The Payroll Protection Program (PPP) brought swift relief to thousands of organizations disrupted by the COVID-19 pandemic by offering potentially forgivable loans to cover employee costs and certain other expenditures. Like the pandemic, the scale of the $650 billion loan program was unprecedented. Accounting and tax rulemakers are now parsing the manner in which PPP loan recipients should report their loan proceeds on financial statements and tax returns.
While forgiveness of PPP loan proceeds is not taxable, a recent announcement from the IRS may create another tax challenge for PPP loan recipients. Absent Congressional action, loan recipients could find they are unable to take deductions for expenses such as payroll that were paid from forgiven PPP loan proceeds. Many businesses have not accounted for this and may be caught off-guard at the end of the year when they are met with a higher than anticipated 2020 tax liability.
The Background for the Business Tax Deduction Issue
PPP loan forgiveness benefits came with strings attached, namely that organizations use the funds to retain as much of their workforce as they could. Recipients are required to demonstrate their funds were used for eligible costs by tracking eligible expenses during a “Covered Period,” and submitting these records as part of their application for loan forgiveness. The Small Business Administration (SBA) will reduce loan forgiveness proportionally if the borrower cannot fully substantiate sanctioned use of the funds.
While the loan forgiveness itself does not result in taxable income, the IRS said in its Notice 2020-32 that expenses funded by the portion of the PPP loan that is ultimately forgiven are not deductible. The IRS’s position is that taxpayers would benefit two-fold if tax-exempt income is received and associated expenses are also deductible (a result ostensibly prohibited by Internal Revenue Code Section 265). This limitation could be a potentially significant blow to taxpayers, which traditionally use these types of expenses as deductions to reduce their year-end tax liability.
The position taken by the IRS was met with resistance from industry groups, which argued that the Coronavirus, Aid, Relief, and Economic Security (CARES) Act did not intend to create this tax scenario for organizations heavily affected by the pandemic. For example, the American Institute of Certified Public Accountants (AICPA) has recommended that the next round of stimulus legislation include a provision expressly allowing the deduction of expenses paid from the proceeds of forgiven PPP loans.
As many organizations (especially small businesses) are still bracing for sustained economic hardship, the most optimistic outcome for this tax quandary would involve a technical adjustment to the PPP loan allotment that would allow for deductions of qualifying expenses such as payroll and would clarify that the PPP loan is a government grant when forgiven.
Guidance for Loan Recipients
PPP loan forgiveness applications are due 10 months after the end of the Covered Period. The SBA loan forgiveness portal is now open, but the lenders facilitating the loans have not started submitting client applications, as they are waiting for additional guidance. PPP loan recipients may want to use this holding period to plan for the procedures they will use to quantify qualifying expenses, and to calculate the potential tax obligations.
It will be important for your organization to consult a tax professional to assist with the determination of what portion of your loan amount will ultimately be forgivable. You should also consider whether repayment is more advantageous than forgiveness in light of tax obligations associated with forgiven loan amounts. Unforgiven balances are due within two years after the loan origination and will accrue interest at a rate of 1%.
There is hope that new stimulus legislation being discussed in Congress, such as the Small Business Expense Protection Act of 2020 and the Health, Economic Assistance, Liability Protection and Schools (HEALS) Act, will reverse the decision announced by the IRS, but so far, additional legislation has failed to pass.
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