The basics of how the Paycheck Protection Program (PPP) works are well-known by now — it provides forgivable1 government-guaranteed loans, if you can get them (after making a good faith certification of need), that carry a coveted one percent rate of interest. One of the key features is that the forgiven amount is not taxable income! (CARES Act Section 1106(b) and (i).) That Congressional largess was needed because forgiveness of a loan generally constitutes taxable income unless an exception applies. (IRC 61(a)(11) and 108.)
But what one Congress giveth, another can taketh away. In this case, action by a prior Congress effectively negates what the current Congress gave, at least that is how the Treasury Department and IRS just interpreted the technical rules on April 30 when they released Notice 2020-32, which confirms that U.S. tax law contains an override. Unfortunately, we agree with the IRS’s technical analysis here even if the result is not what all borrowers were hoping to see.
Without getting all wonkish, Internal Revenue Code (IRC) section 265(a)(1) has long provided that taxpayers should not be able to double dip by receiving tax exempt income and using that income to pay expenses that create a tax deduction. This is a sensible rule. Prior to enactment of IRC section 265, for example, a taxpayer could borrow boatloads of money and use the proceeds to purchase tax free bonds that secured the loan. The interest on the loan supported a tax deduction but the interest on the bonds were tax free, meaning that this smart taxpayer could make a profit even if the interest he paid on his loan was more than the interest he received on his tax free bonds. The provision denying deductions attributable to tax exempt income has application in many other contexts, but you get the idea.
Indeed, we have been warning clients for some time that they should assume that the forgiveness is effectively taxable because using the loan proceeds in ways to support forgiveness necessarily meant that the borrower’s tax deductions should drop by the amount of the loan forgiven. Some commentators argued otherwise, claiming that Congress intended the PPP to be a tax-free injection of capital and said so clearly in the referenced provisions above from the CARES Act. True, but if everyone is deemed to know the law, we have to assume that Congress also knew the law (IRC § 265) and therefore knew that PPP loans would not result in phantom loss: a tax deduction with no offsetting income because the cash used to pay the expense was tax-free.2 A PPP loan is good, but it’s not that good.
Of course, not allowing a deduction for the use of forgiven PPP loan proceeds is “bad” for a borrower only if the deduction provides a tax benefit or the use is deductible. Tax-exempt PPP borrowers don’t care about tax deductions because they are exempt from tax. Of course those taxpayers also didn’t benefit Congress turning off the cancelation of debt income rules.
What about sole proprietors, independent contractors and partners? They can receive a portion of the forgiven PPP loan funds, effectively compensate them for eight weeks’ worth of income, without a corresponding deduction. With no deduction to disallow, they only have the nontaxable income. Maybe the PPP is really that good for some.
Stay tuned for the next episode: As we are going to press with this Legal Update, we received this update from Tax Notes, a well-respected tax publication. So maybe the PPP ultimately will be that good for everyone, not just partners, sole proprietors and independent contractors!
The heads of congressional tax committees want expenses funded with small business loans to be deductible, contradicting recent IRS guidance.
Senate Finance Committee Chair Chuck Grassley, R-Iowa, was quick to share his disappointment with IRS guidance released April 28 that forgivable loans under the Paycheck Protection Program (PPP) are not tax deductible.
“The intent was to maximize small businesses’ ability to maintain liquidity, retain their employees and recover from this health crisis as quickly as possible,” Grassley said in a statement. “This notice is contrary to that intent.”
The small business loan program was created as part of the Coronavirus Aid, Relief, and Economic Security (CARES) Act (P.L. 116-136), in which Grassley played a key role.
Although Grassley didn’t say whether lawmakers would attempt to make changes to the small business loan program in legislation now being negotiated in Congress, his counterpart in the House, Ways and Means Committee Chair Richard E. Neal, D-Mass., intends to. “We are planning to fix this in the next response legislation,” Neal’s spokesperson Erin Hatch said.
The IRS guidance comes after weeks of debate in the tax community about whether the loan proceeds that were used to fund ordinary business expenses that could typically be deducted under sections 162 and 163 could still be written off, because the loans are forgivable on a tax-free basis.
2 When a business pays a deductible expense with forgiven, tax-free PPP loan proceeds, rather than amounts included in gross income, it makes sense for the tax treatment to match the cash flow. Typically, if a business has $100 of taxable gross income and $100 of deductible expenses, the net cash is $0 and the net taxable income is $0. Similarly, for cash flow purposes, if a business has $100 of forgiven PPP loan proceeds and $100 of otherwise deductible expenses, the business has $0 of cash. However, absent some override, the business would have a net taxable loss of $100.