What Congress Giveth, the IRS Taketh Away: PPP Loan Forgiveness and Disappearing Business Deductions
May 1, 2020
As part of the CARES Act signed into law on March 27, 2020, Congress enacted the Paycheck Protection Program (the “PPP”). The PPP is designed to, in general, provide small businesses with a short term loan (a “PPP Loan”) equal to two and a half months of payroll.
In addition, the PPP entitles borrowers to have some or all of the PPP Loan received forgiven if PPP Loan proceeds are used to pay certain expenses during a certain period of time, subject to a series of rules that might reduce the amount of the PPP Loan which may be forgiven. For additional details on the PPP, PPP Loans, and PPP Loan forgiveness rules, please see Forrest Firm blog articles here and here.
On the evening of April 30, 2020, however, the IRS issued Notice 2020-32. This IRS Notice provided guidance regarding the deductibility, for Federal income tax purposes, of certain expenses when (1) a taxpayer obtains a PPP Loan, (2) a taxpayer pays those expenses, and (3) the payment of those expenses results in forgiveness of some of all of the PPP Loan. Without burying the lead, the IRS appears to have taken away much of the benefit that Congress provided by allowing for PPP Loan forgiveness: Notice 2020-32 clarifies that no deduction is allowed for an expense that is otherwise deductible if the payment of the expense results in forgiveness of a PPP Loan.
As a general rule, businesses are entitled to a deduction for ordinary and necessary expenses paid or incurred during the year in carrying on the business. However, a deduction is not allowed for an expense that is allocable to income wholly exempt from taxation. The purpose of this exception is to prevent a double tax benefit – if a business receives income, does not pay tax on that income, pays an expense with that income, and claims a deduction for that expense, then it will have received a double tax benefit: first when it received income and did not pay tax on it and second when it paid an expense with the untaxed income and claimed a deduction for the payment of that expense.
In the case of the PPP, when a borrower obtains a PPP Loan and uses the proceeds for paying certain expenses during a certain time period, the borrower will, in general, have the PPP Loan forgiven, either in whole or in part. Under the PPP, that forgiveness of debt is not treated as income – which is different from the usual rule that borrowers must treat forgiven debt as income.
At the same time, the expenses the borrower pays which entitle it to forgiveness of the PPP Loan are also ordinary and necessary expenses paid or incurred during the year in carrying on the business. Normally, the borrower would be entitled to a deduction for paying those expenses.
However, in Notice 2020-32, the IRS makes it clear that the exception to deductions for payment of business expenses, the exception that prevents the double tax benefit, applies to PPP Loans and PPP Loan forgiveness. As a result, to the extent that a borrower obtains forgiveness of a PPP Loan, the borrower may not claim a deduction for the payment of the expenses that resulted in the forgiveness of the PPP Loan.
What is the impact of this Notice? In the very short term, it may have little impact – borrowers will obtain PPP Loans, pay allowable expenses, have some or all of the PPP Loan forgiven, and continue trying to make sure that their business survives the impact of the coronavirus pandemic; of course, some taxpayers may well decide that they would rather take advantage of other provisions of the CARES Act, such as the Employee Retention Payroll Tax Credit, which provideseligible employers with a refundable payroll tax credit.
The longer term consequences of this IRS Notice are much graver. Next year, when borrowers are preparing their 2020 income tax returns, they will discover that a large portion of their business expenses that, in the normal course, they would deduct and offset against income may not be deducted. The result? A larger 2020 tax bill. An example, from my colleagues Richard Pasquantonio and Adam Shay at Adam Shay, CPA, LLC, illustrates this tax increase. Assume a business has a $100,000 PPP Loan forgiven and the business (and/or its owner) is taxed at a 24% Federal tax rate. As a result of Notice 2020-32, the business (and/or its owner) will not be able to deduct $100,000 of otherwise deductible expenses and will owe $24,000 more in 2020 taxes than it would have expected.
It is difficult to believe that Congress intended to give business owners a benefit during the coronavirus, in order to help keep them operating, keep people employed, and maintain payroll, but also intended to ‘penalize’ those same businesses in 2021 when they pay their 2020 taxes. Neither the PPP nor the CARES Act itself, however, prohibits the conclusion reached by the IRS. At the same time, the IRS guidance makes it clear that the IRS is not relying on new or tortured interpretations of the law; instead the IRS supports its conclusion with well-accepted references to law that has been in place for decades.
Ultimately, it appears that the drafting of the PPP provisions of the CARES Act simply failed to take into account, or potentially even consider, how the IRS would treat the impact of PPP Loan forgiveness of expense deductions. Notice 2020-32 makes it clear that, to avoid this problem and insure that borrowers do not have a 2020 tax ‘penalty,’ Congress will have to enact an amendment to the PPP provisions of the CARES Act. Will that happen? Stay tuned…
If you have any questions about the Paycheck Protection Program, other aspects of the CARES Act, or other tax, risk management, or business needs, please feel free to reach out to me here.