This article is part of a series on personal finance during the coronavirus pandemic. Please check out the Coronavirus and Your Finances Series (link will open in a new window).
[T]his will deliver urgently needed relief to our nation’s families, workers, and businesses.
–President Donald Trump on signing the CARES Act
Disclaimer #1: I am not a CPA. Please consult your tax advisor for tax advice.
Disclaimer #2: I did not stay at a Holiday Inn Express last night because we are sheltering in place.
When I owned my software company, we took our profits in two ways.
The first was a standard paycheck. Technically, these were distributions from the LLC, which are called guaranteed payments. We paid self-employment and payroll tax and received an IRS Form 1065. We were taxed at ordinary income rates for those payments.
The second, and generally larger checks were distributive payments. This would be when we felt like the business was going well and we had excess cash in the bank to pay ourselves. I’d lay out our financial position, our forecasted spending over the next few months, our pipeline, and then ask my 2 partners if we wanted to distribute $X. They never said no, so I’d cut the checks, and we’d all have nice dinners (or a nice prepayment of the mortgage) that weekend. We received an IRS Form K-1 for those payments, and we were taxed at capital gains rates for those payments.
Now that the Coronavirus Aid, Relief, and Economic Security (CARES) Act has passed, one piece of stimulus has started rolling in. The Paycheck Protection Program (PPP) is designed to provide potentially forgivable loans to businesses with 500 employees or less to cover payroll and employment tax costs, amongst other items.
If you are a small business owner who has historically taken your payments via distributive payments, you would not be eligible for the PPP loans because you have no payroll.
The pertinent text of the bill (Section 1102(D)(ii) to be precise) says:
“(ii) INCLUSION OF SOLE PROPRIETORS, INDEPENDENT CONTRACTORS, AND ELIGIBLE SELF-EMPLOYED INDIVIDUALS.—
“(I) IN GENERAL.—During the covered period, individuals who operate under a sole proprietorship or as an independent contractor and eligible self-employed individuals shall be eligible to receive a covered loan.
“(II) DOCUMENTATION.—An eligible self-employed individual, independent contractor, or sole proprietorship seeking a covered loan shall submit such documentation as is necessary to establish such individual as eligible, including payroll tax filings reported to the Internal Revenue Service, Forms 1099–MISC, and income and expenses from the sole proprietorship, as determined by the Administrator and the Secretary.
Note the key part: payroll tax filings. For self-employed people, e.g. those who have LLCs or S-corporations with passthrough tax treatment, you need to file a Form 1099-MISC and pay self-employment tax in order to qualify for the PPP.
So, for the lesser of the next 8 weeks or until June 30, 2020 (unless the CARES Act gets amended via future legislation), you want to convert your typical distributive payments to guaranteed payments so that you can qualify for the PPP.
Why?
Loan forgiveness. See Section 1106 of the CARES Act for more details.
You do want to make sure that your payments are the equivalent of market rate salary just so you don’t trigger eyebrow raises in the SBA and the IRS.
Hat tip to Janet Novack of Forbes and Martin Sullivan of the Washington Post for the discussion about this scenario.
Jason, just to be clear–be patient with this economist–you mean partners (general, without guaranteed payments) and Sub S shareholders maybe should start paying themselves wages (K1 income) during the covered [8-week] period?
Thanks much.
— Martin Sullivan (@M_SullivanTax) April 12, 2020
Thanks.
Max self pay during 8-weeks seems like a dollar-maximizing strategy to me.
(Would that not raise problems given determining an owner’s “reasonable” compensation is already a contentious issue?) (But I guess IRS is only programmed to challenge cuts in compensation.)
— Martin Sullivan (@M_SullivanTax) April 12, 2020
You also want to talk to a tax advisor before going full bore into this decision. See disclaimer #1.