Things get canceled all the time…meetings and appointments, customer orders, and leases to name a few. Sometimes cancellations are good for your business, sometimes they’re bad, and sometimes it’s just what happens and isn’t good or bad for your business. But in all events, cancellations can have tax consequences. The following are some examples of cancellations and what to do about them when it comes to your taxes.
How to handle matters for taxes when things get canceled
Cancellation of debt
When debt is canceled, it may be a relief because you no longer have to worry about repayment. But taxwise, the cancellation of debt usually results in taxable income. The good news: there are various business-related exceptions to this general rule. These include cancellation of:
- Paycheck Protection Program (PPP) loans. There’s no dollar limit of the amount of loan forgiveness that’s excluded from gross income.
- Qualified real property indebtedness (QRPBI). This is debt incurred or assumed in connection with depreciable real property used in a trade or business that’s a pass-through entity (not a C corporation) and is secured by the property. The amount excluded from gross income is limited to the aggregate adjusted bases of depreciable real property held by the business immediately before the discharge. However, the amount of the canceled debt excluded from gross income requires the business to reduce “tax attributes," such as net operating losses, the general business credit, and capital loss carryovers.
- Qualified farm indebtedness. This is debt incurred in connection with the operation of a farm that is a taxpayer’s trade or business and farm income is 50% or more of the taxpayer’s gross receipts for the 3 prior years. Again, the reduction of tax attributes is required here too.
The cancellation of debt also escapes taxation if you’re bankruptcy or insolvent (but only to the extent of insolvency.
Cancellation of trips
Due to state and local government closures during the pandemic, businesses have opened, closed, opened again, closed again, and opened again. What this has meant for some businesses is that travel has been disrupted.
You may have paid for airline tickets that have been canceled and are given the option of receiving a refunds or a credit for booking future flights. The same is true for hotel rooms and other trip-related costs.
If you can’t get your money back for tickets or rooms that you paid for, you can claim a deduction. If there is a cancellation fee, it’s deductible too if the cost to which it relates would have been deductible.
Cancellation of events
During the pandemic, government-mandated shutdowns caused businesses live hosting events to cancel or reschedule them. From a business perspective, handling these events has been a headache. From a tax perspective, if you’ve been paid and then had to cancel, what do you do? Are you offering a refund or allowing customers to enjoy an event that’s simply been postponed?
The AICPA (the national association for CPAs) wrote a letter to the IRS: “For affected taxpayers, there is currently a lack of clarity regarding when to recognize gross income from advance payments attributable to events that were canceled or significantly deferred due to COVID-19, how to account for refunds offered to customers during the pandemic, and how to account for the issuance of a credit to the customer in situations where the customer declines to receive a cash refund and instead requests applying the credit as a prepayment for different event or production to take place at a later date.”
For businesses using the cash method of reporting, which most small businesses do, things are rather simple. If you reported the income in year 1 when the advance payment was made and you give a refund in year 2, then that refund becomes deductible. If the payment and refund occur in the same year, it’s a wash.
But things are more complicated for businesses that use the accrual method of accounting because special advance payment rules come into play. There’s no clear tax treatment for accrual method businesses when it comes to handling the tax issues related to live events. Hopefully the IRS will heed the AICPA’s request for guidance and provide it soon.
There’s much in the media about cancel culture, but it’s not likely to impact small business owners. The question you face is how to handle matters for taxes when things you’re involved in get canceled. Talk to your CPA or other tax adviser if you experience any cancellations.
And looking ahead, be sure to have a solid cancellation policy in place for orders, events, etc. Nextdoor has a guide on cancellation policies that may be helpful to you.