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 DO NOT FOLLOW THE INSTRUCTIONS BELOW — THIS POST IS OUTDATED.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 partners in a partnership — those filing Schedule SE on their personal tax returns due to flow-through income from a Form 1065 K-1. For information on sole proprietors (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 partner income in these calculations. The reason is that partners in a partnership (or, more commonly, multi-member LLC taxed as a partnership) 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%). Partners, 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.)

For self-employment tax purposes, both guaranteed payments to partners for services and their ownership-percentage allocation of net income are included.

Initially, many of us assumed that only guaranteed payments qualified as “payroll” for the PPP calculation, as these are in theory the amounts paid for services rendered. However, many partnerships do not use guaranteed payments, and instead split all of the profits (for various reasons, including increasing the Sec 199A deduction). Since all income to an active member of a partnership is taxed for self-employment/payroll tax purposes, it should not matter whether it is due to guaranteed payments or an allocated portion of net income — that is a distinction left to the partnership agreement and says nothing about whether it is “payroll” for these purposes or not.

So, based on the above perspective, I have been suggesting that partners take the amount on Line 4 from Schedule SE on their personal tax returns to substantiate the amount of income from the partnership 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 partners simply don’t have their personal returns yet.
• Some partners have self-employment income from other businesses as well, such as another partnership or a Schedule C sole proprietorship. 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.

So for partners in either of these situations, here’s what you can do instead:

1. Pull up your client copy of the 2019 partnership tax return — Form 1065.
2. Scroll down to the K-1 forms — there’s one set for each partner.
3. Line 14A of each of the K-1 forms shows self-employment earnings for each partner. This includes guaranteed payments as well as the flow-through portion of net income.
4. Take that amount and multiply it 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.

In a partnership where all partners are actively working for the company — rather than one or more being silent investors — you’ll see that the total of Line 14A for all partners, equals Form 1065, Line 10 (Guaranteed payments to partners) + Line 22 (Ordinary Business Income).

However, if you have investor-partners, these folks usually are allocated their ownership-percentage of net income on which they do not pay self-employment taxes. And because they do not work for the business, they also will not receive guaranteed payments (which are also taxable for self-employment purposes). Therefore they are not eligible to apply for the PPP, and these amounts should not be included in the calculation. This is why I suggest sticking to Line 14A of the K-1 schedules, rather than using the amounts from the front of the 1065.

And if you are one of the unlucky partners whose 2019 1065 partnership return is still on extension, and therefore does not yet have a Schedule K-1, 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 add together the row for Guaranteed Payments and the final row, Net Income, and multiply by 92.35% to back out the employer portion of self-employment tax, as mentioned above. Again, if you have any silent investors, you would need to back out their percentage portion of net income.

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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