The CARES Act provided cash to millions of small businesses during Spring, 2020 with Payroll Protection Program (PPP) loans. Most of these loans will be forgiven by the SBA when the borrowers submit documentation of incurred payroll costs and other covered expenses during the COVID Pandemic.
Forgiveness of PPP Loans is excluded from Income
Borrowers were not subject to tax on their receipt of PPP loan proceeds because there is an obligation to repay the loan. The next question for PPP loan recipients is the loan forgiveness process. Typically, when all or part of a loan is forgiven, this gives rise to cancellation of debt (COD) income. COD income generally is includible in gross income because a taxpayer has been released from the obligation to repay. This principle would have applied to loan forgiveness under a PPP loan, but Section 1106(i) of the CARES Act states that the amount of loan forgiveness under a PPP loan is excluded from gross income. Thus, borrowers are not subject to tax when they are relieved of their obligation to repay their PPP loans.
Expenses incurred to qualify for Exclusion are non-deductible
Offsetting this income exclusion, the IRS has taken the position in Notice 2020-32 that expenses otherwise deductible in a borrower’s trade or business are not deductible if they result in loan forgiveness under a PPP loan. This conclusion is consistent with prior IRS guidance where expenses incurred in collection of tax-exempt income are not tax deductible.
The net result of this ruling is that the PPP loan forgiveness will result in taxable income to most taxpayers.
Under the section of the tax code that the IRS relied on in Notice 2020-32, the expenses that result in tax free loan forgiveness are nondeductible “whether or not [the loan forgiveness amount] is received or accrued.” We expect the IRS to take the position that such expenses are disallowed on the 2020 income tax return to the extent of the expected amount of loan forgiveness, which for the vast majority of borrowers will be 100%. There is a further issue regarding which expenses to disallow—interest, rent, utilities, or payroll—and this decision can impact a borrower’s deduction for interest payments under Section 163(j). The IRS has not addressed that issue under the PPP.
While most tax practitioners do not quarrel with the IRS’s conclusion from a technical tax standpoint, others believe it runs counter to Congressional intent because it negates the benefit of the income exclusion. Without the exclusion, borrowers would have COD income and offsetting deductible expenses. With the exclusion and the IRS ruling, they have no COD income and expense disallowance. Either way, borrowers are in the same place economically, meaning the IRS’s interpretation takes away the benefit that some argue Congress intended to give to borrowers, i.e., tax-free income and deductible expenses. As of this writing, Congress has not advanced any legislation that would change this outcome.
As a result of the expense disallowance rule in Notice 2020-32, borrowers may need to increase their estimated tax payments during the year to account for the increased tax liability that will be due for 2020 (and to avoid penalties if they are relying on the current year’s estimated tax payment safe harbor), and they need to decide whether to include the relevant deductions on their 2020 income tax returns.
Favorable Tax Treatment of Self-Employed Individuals and General Partners
The IRS has not yet addressed the treatment of l forgiveness loans based on the income of self-employed individuals and general partners in partnerships. Most commentators agree that PPP loan forgiveness to these two classes of borrowers will receive more favorable tax treatment. While they will receive tax-free loan forgiveness like everyone else, they will not suffer expense disallowance with regard to their owner compensation replacement amounts because such amounts are not otherwise deductible, i.e., there are no deductions to disallow. Thus, a self-employed individual filing Schedule C with her Form 1040 income tax return will realize tax free income of up to $15,385 if she uses an 8-week covered period on her PPP loan, and up to $20,833 if she uses a 24-week covered period on her PPP loan. The same result will be available for a general partner in a partnership that receives a draw (as opposed to a guaranteed payment) for her owner compensation replacement amount. Note this favorable treatment applies only to the owner’s compensation replacement amounts of self-employed individuals and general partners, and it does not apply to any payroll costs of employees. Contact us if you have questions.