Editor: Marcy Lantz, CPA
[Editor's note: Congress solved the issue of the deductibility of PPP-funded expenses, discussed in this article, in the Consolidated Appropriations Act, 2021, P.L. 116-260, enacted Dec. 27. For coverage of the act, see "Tax Provisions in the Year-End Coronavirus Relief Act."]
The Paycheck Protection Program (PPP) is a federally guaranteed Small Business Administration loan program that was created by the Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136, which became law on March 27, 2020. As of this writing, lawmakers are considering the possibility of expanding the PPP program but have yet to do so. This item discusses tax issues related to the forgiveness of PPP loans.
Under the PPP, a recipient of a covered loan can use the proceeds to pay
- Payroll costs;
- Employer health care;
- Interest on mortgage obligations;
- Utilities; and
- Business interest.
The maximum PPP loan is based upon 2½ months' average payroll costs for the prior 12 months. The entire debt may be forgiven if the business pays qualifying costs over the covered period beginning with the funding of the loan. The discharge of a PPP loan is excluded from the business's gross income for federal income tax purposes, but the corresponding expenses paid with the loan proceeds are deemed not deductible, as discussed in more detail below.
PPP loans and forgiveness
Borrowers of a PPP loan are not subject to tax on their receipt of proceeds because there is a requirement to repay the loan. This is the same as with any ordinary loan. With an ordinary loan, if all or part of the debt is forgiven, cancellation-of-debt (COD) income arises because the taxpayer has been released from the obligation to repay and this is viewed as an accession to wealth (Sec. 61(a)(11)). This principle would have applied to loan forgiveness under a PPP loan, but Section 1106(i) of the CARES Act states that "any amount which . . . would be includible in gross income of the eligible recipient by reason of forgiveness described in subsection (b) shall be excluded from gross income."
Thus, borrowers who are released from their obligation to repay a PPP loan do not have COD income. Loan forgiveness may affect their taxes in other ways, however. Borrowers may have to pay additional income tax as a result of the loan forgiveness because expenses funded by the PPP loan are not deductible for tax purposes. Under Notice 2020-32, the IRS took this position, stating that "no deduction is allowed under the Internal Revenue Code . . . for an expense that is otherwise deductible if the payment of the expense results in forgiveness of a covered loan pursuant to section 1106(b) of the [CARES Act] . . . and the income associated with the forgiveness is excluded from gross income for purposes of the Code pursuant to section 1106(i) of the CARES Act."
The impact of IRS Notice 2020-32
Notice 2020-32 explains why the IRS regards these PPP-funded expenses as not deductible:
[T]o the extent that section 1106(i) of the CARES Act operates to exclude from gross income the amount of a covered loan forgiven under section 1106(b) of the CARES Act, the application of section 1106(i) results in a "class of exempt income" under [Regs. Sec.] 1.265-1(b)(1) . . . Accordingly, section 265(a)(1) of the Code disallows any otherwise allowable deduction under any provision of the Code, including sections 162 and 163, for the amount of any payment of an eligible section 1106 expense to the extent of the resulting covered loan forgiveness . . . because such payment is allocable to tax-exempt income. Consistent with the purpose of section 265, this treatment prevents a double tax benefit."
Because the expenses are not deductible, borrowers' taxable income increases as a result of the loan forgiveness and, therefore, the result is the same as if the discharge of the debt was taxable. This can affect a business for multiple tax years through the increase in taxable income, reduction in potential net operating losses (NOLs), and the effects on various characteristics that impact a borrower's deduction under Sec. 163(j) and/or Sec. 199A.
Example: In 2020, borrower A has $1.8 million of revenue and $2.5 million of expenses, comprising the following: $500,000 of rent, $1,000,000 of payroll, $100,000 of utilities, and $900,000 of business interest. A would normally have a taxable loss of $700,000. This loss has value to the borrower as an NOL, either through a five-year carryback or an indefinite carryforward, as well as $1,000,000 in wages for Sec. 199A purposes. However, if $800,000 of expenses were related to loan forgiveness, then those expenses would not be deductible, and the borrower would have $100,000 of taxable income ($1.8 million of revenue less $1.7 million of expenses). For purposes of Secs. 199A and 163(j), A would need more details from Treasury on how to allocate the $800,000 of expenses between the various covered expenses. Once A has the allocation, it would also need to potentially back out the amounts for the Secs. 199A and 163(j) calculation.
Self-employed individuals and partners
Compared to the tax implications for corporate taxpayers, self-employed individuals and partners in partnerships generally fare better from PPP loan forgiveness, resulting in a type of unequal treatment. While Notice 2020‐32 disallows a deduction for expenses funded by the forgiven loan, there is no expense to be disallowed in the case of a sole proprietor's "owner replacement income." The result is that a self-employed individual filing Schedule C, Profit or Loss From Business, with his or her Form 1040, U.S. Individual Income Tax Return, will realize tax-free income of up to $20,833 with a 24-week covered period on the PPP loan. The same result will occur for a partner in a partnership who receives a draw for his or her owner compensation replacement amount. The portion of forgiveness related to covered rent, utilities, or interest would still be disallowed.
Because of the tax consequences of loan forgiveness, obtaining a PPP loan may not prove to be as beneficial as some taxpayers originally expected. As of this writing, some members of Congress favor overturning the rule set forth in Notice 2020-32 and allowing expenses paid with PPP loans to be deductible. The AICPA, along with more than 170 business and trade organizations, is on record asking congressional leaders to reverse Notice 2020-32, on the ground that the notice is contrary to Congress's intention in passing the CARES Act. (For more on the AICPA position, see Schreiber, "AICPA Continues to Ask Congress to Include PPP Deductibility in Upcoming Legislation"; Nevius, "AICPA Mobilizes Members to Push for Deductibility of PPP-Funded Expenses.")
Marcy Lantz, CPA, CSEP, is a partner with Aldrich Group in Lake Oswego, Ore. Ms. Lantz would like to thank the following practitioners for their help editing the December Tax Clinic: Michael T. Odom, CPA, CVA, partner at Fouts & Morgan CPAs PC in Memphis, Tenn.; Carolyn Quill, CPA, J.D., LL.M., principal at Thompson Greenspon CPAs & Advisors in Fairfax, Va.; Kristine Boerboom, CPA, CMA, MBA, partner at Wegner CPAs in Madison, Wis.; and Todd Miller, CPA, partner at Maxwell Locke & Ritter in Austin, Texas.
For additional information about these items, contact Ms. Lantz at 503-620-4489 or email@example.com.
Contributors are members of or associated with CPAmerica, Inc.