PPP Loans and Basis Increases: When Does it Happen?

The latest stimulus bill gives businesses the ability to deduct expenses paid with forgiven PPP proceeds. This is good news, but is not what this post is about.

The stimulus bill says deductions are allowed and “no basis increase shall be denied.” It’s the “basis” piece I want to address here. This seems like an obscure topic but it is not.

In fact, even if you’re not a tax pro but instead are a business owner of an S-corp or a partnership, the subject of basis is something you need to know about.

Crash Course in Basis

Let’s say you start an S-corporation by putting $10,000 into it. Your initial basis in the business is $10,000. Let’s say the business has net income of $25,000 that year, which you are taxed on. Now your basis is $35,000.

You can draw up to $35,000 out of your business as a tax-free distribution.

If a business suffers a loss in a particular year, you can deduct the loss … if you have enough basis.

So let’s say you put $10,000 into your S-corp at startup, and it suffers a $9,000 loss in year 1. You can deduct all $9,000 of the loss, and your basis in the S-corp is now $1,000. What if your loss was $11,000? You could deduct $10,000 of the loss; the other $1,000 is suspended and carried forward to a future year.

Tax-Exempt Income

The PPP forgiveness is not taxable, thus making it tax-exempt income — see Section 276(a)(3)(A) of the stimulus bill. Basis increases in a partnership and S-corporation include tax-exempt income. So this means PPP forgiveness increases basis, even though the forgiveness isn’t taxable.

So with that crash-course, let’s look at the issue as it relates to the question of: when does the basis increase happen?

The Basis Problem

  • Let’s say an S-corp has a sole shareholder who always receives 100% of the profit as either salary or a distribution, so his stock basis at the start of 2020 is $0.
  • Let’s say the corporation has income of $100,000, the shareholder takes a salary of $50,000, and other expenses total $100,000, and $100,000 of expenses are covered by the PPP loan and so all forgiven. (This is a hypothetical so let’s roll with this example even though we can pick apart the details….)
  • So the business loss is $50,000.

If the loan isn’t forgiven until 2021 and the basis increase doesn’t happen til then, here is the problem.

  • $100,000 income in 2020 – $150,000 expenses in 2020 = $50,000 loss
  • Beginning basis = $0, and if basis isn’t increased by the amount of forgiven PPP loan in 2020, basis remains $0 and the $50,000 loss isn’t deductible at all in 2020 — the shareholder wouldn’t be able to take the loss until he or she gets a basis increase in 2021 when the loan is forgiven

But if we can count the forgiveness as tax-exempt income in 2020, then this is what happens:

  • $100,000 income + $100,000 tax-exempt PPP forgiveness = $200,000 – $150,000 expenses = $50,000 basis = the loss is deductible in 2020

The legislation doesn’t say “when” you count the forgiveness as tax-exempt income. So you’re taking deductions in 2020 for which there may not be basis. This is a big deal.

Partnerships

A lot of tax pros I talk to have said this is an S-corporation issue, not a partnership issue. Here’s why they say that: partners in a partnership get a basis increase for debts of the partnership. So the PPP loan in and of itself creates basis. Thus a lot of folks say the basis issue doesn’t exist for partners.

The way debt basis works is: paydown of the debt is treated as a distribution, which reduces basis. And so a lot of tax pros say: you increase basis when the PPP loan is received, then reduce basis (via a deemed distribution) when the PPP loan is forgiven, then you increase basis by the amount of the tax-exempt income.

All of this is true, but I say: not so fast.

In order to deduct losses, your basis must be “at risk.” This is more complicated than we can get into in this post but here’s a sentence or two about this: there are two types of basis — regular basis and at-risk basis. Regular basis allows distributions to be paid tax-free. But unless you have “at-risk” basis, you can’t deduct losses.

With debt in a partnership, there’s recourse debt and non-recourse debt. (And also “qualified non-recourse debt” but this post has gone on too long so let’s not talk about that.) Recourse debt increases both regular and at-risk basis. Non-recourse debt only increases regular basis but does not increase at-risk basis.

PPP loans are considered non-recourse, meaning the PPP loan itself does increase basis but not at-risk basis. This means that this discussion applies to partnerships too.

Conclusion

So to recap since we’re now over 750 words in: as it relates to PPP loans and basis — do you increase basis in 2020 when you take the deductions, or do you have to wait until the loan is forgiven in 2021? The answer is key if there are losses, or distributions where basis comes into play to determine taxability of the distribution. And we don’t know the answer.