As we close in on year-end, questions still remain about how and when PPP loans will be eligible for forgiveness. As rules change and guidelines evolve, we want to help our business clients puzzle-out how to account for their PPP loan funds, keep them informed on how those funds will affect their Federal tax picture, and guide them through continued uncertainty. Together, we will roll into 2021 prepared for whatever comes along!
-Your Accountability Services Team
How PPP Forgiveness Could Impact Taxes and Financial Reporting
Paycheck Protection Program (PPP) loan forgiveness and its tax and financial reporting implications are steeped in uncertainty and subject to change. The key challenges are the timing of income recognition and deductibility of expenses, among other tax and reporting questions.
Complexity With Timing – What, How and When?
It’s possible you won’t know if your loan is forgiven and by how much until 2021, which will have implications on your tax planning and financial reporting. Here’s what we know about the timeline to apply for forgiveness:
Forgiveness Application Timeline:
Companies can choose a covered period of 8 or 24 weeks or a cutoff date between that range. Each has its own financial implications to consider.
From the end of their chosen covered period, borrowers have 10 months to apply for forgiveness. Once the application is received by the lender, the lender has 60 days to render a forgiveness decision and request payment from the Small Business Association (SBA).
From that point, the SBA has 90 days to remit payment of the forgiveness amount and interest through the payment date back to the lender. It’s then the lender’s responsibility to notify the applicant of the forgiveness amount received from the SBA. If the forgiveness application is denied by the lender, the borrower has 30 days to notify the lender that they request a review by the SBA, which the SBA isn’t required to accept.
2020 vs 2021:
With this timeline, it could be well into 2021 until a borrower knows how much of their loan is forgiven. The question is whether the forgiveness of the loan increases taxable income in 2020 when the proceeds are received and expenses are incurred, or in 2021 when the borrower receives confirmation their loan is forgiven. There’s also a question of whether the ultimate tax treatment of these income and expense items will match your generally accepted accounting principles (GAAP) financial statements or not.
Taxable or Not? What We Know About The Tax Implications
For federal purposes, PPP loan forgiveness may be excluded from gross income by an eligible recipient by the Coronavirus Aid, Relief, and Economic Security (CARES) Act.
However, the IRS issued Notice 2020-32 in April 2020 that stated expenses associated with the tax-free income are nondeductible. This guidance was consistent with historic IRS guidance regarding nontaxable income and related expenses but has the net effect of essentially reversing the tax-free benefit of the exclusion on the loan forgiveness.
While the IRS guidance doesn’t appear to align with Congress’s expressed intention, there hasn’t yet been a law to rectify it despite discussion in Congress about fixing it.
What do these words mean? If the loan is not taxable as income, and the expenses aren’t deductible, the two will cancel each other out. The problem now is around timing (especially with year-end only two months away).
In the company’s financial statements, your accountant will record the forgiven loan differently: as Cancellation of Debt Income, Extinguishment of Debt Income, or Other Income.
Taxability of Expenses:
Based on current guidance, we know that expenses associated with forgiveness are nondeductible. What isn’t clear is if they’re nondeductible for 2020 tax returns or not until 2021 when forgiveness is determined.
This leaves timing the most significant question mark.
Forgiveness in 2021:
As detailed above, most borrowers aren’t likely to see their final forgiveness notification until 2021. If you file your upcoming 2020 tax return before forgiveness is determined, should you deduct the expenses related to the use of the PPP funds? Or do you disallow the deduction, assuming the loan ultimately will be forgiven? If you deduct the expenses, what happens when the loan is forgiven?
At this point, these questions are still unanswered. Businesses should consider filing extensions for their upcoming 2020 tax returns to hold off on filing until forgiveness is determined or Congress potentially acts to address this issue.
It’s also important to note that, depending on the timeline of your application and other factors including your fiscal year-end, you may have to file a tax return before you know the ultimate forgiveness amount. In this case, there’s limited guidance available on the tax return reporting requirements.
Forgiveness in 2020:
If you’re able to apply and receive forgiveness in 2020, the answer on timing is simple. You have nontaxable income and nondeductible expenses in the same period for federal purposes based on current guidance.
Estimated Tax Payments:
All of the uncertainty impacts tax planning, particularly estimated tax and extension payments for 2020.
Due to business disruption related to the pandemic, many business owners have chosen to forgo protective estimated tax payments based on the safe harbor 110% of prior year tax. Instead, they are estimating their tax based on current year projected taxable income. If you do decide on the protective safe harbor approach, assess it from a cash-flow perspective to make sure it’s the right approach for you.
Election Impact:
Any election year creates uncertainty with tax planning.
If loan forgiveness produces taxable income through a reduction in deductible expenses, you’ll need to assess the year it’s taxable in and the respective tax rates, if different. Legislation that may provide the basis for determining answers to these questions may be delayed during an election period or during a change in administration. Filing an extension for 2020 may give you the opportunity to see the full impact of any planning.
Financial Reporting. How to Account for Your PPP Loan.
Although the legal form of the loan is debt, it’s possible in certain circumstances to account for your PPP loan as a government grant. There’s no guidance in existing US GAAP that specifically considers how to account for forgivable loans obtained from, or guaranteed by, a governmental entity.
Business entities will generally account for a PPP loan as either:
1. Debt. The loan proceeds are recorded as debt on the balance sheet. Any amount forgiven would be recognized in the income statement only when loan forgiveness is granted and approved by the SBA.
2. In-substance grant. If the loan is expected to be forgiven and specific conditions are met, the loan proceeds may be recorded as a deferred income liability on the balance sheet. Income would be recognized as you spend the money on eligible expenses.
There are significant hurdles, however, to be eligible to account for a PPP loan as an in-substance grant. There must be reasonable assurance that your loan will be forgiven and that you meet all requirements on the loan application, including proving the necessity for that loan. Consult with your accounting advisors and auditors before selecting this accounting treatment.
Depending on the accounting policy elected, your GAAP financial statements may or may not match your tax returns. You’ll be required to disclose the accounting policy for the loan and the related impact to the financial statements, regardless of the accounting treatment applied.
Bank Covenants:
How lenders view PPP loans may have a significant impact on financial covenants.
Accounting for a PPP loan as debt could impact your ability to meet certain covenants because the full amount of the PPP loan would be recognized as debt on the balance sheet and you won’t recognize the benefit of loan forgiveness income until the lender formally forgives the loan and the debt is extinguished.
On the other hand, if you meet the criteria to account for the loan as an in-substance grant, you may be able to recognize the income (or off-set to expense) from PPP loan forgiveness sooner, as the related expenses are incurred. Additionally, the portion of the proceeds that are spent on eligible expenses wouldn’t be presented as debt. This treatment may have a favorable impact on certain covenants.
It’s advisable to have a conversation with your bank about how you’re accounting for your PPP loan to better understand the ramifications of either approach. In most cases, companies received their PPP loan from their current lender.
Other Considerations. What’s Left?
There are two additional considerations to keep in mind:
1. Record keeping. It will be very important to keep records helping to prove to the SBA the necessity of your loan because the SBA has a five-year statute of limitations to reassess its forgiveness.
2. Up-to-date information. There’s a significant calculation that goes into applying for forgiveness. It’s important to keep up on the latest rules and regulation on the program to be sure you’re making decisions based on accurate data. Keep in mind, too, that the SBA will continue to release updates to its FAQs.
We’re Here to Help
For more information on your tax and financial reporting implications or if you have general PPP questions, please feel free to contact us.
We are a local accounting firm founded on old-fashioned values. We are motivated by entrepreneurial thinking, and — as our name says — are anchored by individual accountability. If you’re not in our area, we welcome you, too. In today’s world, postal code really doesn’t matter. Hundreds of growing businesses throughout the US and abroad have relied upon us for their accounting, tax, systems, and financial leadership.
Sincerely,
Elizabeth Mance
