PPP Loan Forgiveness: Authorized Expenses Paid With PPP Money Are Deductible

December 29, 2020 by Leave a comment

Many of our readers took advantage of the Paycheck Protection Program (PPP), which offered forgivable loans to businesses that were wiling to use the money for payroll purposes.

One open question was the tax treatment of the covered expenditures. An IRA Notice explained that the expenses would not be deductible, which reduced the total value of the PPP forgiven loan. That issue has been resolved in the recent Omnibus Bill. This issue presents itself like this:

  • First, under normal circumstances, loan forgiveness is taxable. You treat it like taxable income.
  • Second the CARES Act explicitly provided that loan forgiveness for CARES Act PPP loan forgiveness would not be taxable as income.
  • Third, the IRS released an interpretation – IRS Notice 2020-32 – explaining that although the PPP loan forgiveness would not be taxable as income, the payroll and other expenses paid with this money would also not be deductible. This was based on 26 U.S.C. § 265. You can see a complete analysis in our earlier article, here. For most taxpayers, this yielded the same result as if the PPP loan forgiveness had been taxable as income, and the payroll and other expenses had remained deductible.
  • Finally, this issue was resolved in the recent legislation, which confirmed that:
    • The CARES Act PPP loan forgiveness would not be taxable as income, as originally intended; and
    • The authorized expenses paid for with the forgiven PPP loan funds would remain deductible, without regard to 26 U.S.C. § 265.

In general, this means that the once the PPP loan has been forgiven, it will generate no additional tax liability, and it will not affect the deductibility of your payroll and other expenses. This makes PPP Loan forgiveness even more valuable to the taxpayers that receive it.

For those who apply for a second draw PPP (which will soon become available), comparable forgiveness and deductibility rules will apply. Se our article on the second draw PPP for more details.

This statutory authority can be found in Division N, Section 276 of the Omnibus bill (the particular subtitle is known as the ‘‘COVID-Related Tax Relief Act of 2020’’). You should review this authority with your tax accountant to understand how it affects your particular tax situation.

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IRS Thwarts Congress’ Efforts to Make PPP Loan Forgiveness Tax-Free

May 4, 2020 by 3 Comments

The IRS has published new guidance that makes Paycheck Protection Program (PPP) Loan Forgiveness less valuable (but it is still valuable).

Under ordinary circumstances, when a loan is forgiven, the debtor recognizes taxable income in the forgiven amount. So, if a debtor borrows $100,000 and the lender agrees that the loan does not need to be repaid, the lender typically gets a $100,000 deduction for bad debts and the debtor must declare income in the amount of the $100,000 forgiven (or “cancelled”) loan. For tax purposes, it is like the bank paid that money to the debtor.

Congress anticipated that the PPP would be forgiven if the payroll-related purposes of the PPP loan were met. The US government would reimburse the bank for the loan amount. Thus, the bank would not have an offsetting deductible loss associated with the cancellation of debt. To ensure that the debtor doesn’t need to pay extra taxes for this life-line, Congress explicitly stated in the CARES Act Loan Forgiveness provisions:

“For purposes of the Internal Revenue Code of 1986, any amount which (but for this subsection) would be includible in gross income of the eligible recipient by reason of forgiveness described in subsection (b) shall be excluded from gross income.”

So far it all makes sense. Forgiven PPP loans become truly free money to those who receive them. And this fits the intended purpose, which is to bail out companies in a time of need. But recently, the IRS issued IRS Notice 2020-32 explaining how this provisions would be interpreted. And that is where the problems begin.

The IRS Notice explains that there is a law – 26 U.S.C. § 265 – that disallows a deduction to a taxpayer for any amount that is allocable to income that is exempt from income taxes. The IRS Notice interprets this to mean that the offsetting payments that make the loan forgivable become nondeductible under section 265. In other words, the expenses that the forgiven loan is spent on becomes non-deductible expenses. The net result of the IRS Notice for many businesses would be the same as if they had treated the loan forgiveness as taxable income in the first place. Here is a simple example to illustrate the effect:

Example

Let’s say that a business has $1,000,000 in taxable income from normal operations in 2020. That business obtained a $100,000 PPP loan and used 100% of it on payroll. During 2020, the business paid total deductible wages of $600,000. Late in 2020 our hypothetical business applied for and received 100% loan forgiveness. To make this simple let’s assume that the business had $400,000 of other ordinary business expenses and no retained revenues.

If this had bean an ordinary loan that was forgiven, then the business would have an extra $100,000 income from the loan cancellation. Since it had $1,000,000 in taxable income from normal operations, $1,000,000 in ordinary business deductions, and an extra $100,000 income from the loan cancellation, it would pay 2020 taxes on $100,000 of income.

Because of the way that the IRS has interpreted the deduction issue under the Notice, when filing 2020 taxes, the business would exclude the $100,000 loan cancellation from income, but it would need to also exclude $100,000 of payroll from its deductions (because of section 265). Which means that the net result would be a payroll deduction of $500,000 instead of $600,000. The business would still be liable for taxes on $100,000 of income. This gets the business to the same tax result as if it had treated the loan forgiveness as income in the first place!

In some cases there may be a slight advantage to this approach (e.g. if the business has concerns about income caps or deduction caps) but for most businesses it simply unnecessarily complicates their tax filing, with little real change. Most importantly it frustrates the clear intent of Congress to prevent the loan forgiveness from being treated as taxable income.

There are ways to address this discrepancy. Many have talked about a legislative solution by which Congress would clarify that it did not intend to impose extra taxes on recipients of PPP loan forgiveness. If the IRS wanted to come up with a corrected notice, then the IRS could recognize that the language of the CARES Act excludes the forgiveness from income while the language of the section 265 talks about exemption from income (and could use this semantic difference to declare that section 265 does not apply in this particular situation).

To the extent that the PPP replaces lost revenues, on which a business would have paid taxes anyway, the IRS Notice puts businesses in a comparable situation to that they might have experience without Covid-19 (comparable – not the same). The business receives money and pays taxes on that money as income. The reason the IRS position is disappointing is because it is clear that Congress intended something different.

Even if this issue does not receive a legislative solution, PPP loan forgiveness is still a positive thing for those who are able to benefit from it.

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