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Over the last year, law firms of all sizes, from the largest in the world to small and midsize firms, have pursued funding from multiple rounds of the Payment Protection Program (PPP). For some, the PPP loans they received were insurance for rough patches that never materialized. For others, their loans staved off layoffs and may have even prevented them from going out of business.
But as we approach the first tax season since the U.S. Small Business Administration established the PPP and began disbursing loans through it, law firms must now come to grips with the tax implications of receiving those loans and taking advantage of other COVID-19-related assistance. Here are five things law firm owners need to know about the tax implications of PPP loans.
Typically, when taxpayers borrow money from commercial lenders only to have a lender cancel or forgive that debt, the amount of that debt is taxable income to the borrower and should be reported on their tax return. When PPP loans were first disbursed in 2020, there was some concern by recipients that if the loans were to be forgiven, they would face a significant taxable event. Since some law firms took out loans that represented as much as 7% of their 2019 gross revenues, those concerns had merit.
However, when former President Donald J. Trump signed the Coronavirus Response and Relief Supplemental Appropriation Act (CRRSAA) into law on December 27, 2020, those concerns vanished. In Sections 276 and 278 of the CRRSAA, which are part of the COVID-related Tax Relief Act of 2020 included in the bill, Congress made clear that the amounts of forgiven PPP loans should not be included in recipients’ gross incomes.
PPP loans are forgivable when used to pay certain business costs as authorized by the federal government. In the Spring 2020 batch of PPP loans, if recipients wanted their loans forgiven, they could only have spent the proceeds on payroll, interest, utilities, and rent. With the CRRSAA, the universe of authorized costs expanded to include certain business software, property damage, supplier costs, and worker protection expenditures such as the cost of personal protective equipment or modifying or building a structure to allow for the safe operation of a business in compliance with federal, state, or local COVID-19 regulations.
Notably absent from those covered costs are business taxes. Law firms that use PPP loan proceeds to pay their business taxes will be unable to claim loan forgiveness for those amounts.
The CRRSAA and COVID-related Tax Relief Act of 2020 alleviated another set of PPP-related concerns by allowing the business expenses paid with forgiven PPP loan proceeds to be deductible on federal tax returns. This reversed the federal government’s position on the issue dating back to when the Coronavirus Aid, Relief, and Economic Security (CARES) Act became law in March 2020.
The IRS made clear in guidance issued in April 2020 and in November 2020 that such expenses were not deductible. It relied on Section 265 of the Internal Revenue Code in suppo at because businesses would not be taxed on the proceeds of a forgiven PPP loan—a class of tax-exempt income—the expenses paid with those proceeds are not deductible. In May 2020, then-Treasury Secretary Steven Mnuchin explained that businesses receiving forgiven PPP loans could not “double dip,” stating, “You can't say you're going to get deductions for workers that you didn't pay for."
Given the large percentage of law firms’ and other businesses’ revenues that authorized PPP expenses comprise (notably payroll and rent), it is no wonder that owners of law firms and other small businesses likely lost some sleep wondering if they would be able to deduct those expenses from their 2020 federal taxes. Hearing these concerns raised by small business owners, the SBA’s Office of Advocacy wrote to the U.S. House of Representatives’ and Senate Small Business Committees in December 2020 asking for a legislative fix. That fix was delivered in the CRRSAA to the relief of many owners of law firms and other small businesses.
The CRRSAA extended and modified the Employee Retention Tax Credit established by the CARES Act. To encourage businesses to keep employees on their payrolls as the COVID-19 pandemic was beginning to take a toll on their operations, Congress established the ERTC, a refundable tax credit. When first established, it was equal to 50% of $10,000 in qualified wages paid by an eligible employer to each of its employees between March 12, 2020, and January 1, 2021, whose business was financially impacted by COVID-19.
The CRRSAA tweaked the ERTC in several ways. First, the period covered by the ERTC has been expanded to cover the six months from January 1, 2021, through June 30, 2021. Second, eligible employers may claim the tax credit equal to 70% of $10,000 per employee per calendar quarter through June 30, 2021. As a result, eligible employers can now claim a maximum credit of $14,000 per employee in 2021 compared to $5,000 in 2020.
To qualify for the ERTC in 2021, employers must have experienced “full or partial suspension of the operation of their trade or business” because of “governmental orders limiting commerce, travel or group meetings due to COVID-19,” or a decline in gross receipts in a calendar quarter in 2021 to less than 80% of the gross receipts in the same calendar quarter in 2019.
Notably, the CRRSAA further tweaked qualifications for the ERTC so that employers who received PPP loans can claim the tax credit for qualified wages that were not paid for by PPP loan proceeds.
While the IRS has spoken on the pressing federal tax issues related to PPP loans, some state tax authorities disagree with the IRS and have taken contrary positions. For example, some states may treat forgiven PPP loan proceeds as taxable, deny a law firm’s attempt to deduct the business expenses it paid for with forgiven loan proceeds, or both. This could pose problems for law firms that used their PPP funds in ways that maximized their tax efficiency under the IRS’s treatment of those uses but did not consider the potential state tax implications of doing so.
According to the Tax Foundation, more than 30 states, including Colorado, Delaware, Illinois, New Jersey, New York, and Pennsylvania will not tax forgiven PPP loan proceeds. Some states, like Arizona, Florida, Utah, and Virginia, will consider forgiven PPP loan proceeds to be taxable income but will allow the deduction of business expenses paid for with those proceeds. Other states, like California, Kentucky, Hawaii, and North Carolina will exclude forgiven PPP loan proceeds from taxable income but will disallow deductions for business expenses paid for with those proceeds.
The CARES Act and the CRRSAA threw several lifelines to law firms and other small businesses struggling with the financial damage caused by the pandemic. As the 2021 tax season rolls around, law firms should seek counsel from their accountants or tax planning professionals to determine how those lifelines will impact their 2020 taxes. Law firms should also discuss with their accountants what they can do in 2021 to take advantage of those lifelines so that they are well-positioned when the 2022 tax season rolls around.