PPP Loan Forgiveness Will (Not) Be Taxable After All

Edit 12/21/20- The relief bill passed by the Congress in late December 2020 explicitly allows expenses covered by PPP funds to be deductible in the year incurred, whether or not the associated loan is forgiven. The information provided below is no longer correct under current law.

Section 1102 and 1106 of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) established the Paycheck Protection Program (PPP) as a new loan program administered by the Small Business Administration (SBA). Congress designed the PPP to help small businesses adversely impacted by COVID-19 meet payroll and other eligible expenses.

Under the PPP, the SBA may guarantee the full principal amount of a loan made under the program and certain loans whose proceeds were used to cover eligible expenses may be completely or wholly forgiven, tax free. However, the tax free aspect of the loan comes with a catch: expenses covered by a forgiven loan may not also be deducted on the borrower’s tax return. The IRS announced with proposed rules earlier in 2020 and clarified in Revenue Ruling 2020-27, that a taxpayer that received a Paycheck Protection Program (PPP) loan may not deduct otherwise deductible expenses if, at the end of the tax year, the taxpayer reasonably expects to receive forgiveness of the covered loan based on the otherwise deductible expenses.

In its ruling, the IRS gave the following examples:

Situation 1. During the covered period, taxpayer A paid eligible expenses including interest on a mortgage, utilities and rent. In November 2020, A applied to its lender for forgiveness of its covered loan based on the eligible expenses it paid during the covered period. At that time, and based on A’s payment of the eligible expenses, A satisfied all requirements for forgiveness of the covered loan. The lender did not inform A whether the loan will be forgiven before the end of 2020.  

Situation 2. During the covered period, taxpayer B paid the same types of eligible expenses that A paid in Situation 1. B, unlike A, did not apply for forgiveness of the covered loan before the end of 2020, although, based on B’s payment of the eligible expenses during the covered period, B satisfied all other requirements for forgiveness of the covered loan. B expects to apply to the lender for forgiveness of the covered loan in 2021.

At the end of 2020, the reimbursement of both A’s and B’s eligible expenses, in the form of covered loan forgiveness, is reasonably expected to occur – rather than being unforeseeable. Accordingly, A’s and B’s eligible expenses are not deductible because there is a reasonable expectation of reimbursement.

The IRS further noted: “[i]n the alternative, Code Sec. 265(a)(1) disallows the deduction of A’s and B’s eligible expenses to the extent the payment of such eligible expenses is allocable to tax-exempt income in the form of the reasonably expected covered loan forgiveness. The fact that the tax-exempt income may not have been accrued or received by the end of the tax year does not change this result; the expenses are disallowed whether or not the taxpayer receives or accrues any tax-exempt income (in the form of covered loan forgiveness) to which the eligible expenses are allocable.”

The issue of deductibility has been the subject of some controversy. As noted by the AICPA and other business and accounting industry advocates, denial of a deduction for related expenses has the effect of rendering the loan proceeds taxable. Put another way, reducing otherwise allowable deductions by $50,000 has a substantially similar effect to adding $50,000 in income. According to the AICPA, if the intent of the Congress was that loan forgiveness would be a non-taxable event, then the covered deductions should still be allowed. With another round of stimulus and possibly a second round of PPP funding under discussion, keep an eye out for further action on this issue.

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