How should PPP loan forgiveness and the related expenses be reported on IRS Form 1120-S? Some practitioners and tax software providers defaulted to including PPP loan forgiveness income in an S Corp’s Other Adjustments Account (OAA) while leaving the related expenses in its accumulated adjustments account (AAA).
This can create unintended tax consequences for S Corps with C Corp earnings and profits (E&P) and could result in additional tax to shareholders regarding S Corp distributions. But is this treatment correct?
No. On December 22, 2021, the IRS released draft instructions for Form 1120-S (annual S Corporation income tax return) stating that the OAA should include both the PPP tax-free income and the expenses giving rise to forgiveness. Taxpayers may want to review their prior year S Corp returns to ensure they did not unintentionally pay more in tax than is necessary.
Prior C Corps and E&P
E&P generated in a C Corp are subject to two levels of taxation, once at the Corporate level and a second time at the shareholder level when paid out as dividends. Even though S Corps do not generate E&P, E&P can exist in an S Corp if the S Corp used to be a C Corp. E&P in an S Corp is not a good thing because distributions out of E&P are subject to tax at the shareholder level, even if the shareholder has tax basis that otherwise would have made the distribution tax-free.
Profitable S Corps that were previously C Corps can kick the can down the road on the shareholder-level tax on dividends by distributing the profits generated by the newly-converted S Corp. If the S Corp keeps generating profits, shareholders can treat distributions as coming out of the AAA while leaving the E&P untouched (and untaxed).
This works because the S Corp provisions of the tax code treat distributions from an S Corp with E&P as made (or sourced) from the following items, in the following order:
- AAA;
- Previously taxed income (PTI);
- E&P; and
- OAA.
Distributions in excess of these items are non-taxable up to the amount of the shareholder’s stock basis (but not debt basis), and any excess distributions are taxed as capital gain.
So How Do These Provisions Interact with PPP Loan Forgiveness?
There would have been increased taxation on shareholders in S Corps with E&P if tax-free PPP loan forgiveness income were included in OAA, but the expenses were included in AAA. That is because the reduction in AAA would have caused distributions to come out of E&P before hitting the OAA, causing unnecessary tax on distributions to shareholder. But if the tax-free income and expenses both hit the OAA, then there would be additional AAA to make the distributions tax-free before having to dip into the E&P. This is what the new guidance allows.
Consider an S Corp with $3M in each of its AAA, PTI, E&P, and OAA accounts, and $10M of PPP loan forgiveness income. What if the S Corp wanted to distribute $5M to its sole shareholder? Under the new guidance, the $10M of PPP tax-free income and expenses both hit the OAA, and not the AAA. Thus, the $5M distribution would trigger no tax at the shareholder level because the distribution would be sourced from AAA ($3M) and PTI ($2M), and nothing would be sourced from E&P. If the PPP expenses reduced AAA, then the distribution would cause $2M of tax at the shareholder level because there would be no AAA to absorb the first $3M, i.e., the distribution would be sourced from PTI ($3M) and E&P ($2M).
This small fix by the IRS could save taxpayers tremendous amounts of tax by allowing them to kick the E&P can down the road. If an S Corp has already filed its 2020 income tax return, then it might need to amend its return to reflect the new guidance.
