CWG Publication: How to know if you have to pay taxes on your PPP loans

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Tax deadlines can be confusing and vary by business classification. 

S-corps, multiple-member LLCs, and pass-through entities should have filed 2020 tax returns by April 15. But if you file your business taxes as part of your personal return, you may have until May 17 to file. 

One thing that many small businesses in the US have in common this year is that those who received funding through the Small Business Association's Paycheck Protection Program (PPP) or other grant and loan programs intended to help businesses stay afloat during COVID-19 may be in for a stunning state tax bill just as they're getting back on their feet. That's because some states have decided to depart from the federal government's decision to forego taxing forgiven PPP funds. 

How to know if you're going to owe your state tax money on PPP loans

11 states listed by the Tax Foundation, including California, Florida, Hawaii, Minnesota, Nevada, New Hampshire, North Carolina, Texas, Utah, Vermont, and Virginia, tax forgiven PPP funds.

In Ohio and Washington, they're mostly not taxable due to the way the states' tax policies are set up. However, even that's not final: In some of these states, legislation to make changes to this situation is currently on the table. 

The North Carolina House, for example, has already approved a bill to align the state's tax code regarding forgiven PPP funds with that on federal tax forgiveness. The bill is now sitting in the state Senate, and once passed, will go to the governor to be signed into law. Companies operating in North Carolina that have forgiven funds on their books will either need to file an extension to wait for the bill to be ratified, or if they've already filed and have forgiven funds on their books, file an amended return to take advantage of the change — assuming it goes through.

Eileen Sherr, director for tax policy and advocacy at the Association of International Certified Professional Accountants, told Insider that businesses with forgiven PPP funds that have any doubt about their states' standing should file for an extension if possible.

If you're wondering how these taxation policies impact Economic Impact Disaster Loans (EIDL) funding, Nick Kolbenschlag, CEO of Charlotte, NC's Crown Wealth Group, told Insider that these funds are taxable just like forgiven PPP loan funds in the states listed above. He also said that funds received via state, local, or privately-funded grants are taxable on both the federal and local level.

"Because these funds weren't related to the CARES Act or any of the federally-passed laws that came behind it, they're considered free money and that's taxable," he said. "It has the potential to be a mess, especially if you're a very small business."

While this is the most impactful area in which the states' governments have failed to adhere to federal regulations across the board, there are other, smaller schisms as well.

"In December, the federal government enacted that loan expenses would be deductible, and there have been some guidance issues from the states as to whether they're going to follow that as well," Sherr said.

Ensuring that you file correctly is a matter of properly classifying your funds

In accounting, PPP loans are treated like conventional loans – until they're forgiven.

When a business gets a conventional loan, it's applied to the liability side of the business's balance sheet. When the loan is paid, the business can take the interest as a deduction, and it comes off of the business's balance sheet. If a conventional loan is forgiven, it's considered cancellation of debt income and should be recorded as "other income" on your profit-and-loss statement, Kolbenschlag said. 

PPP loans are tracked on the liability side of the balance sheet, and when they're forgiven, most accounting systems are triggered to convert the funds to income — but that's incorrect. 

"When a PPP loan is forgiven, it's a different situation," Kolbenschlag told Insider. "It would be considered taxable income in the normal world and is taxed as profit. But when the bookkeeper or the CPA follows that path, QuickBooks puts it into an income account and says it's taxable income. PPP loans need to be separated out manually so that profit figures aren't inflated and these businesses don't end up looking at unreasonable tax bills."

Kolbenschlag suggested businesses rename the income account where the PPP funds reside "Forgiven Debt Income," and indicate specifically that those are non-taxable PPP funds to make sure the accountant preparing the return understands exactly what those monies are and knows that they're not taxable. 

While Kolbenschlag's firm doesn't prepare his clients' tax returns, he's done a fair amount of consulting to ensure that the business owners with whom he works don't come back with "sticker shock" when they see the amount they owe. He said he's seen PPP funds end up on the company's profit-and-loss sheet, which artificially inflates its income and thus its tax bill.

Then there's the matter of state taxation of forgiven funds being different from federal taxation that can have significant repercussions. 

"This has the potential to be a big mess, especially if you don't have anyone explaining it to you," Kolbenschlag said. "I have a client that between all of their businesses, they had about $1.3 million worth of PPP loans — that's a huge amount of state tax coming out that they may not have been prepared for if we hadn't already had that conversation about it."

Kolbenschlag, who has been working with businesses throughout the entire PPP process, also emphasized the importance of having all your backup documentation — for both the loan process and the forgiveness process — organized and at the ready, just in case it's needed.

The potential of being called on to present this documentation is very remote, he said, but should you be asked to "show your work," you don't want to be scrambling for it when the IRS comes to call. Integrated, cloud-based accounting and payroll-software packages make it easy for even the smallest businesses to print out reports on demand and keep up with financials on an ongoing basis, Kolbenschlag added.  

What to do if you think you've filed incorrectly or your state's laws change

Kolbenschlag first advised business owners to invest in expert help.

"This year, more than any year, it's very prudent if you're a small business owner to have a good CPA handling your taxes that understands how all of these things play together," he said. That could make the difference between a smooth experience that ends in a smaller bill and a rocky experience that wastes both time and money.  

"Keep in mind that you can always amend your return," Sherr added, if you file now and additional guidances from either the states or the IRS come out later.

For other businesses who received funding through the later rounds, this issue may not affect the taxes they file this year.

"This may not end up being a 2020 tax problem for many businesses — it may end up being a 2021 tax problem for people," Kolbenschlag said. "Potentially by the spring of 2022 when you go to file your taxes, your business will be in a better shape by then (to absorb any applicable state tax bills) or legislation will have changed in your favor." 

Sherr also advocated for businesses to carefully maintain their backup data documenting how PPP funds were spent and to be ready not only in the event of a change in laws but also in the event of an audit.