Small businesses have felt the brunt of the COVID-19 pandemic, with thousands of enterprises forced to close since the beginning of March.
As if going under because of a pandemic isn't bad enough, some will face tax hits from their closures if they aren't careful. Moreover, some are left wondering what to do with their COVID-19 loans and grants. As a result, instead of being able to walk away after closing up shop, they're forced to navigate taxes and potential penalties.
"The last thing people think about when wrapping up a business is their tax obligations," Mike Slack, senior tax research analyst at H&R Block's The Tax Institute, told business.com. "They are running at a loss; they didn't generate any taxable income. But there are still a lot of tax implications."
Whether it's filing your business's final tax return or determining if you have to treat COVID-19 loans as income, there are several things small business owners have to consider when closing operations.
PPP loan proceeds may be taxable.
In the early days of the pandemic, the federal government released more than $2 trillion in aid under the CARES Act, with billions of dollars going to help small businesses stay afloat. Under the act's Paycheck Protection Program, small business owners received loans that were forgivable if they used the money to keep workers on the payroll.
Despite all these efforts, thousands of small businesses couldn't survive. Now they're left wondering if they have to pay taxes on the money they received or, worse, pay back the loans.
"As currently written in the CARES Act, PPP proceeds are not taxable, but the IRS made a determination in notice 2020-32 that indeed it is taxable in a back-ended way," said Mark Alaimo, who sits on the American Institute of Certified Public Accountants' (AICPA) Personal Financial Specialist Committee.
Under this IRS rule, PPP borrowers can't deduct the expenses they incur to qualify for loan forgiveness. It throws murkiness into the mix and is a rule the AICPA is squarely against.
"That means if you have a $200,000 loss and if you received a $250,000 loan, you may have $50,000 worth of income," Alaimo said. "The easiest thing people can do is assume all PPP proceeds are taxable income even if it's been forgiven."
According to Alaimo, most states have already indicated that they will tax any forgiven PPP loans just as they would tax any other forgiven debt. However, if your business loan wasn't forgiven before you shut down operations, you may have to pay it back – plus taxes – unless you file for bankruptcy.
Forgiveness of debt can be a taxable event.
If you're writing off debt as part of your business shutdown, it could trigger a taxable event. Like PPP loans, any reduction in debt you negotiate as part of your closing may be subject to tax. Let's say you owe $100,000 to a creditor and they forgive you that debt: That $100,000 is treated as taxable income, according to John Smallwood, president of Smallwood Wealth Management.
Keep the IRS in the loop.
To avoid tax penalties, you have to make your business closure official. To do that, you must file your final tax return with the IRS. Whether you operate a partnership, C corporation, S corporation or sole proprietorship, the IRS needs to know your business is closed.
"The final tax return is due within three to four months after the business date it closed," said Slack said. "People get in trouble with that. Late filings are subject to penalties."
When filing your final taxes, Slack said, be mindful of how you account for proceeds from the sale of business assets. "When you sell assets, you are still supposed to report them as a disposition on your tax return. There's a lot of nuances to it."
"A lot of nuances" is particularly true during the COVID-19 pandemic, as business owners navigate forced closures and social distancing rules. Some run into tax trouble, despite states' assurances.
That was the case with Heather Manto, owner and operator of Independence Barber Co. in Austin, Texas. To help businesses forced to shut down by the pandemic, Texas announced that it would extend the sales tax due dates and waive late fees. That was a relief to Manto, who had no income as her shop remained shuttered. But when she paid her sales tax a week late, she got hit with a penalty.
"Getting a human on the phone at that time was impossible, so I just paid and lived with it," said Manto, who has since reopened her business. "It's just a small example, but for a small business like mine, even those minor things hurt an already-pained business."
Sweat the small stuff.
Paying sales tax late isn't the only thing that can get you in trouble with the IRS or local tax collectors. You can face penalties for myriad reasons. The two big ones in dissolving a small business are neglecting to notify the state and failing to pay payroll taxes.
1. Notify the state.
Unless you file dissolution documents with the state where you operated, your business is not closed in the state's eyes.
"As far as the state is concerned, they think you are still running your business and may hit you with state taxes for that year," said Lisa Lewis, CPA and editor of the TurboTax Blog.
Make sure to cancel your employer identification number (EIN) and close your IRS business account. That requires you to send the IRS a letter that includes the business name, EIN, address and the reason you're closing the account. The business remains open until you've filed all the required returns and paid all the taxes you owe.
2. Don't forget payroll taxes.
If you have any employees, you must not only pay them their final wages, but also make good on any payroll taxes and report employment taxes. Failure to withhold or deposit employee income, Social Security and Medicare taxes could subject you to the trust fund recovery penalty.
Taxes are an unavoidable headache of starting, running and closing a business. But they shouldn't be ignored; the last thing you want to do is simply walk away.
"You really have to be deliberate and thoughtful when winding up your business," Smallwood said. "You have to make sure there are no personal problems and consequences that come as a result of your failed business." [Read related article: Starting Over When Your Business Fails]