IMPORTANT UPDATE: SINCE THE ORIGINAL PUBLISHED DATE OF THIS BLOG POST, FURTHER GUIDANCE FROM TREASURY HAS BEEN RELEASED. DO NOT FOLLOW THE INSTRUCTIONS BELOW — THIS POST IS OUTDATED. I HAVE FOUND THIS COLLEAGUE’S WRITE-UP WORTH READING INSTEAD — AND I RECENTLY RECORDED A FREE WEBINAR ON HOW TO APPLY.
Note: this post is about sole proprietors — those filing Schedule C on their personal tax returns, whether or not they have employees. For information on partners in partnerships (who are also considered self-employed for the purposes of the PPP), please see this post instead.
There has been so much back-and-forth and conjecture and guidance on how to calculate W-2 payroll for purposes of the PPP loan, but very little on the subject on how to include self-employment income in these calculations. The reason is that sole proprietors (single-member LLCs, independent contractors, gig workers, and anyone else who files Schedule C) are by law prohibited from paying themselves as an employee, through a payroll system. They therefore do not receive W-2 forms and are not included in quarterly “941” payroll reports.
The key here is that this is a “Paycheck Protection Program” — the goal is to keep people working instead of going onto the unemployment rolls. Why? Because it’s better for 1) business owners, 2) workers, and 3) the economy. Business owners are able to keep their companies afloat in a challenging environment (to put it mildly), continuing to produce products or services and maintain revenues at some level; workers generally earn more in their jobs than on unemployment (and if not, this means they are low-paid workers and probably deserve a raise for hazard pay); and the economy of course benefits because companies spend money on their vendors and landlords, and individuals spend their money on other products and services, and all of this helps to keep other businesses going, too.
So what constitutes a “paycheck” if you aren’t allowed to be on payroll?
The key here is “payroll taxes” — which are the portion of taxes that go to Social Security and Medicare programs, often known as FICA. Employees have 7.65% of each paycheck withheld for these purposes (and their employers match this amount for a total of 15.3%). Sole proprietors, on the other hand, pay estimates quarterly toward this and other taxes, and reconcile them on their annual personal tax return, using Schedule SE (Self-Employment) to calculate “self-employment tax”. This tax is the same as “payroll tax” for employees — with the painful added cost of having to pay both sides of the tax… the employee 7.65% and the matching 7.65% as they are their own “employer”. (Yes, ouch. Being self-employed is expensive.)
All net income earned by a sole proprietor is taxed for self-employment/payroll tax purposes, regardless of whether that income was pulled out of the company in the form of a draw. This amount flows through from Line 31 of Schedule C onto the Schedule SE.
So, based on the above perspective, I have been suggesting that sole proprietors should take the amount on Line 4 from Schedule SE on their personal tax returns to substantiate the amount of income from their business on which they paid “payroll taxes”. And to clarify: this is still the easiest approach for most people!
But here are the potential problems with that approach for some. If you fall into one of these groups, then keep reading for an alternative method:
- Tax deadlines have been moved to July 15th — for many small businesses, preparing their books for taxes is the last thing on their minds, and CPAs such as myself are scrambling to help their clients apply for relief, so we’re behind on the returns from folks who have found time to submit their info. As such, many sole proprietors simply don’t have their personal returns yet.
- Some sole proprietors have self-employment income from other businesses as well, such as a partnership or another Schedule C sole proprietorship business activity. Well, Schedule SE adds all businesses together. Guidance has not been forthcoming here, but it is likely that those in this situation will need to apply for PPP separately for each business — or at least the businesses that also have employees.
If you are in the first of those situations — no tax return yet — Treasury regulations allow you to use a reconciled Profit & Loss from your bookkeeping software to calculate these totals. (Make sure your banker knows this, as I have had some requiring 1099-MISC forms as substantiation, which is nothing short of ludicrous for many reasons — I won’t go into that here, as this post is plenty long already.) You would in this case simply take the final row, Net Income, and multiply by 92.35% to back out the employer portion of self-employment tax, as Treasury regulations for the PPP do not allow the employer portion of payroll taxes to be included in the calculation.
For sole proprietors in the latter of these situations (multiple businesses), here’s what you can do instead:
- Pull up each Schedule C for which you have employees and multiply Line 31 by 92.35% to back out the deductible portion — which is the Employer part of self-employment tax. (Treasury regulations for the PPP do not allow the employer portion of payroll taxes to be included in the calculation.) You can apply for a PPP loan for each one of these businesses separately. The reason you’ll have to do each one separately is that you also need to include the payroll for your staff in the calculation.
- Do the same for each of the other Schedule C businesses for which you do NOT have employees. Add all these together and apply for one PPP loan. There is no need to apply for each one separately.
- If you have self-employment income from a partnership, apply for a PPP for each partnership separately. If you have employees, add it to that partnership’s application. If you do not, apply for each one separately in your capacity as a self-employed partner. See this post for more guidance on partnership “payroll”.
If you already submitted an application and did not use the correct period or amounts, it’s by no means too late. Based on recent clarifications by the SBA and Treasury, you will be given an opportunity to revise your application — just explain the situation to your banker. It’s only “too late” once your application has already been approved — and in that case, Treasury says anything submitted based on older guidance is still considered accurate as long as it was consistent with the rules in place at the time of the application.
Keep in mind that this is only my personal interpretation of the Treasury regulations concerning what constitutes “payroll” for the purposes of the PPP, and ultimately your banker or lender will be the person with final authority on the matter. However, the Treasury is clear that they will allow lenders to rely on borrowers’ representations. Furthermore, the American Bankers Association is still in the process of seeking SBA and Treasury clarification for many issues, and as they receive it, they have to communicate it to member institutions, who then have to pass it along to the bankers themselves — who are overworked and have scarce little time for daily continuing education. You can do a favor for your banker by organizing your calculations and documents in such a way as to make their job easier, especially if you include a brief note explaining why you used the data you did, and as in middle-school math class: always show your work.
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