credit against the employer share of employment taxes

We review the rules for this tax credit in COVID-19: Significant Payroll and Self-Employment Tax Relief.

But the law also states that “rules similar to the rules of sections 51(i)(1) and 280C(a) . . . shall apply.”

Code Section 280C(a) states you can’t deduct wage expenses equal to the employee retention credit you receive—no double dipping.

Code Section 51(i)(1) affects the S corporation shareholder by denying the employee retention credit for wages paid to the following family members of a 50-percent-or-more shareholder:

  • A child or a descendant of a child
  • A brother, sister, stepbrother, or stepsister
  • The father or mother, or an ancestor of either
  • A stepfather or stepmother
  • A son or daughter of a brother or sister of the taxpayer
  • A brother or sister of the father or mother of the taxpayer
  • A son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law

The provision does not prevent the S corporation owner from taking the employee retention credit on his or her wages, provided that the S corporation otherwise meets one of the following requirements:

  • A government order fully or partially suspended your operations during a calendar quarter due to COVID-19.
  • Your calendar-quarter gross receipts are less than 50 percent of gross receipts from the same quarter in the prior year.

PPP Exception. If you receive a PPP loan, then you don’t qualify for the employee retention credit.

Example 2. ABC Corporation is an S corporation with four equal owners who each own 25 percent. It has eight employees: the four owners and four children of the owners. A government order partially suspended the business operations. Because no shareholder has 50 percent or more ownership, the wages of all eight employees qualify for the employee retention credit.

Example 3. DEF Corporation is an S corporation that is 100 percent owned by a married couple. It has four employees: the two owners and two children of the owners. A government order partially suspended the business operations. Only the wages of the two owners qualify for the employee retention credit.

Tax-Free Disaster Payments

As we discussed in Tax Loophole Allows Tax-Free COVID-19 Payments to Employees, Congress allows your S corporation to make tax-deductible disaster-related payments to its employees, and those payments are tax-free to its employees.

But as you likely know, S corporation owners usually can’t take advantage of tax-free fringe benefits, and usually have to include their value as taxable income on their W-2. Be sure to read S Corporation Fringe Benefits after the Recent Tax Return to learn all the details.

We have good news about disaster-related payments: none of the guidance issued about these payments denies their favorable tax treatment to the S corporation shareholder. In addition, the IRS doesn’t mention such payments in Publication 15-B, Employer’s Tax Guide to Fringe Benefits.

But we have some bad news, too—there is no guidance explicitly allowing the S corporation owner to take advantage of the tax-free disaster-related payments.

If you choose to have your S corporation provide tax-free disaster-related payments to you, we recommend you implement a formal, written plan and keep excellent documentation—even though such steps are not required by the law.

Example 4. Your S corporation sets up a plan to give every employee a $500 payment to cover telework supplies and ongoing expenses during the COVID-19 pandemic. Your business is subject to a shutdown order, and all 12 of your employees, including you, must work remotely from home.

The $6,000 in payments your S corporation provides is tax-deductible to the corporation and tax-free to the employees, including the S corporation shareholder.

Takeaways

Many small-business owners, like you, operate out of an S corporation. And as you know, the tax law sometimes isn’t kind to S corporation owners, because the law limits or eliminates tax breaks other business owners can take.

Luckily for you, S corporation owners get to benefit from most of the big COVID-19 tax benefits, including:

  • Payroll tax deferral
  • Employee retention credit
  • Tax-free disaster-related payments

If you need help with any of the COVID-19 tax laws, please call me on my direct line at 408-778-9651.

Sincerely,

The Financial Dream Team, USA

 

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