Forgiven, Yes … Taxable, Yes
CATCH-22…a dilemma or difficult circumstance from which there is no escape because of mutually conflicting or dependent conditions.
The Paycheck Protection Program (PPP) is aptly named. As a provision of the Coronavirus Aid, Relief and Economic Security Act (CARES Act), Congress authorized guaranteed loans to employers from the SBA to keep workers on the payroll. Provisions of the PPP require loan proceeds to be applied to specific overhead expenses, e.g. employee salaries, paid sick or medical leave, insurance premiums, mortgage, rent, utility payments as well as to pay family, medical, and sick leave.
As the PPP terms evolved, virtually all U.S. employers qualify … corporations, sole proprietorships, independent contractors, gig-economy workers, and self-employed individuals all became eligible. In addition to the obvious appeal to employers to pay and retain quality employees during the COVID-19 crisis, the loans are forgiven if companies meet the benchmarks for keeping employees on the payroll and if the loan proceeds are used as intended.
Click here for a detailed review of the requirements and evolution of the PPP provisions.
Catch-22 Consequences #1
Historically, the IRS has held that a forgiven loan will be treated as taxable income. In contrast, the CARES Act provides that, unlike other debt that is forgiven, PPP loan amounts do not constitute cancellation of debt and will not result in taxable income. For example, a $100,000 loan applied to payroll would result in ultimate forgiveness of the loan while permitting a tax deduction for the corresponding payroll expense.
Then, in April of this year the IRS announced in Notice 2020-32 that taxpayers whose PPP loans are forgiven cannot deduct the business expenses for which the forgiven loan proceeds were applied. Specifically, the IRS clarified that no deduction is allowed under the Internal Revenue Code for an expense that is otherwise deductible if the payment of the expense results in forgiveness of a covered loan pursuant to section 1106(b) of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act).
Effectively, the IRS Notice essentially reverses the tax-free benefit of the exclusion on the loan forgiveness as provided in the CARES Act … which makes any expenses used to offset the loan non-deductible. Net result is that loan proceeds become taxable.
What’s a Loan Recipient to Do? Questions to Ask? Timing of Taxable Event?
The above IRS Notice prompted 2 key questions by PPP loan recipients:
1. When to apply for forgiveness, and
2. How to treat expense deductions for items to which the PPP loan funds were applied.
When to Apply for Forgiveness: Much depends on the loan recipient’s “borrowing tier”. The SBA and Treasury Department has announced total forgiveness for all PPP loans of $50,000 or less. Click here to view an easy to complete loan forgiveness application.
Many, if not most, businesses with loans in excess of $50,000 will not have applied for forgiveness before year-end. The delay is driven by a hope for final clarification by the IRS as to which year the loan proceeds are to be declared as income … when received or when forgiven. Consider these two polar scenarios.
Taxable in 2021
1. The taxable income may be deferred until notification by the bank that the loan is forgiven.
This line of thought suggests that loan proceeds received in 2020, but not officially forgiven until 2021 are not taxable in tax year 2020.
Taxable in 2020
2. If the loan proceeds were received in 2020, the funds received are taxable income this year.
Tax advisors expressing this point of view concur that the taxable event occurred in the tax year the funds were received.
Adherence to either perspective demands a decision to when to apply for forgiveness and how to treat expense deductions for items to which the PPP loan funds were applied.
Catch-22 #2 - Breaking News! IRS Clarification Plus New Set of Questions
On Thursday of this week, the IRS released Revenue Ruling 2020-27. The intent is to clarify the rules for deducting expenses paid with PPP funds.
The new Ruling again provides that expenses paid with PPP loan funds are not deductible (see Catch-22 Consequences #1 earlier in this article). However, the Ruling goes on to state, “no deduction is allowed for an eligible expense that is otherwise deductible if the payment of the eligible expense results in forgiveness of the covered loan” (underline is Blair + emphasis). This implies “forgiveness” is a condition precedent to the provisions of this rule. That means borrowers who haven’t applied for forgiveness before year-end (the vast majority!) should not deduct expenses paid with loan proceeds on their 2020 return.
The Ruling continues with deducting the above referenced expenses is precluded if the borrower has “a reasonable expectation of reimbursement.” So, in the absence of current forgiveness, a borrower can’t deduct expenses paid for with PPP funds if they anticipate the loan will be forgiven in the future.
Note: It’s critical for your end-of-year tax planning to seek guidance from your tax advisor.
Predictably, there is more to the story in questions yet to be voiced and answered. That mirrors past attempts at PPP clarification and guidance. That said, we will not only survive the current confusion … we shall prevail in understanding and compliance.
Summary & Takeaways
A month following the April IRS Notice, a bill was introduced in the Senate with the stated intent … This bill amends the Coronavirus Aid, Relief, and Economic Security Act to provide that tax deductions for ordinary business expenses and other tax incidents shall not be affected by the exclusion from gross income of amounts related to loan forgiveness received in response to COVID-19. If this bill, or one similar in content, is passed in the Biden administration, Congress will have acted to restore the original CARES Act intent?
To date there has been no further action by lawmakers. So, as we approach year-end, the conservative route for taxpayers is to proceed with end-of-year tax planning on the assumption that there will not be Congressional reversal of the latest IRS Revenue Ruling before the new year.
On balance the PPP has proven to be a transitional boon during the economic and health scourge of C-19. As with any new, complex set of regulations there are unintended consequences, ongoing IRS guidance and the potential for continuing Congressional revisions.
So, you get the picture. “We Don’t Know What We Don’t Know!” There are many questions … some answered and more yet to be. Stay tuned. We’ll keep you posted as further developments surface.
Have Immediate Questions or Concerns!
Blair + Assoc stand ready to help as needed. A phone call or email is all it takes.
We’ll respond promptly.
Note: Loan Forgiveness Does Not = Tax-free!