PPP Loans Create Confusion in Child Support and Alimony Cases Involving Self-Employed Parties
Government relief program distorts profits and losses for small business for 2020 and 2021, generating chaos in child support and alimony cases.
Calculating self-employment income for child support and alimony cases is a challenge in the best of times. The Covid-19 pandemic has only deepened this complexity, forcing parents and spouses to calculate self-employment income for support orders during a sharp economic downturn. For cases in which a party’s business received a PPP loan in 2020 or 2021, the difficulty of calculating child support and alimony for self-employed parents is about to get even harder. To put it succinctly, business owners who receive PPP loans are not required to declare the loans proceeds as income, but the very same owners can write off all expenses paid with the PPP funds as deductible expenses. The result: phantom paper “losses” for small businesses that benefited greatly from forgivable PPP loans in 2020 and/or 2021.
In December 2020, Congress passed its second major Coronavirus relief bill, which included a new cash infusion for forgivable small business loans through the Paycheck Protection Program. Buried within the text of the bill was a controversial provision allowing business owners who received a forgivable PPP loan during 2020 to deduct all of the loan proceeds the company spent as business expenses – without treating the forgivable loan as a source of income for the business. In other words, a company that received a forgivable PPP loan for $500,000 in 2020 can essentially write off the entire $500,000 as a loss on the company/owner’s 2020 tax returns – without reporting the $500,000 in funds it received as income.
December Relief Bill Provision Shocks Tax Professionals by Making PPP Expenses Deductible
Congress passed its second coronavirus relief bill in late December in a moment of social and political chaos. While President Trump was contesting the 2020 election results, control of the Senate was still up for grabs in Georgia. Covid cases were spiking across the nation. The resulting Covid bill that passed on December 27, 2020 was unquestionably the product of a political system in turmoil.
Nevertheless, as the terms of the new bill emerged, tax professionals expressed shock at a little-noticed provision that would have a big impact. Like many in his field, Steve Rosenthal of the Tax Policy Center expressed astonishment that Congress would allow business owners to not only have their PPP loans forgiven, but to also write off the entire balance of the PPP loan as a business loss/expense, writing:
The PPP program is generous enough without double-dipping, which is costly and perverse. Permitting deductions for these reimbursed costs ultimately deprives funds to other deserving businesses by increasing the overall cost of the program.
Rosenthal offers an example of how the “double dip” works, writing:
A corporation laid off employees as its business foundered due to COVID-19. On May 1, 2020, the firm borrowed $1 million through the PPP and spent the loan proceeds on payroll over the following eight weeks, adding employees. The corporation covered its average headcount and payroll from 2019. As a result, the government will turn the loan into a grant and forgive the entire $1 million, tax-free.
As this example shows, the PPP made the firm whole: It paid $1 million to its employees and received a $1 million tax-free reimbursement from the government. If the corporation could deduct the $1 million expense this year, it would get a bonus windfall of $210,000 or, potentially, $350, 000, if it could carry back losses to years before 2018. For pass-through businesses, owners could, potentially, claim a bonus windfall of $370,000. If permitted, businesses would profit by paying employees not to work.
As Rosenthal and others pointed out, making the PPP loans tax deductible crates a double benefit for business owners: The business owner not only gets to keep the PPP loan proceeds without having to pay them back, he or she also gets a big tax break by allowing the business/owner to treat the loan as business expense or loss for tax purposes. For self-employed parents and former spouses paying child support and/or alimony, however, PPP loan provide a host of additional temptations.
For family courts, attorneys and opposing parties, the PPP program is likely to become a nightmare. Why? Because the tax returns filed by small business owners are likely to portray the business as suffering a major loss in the year the business received a PPP loan, while utterly concealing the real-world economic benefits of the PPP loan.
How Do Tax Returns Impact Self-Employment Income in Alimony and Child Support Cases?
Simple question: Where is the first place that a judge looks when trying to determine a parent or spouse’s self-employment income in a child support or alimony case? Answer: The last year’s tax return for the self-employed parent. Although income for support purposes differs from taxable income, virtually every state’s Child Support Guidelines borrows heavily from the tax code when defining self-employment income in some form or fashion as the business’s gross receipts minus ordinary its ordinary and necessary business expenses.
For example, the 2018 Massachusetts Child Support Guidelines define self-employment income as follows:
Income from self-employment, rent, royalties, proprietorship of a business, or joint ownership of a partnership or closely held corporation is defined as gross receipts minus ordinary and necessary expenses required to produce income.
This language is borrowed directly from Internal Revenue Code § 162(a), which defines tax deductible business expenses as “ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” Accordingly, when a court must determine a self-employed party’s income for child support or alimony purposes, the first place they check is often the most recent tax return filed by the business or business owner.
Most judges dig a bit deeper than the tax return in child support and alimony cases. Business tax deductions like depreciation, home office expenses and other deductions that provide a personal benefit for the business owner are often set aside for child support or alimony purposes. That said, a family court judge will often be the first to tell you that he or she is not a CPA. Indeed, explaining complex financial issues to family court judges is such a challenge that I dedicated an entire 30-page article to the subject in 2011.
Why Will PPP Loans Create So Much Chaos in Alimony and Child Support Cases in 2021 and 2022?
There are three main reasons that PPP loans will create chaos in Alimony and Child Support Cases in 2021 and 2022:
1.) PPP Loans will be difficult to detect on tax returns. Because PPP payments are “forgivable loans”, business owners will not need to report the loan proceeds as gross income on their business or personal tax returns. Although a careful reader may be able to discern that a business received a PPP loan somewhere in a state or federal tax return, it may not be easy to spot. As of the date of this blog, there appears to be no requirement in the federal tax code (nor the Massachusetts code at the state level) requiring business owners to disclose their receipt of a forgivable PPP loan.
Suggestion: In any case involving self-employment income for at least the next three years, family law attorneys must use discovery to aggressively seek to determine whether the opposing party receipt a PPP loan in 2020 or 2021.
2.) In practice, PPP Loans proceeds are like (hidden) business sales, only better. Although the proceeds of a PPP loan are not reported as “gross receipts” on the business’s tax return, the economic reality for business owners is that a PPP loan, once forgiven, is completely indistinguishable from sales receipts. Only, unlike ordinary gross receipts, the PPP loan proceeds are not taxable. In the
Suggestion: Family law attorneys should argue that the entire balance of a forgiven PPP loan must be attributed to the self-employed party as gross income for support purposes in the year the loan was received. Indeed, if the PPP loan was very substantial, attorneys should consider seeking an additional attribution due to the non-taxable nature of the forgiven loan.
3.) Business expenses paid by the business using PPP loan were not legitimately paid by the business. It is crucially important for attorneys and judges to understand that just because the tax law allows business owners to deduct business expenses paid using PPP loan proceeds, these “expenses” were paid by the US treasury, not the business itself. Allowing a business to report a non-existent loss may be allowed under the tax code, but courts should not allow such expenditures to be used to reduce income for child support or alimony. (In many ways, this is the most insidious challenge posed by PPP loans, since the deductibility issue will allow businesses that had an excellent financial year to appear as if they suffered a massive loss in tax years 2020 and 2021.)
Suggestion: If a judge agrees that the PPP loan proceeds should be treated as income to the business owner for support purposes, it not necessary for the judge to set aside the business expenses paid for with the loan proceeds. However, if the PPP loan has not been forgiven, or the judge expresses uncertainty about whether the PPP loan should be countable as income for the owner, it is imperative that the attorney argue that all business expenses paid for with loan proceeds be treated as non-deductible for support purposes.
In short, the easiest way for judges and attorneys to address PPP loans in the years ahead is to simply treat the forgivable loan proceeds as additional income to the business owner. If the loan proceeds are countable as income to the owner, then there is generally little need to address the business expenses that were paid for using loan proceeds and deducted on the business owner’s tax returns. However, until there is wide acceptance among judges and bar associations on the issue of PPP loans in the support context, attorneys should be prepared to argue why (a.) the loan proceeds should be treated as income for support purposes and (b.) allowing the deduction of expenses paid for with loan proceeds is unconscionable if the loan proceeds are not treated as income to the owner.
The Special Problem of PPP Loans that Have not Been Forgiven Yet
At this point, most businesses who received a PPP loan in the spring of 2020 will have already learned whether their 2020 PPP loan was forgiven (hint: the vast majority of PPP loans are forgiven in full). However, the December 2020 coronavirus relief bill also included a new tranche of PPP loans that business owners could apply for in early 2021. Businesses that received a PPP loan in early 2021 probably will not learn whether the loan is forgiven until much later in the year.
On January 12, 2021, the SBA announced that more than 85% of PPP loans issued in 2020 had been forgiven under the PPP loan. For businesses borrowing less than $50,000, the forgiveness rate was 88%. Where the vast majority – but clearly not all – PPP loans are ultimately forgiven, family law attorneys face challenges when dealing with PPP loan that have been received but not yet forgiven. Additional challenges can arise out of PPP loans proceeds that have been received by a business, but not yet spent on business expenses.
There is no one-size fits all argument for attorneys grappling with PPP loans that have not been spent or forgiven. In many cases, the most effective argument may be to argue that such loans should be treated as income on the party’s current Financial Statement, subject to revision if the loan is later not forgiven for some reason. After all, understanding any business owner’s income generally requires looking at earnings and expenses over a period of time; a one-time snapshot of the business taken midway through the business year is unlikely to provide an accurate picture anyway.
The Key to PPP Loan Litigation: Disclosure, Disclosure, Disclosure
The first and most important task for attorneys involved in child support and alimony cases for self-employed individuals is to determine if the business owner received a PPP loan in 2020 or 2021. Where federal tax returns (and most likely state returns) do not seem to require business owners to disclose the existent of a PPP loan, it is incumbent on attorneys to ask – and keep asking – until they get a straight answer from the business owner.
From disclosure follows the most clear-cut argument, which is that PPP loan proceeds should simply be added to the business owner’s income for support purposes. As time passes – and more and more 2020 tax returns make their way into contested child support and alimony cases – it seems likely that judges will eventually gain an awareness of how PPP loans should be treated in support cases. However, attorneys should not expect all judges to understand this issue uniformly.
PPP Loan Confusion Also Confuses Business Valuations in Divorce Cases
Any family law attorney will tell you that calculating the value of a small business for the purposes of the division of marital assets is one of the most complex areas of family law. If you want to review the in’s and out’s of business valuation, check out our 2019 blog, “Appraising the Value of a Small Business in a Divorce”. What is important to know about business valuation in the context of PPP loans is this: most business valuations rely on the “income method” of valuation, which calculates the current value of a small business based on the projected future earnings of the business.
Because the income method generates a value for a business based on the company’s recent profits, many of the issues surrounding PPP loans in child support and alimony cases can impact business valuations in similar ways. In short, if a small business shows a phantom “loss” in 2020 and/or 2021 due to the receipt of a PPP loan, this can distort any business valuation that relies on the income approach. Of course, because most business valuations are conducted by financial experts, these professionals are likely to be in a better position to account for the distorting impact of PPP loans in the valuation context – at least as compared to a typical family law attorney in a child support or alimony case.
Last Word: Key an Eye Out for Credible Publications Explaining PPP Treatment in Support Cases
Over the years, attorneys have told us about printing out Lynch & Owens blogs and submitting them directly to judges. I will be honest: We cannot help being a little tickled whenever we hear these stories. That said, attorneys are advised to keep an eye out for articles in publications from trusted sources for legal information and analysis – such as your state bar association or leading CLE group – that can be provided to judges to help clarify the appropriate treatment of PPP loans in child support and alimony cases in your jurisdiction. As of the date of this blog, we are seeing very little guidance on this issue across the world wide web, but we expect that to change in the months ahead.
About the Author: Jason V. Owens is a Massachusetts divorce lawyer and family law attorney for Lynch & Owens, located in Hingham, Massachusetts and East Sandwich, Massachusetts. He is also a mediator for South Shore Divorce Mediation.