On April 30, 2020, in its Notice 2020-32, the IRS issued a controversial guidance regarding income tax deductions for taxpayers who receive small business loans under the Small Business Administration’s Paycheck Protection Plan (PPP). The guidance clarified that tax deductions will not be allowed for expenses that normally would be deductible if the payment of the expense results in forgiveness of a PPP loan.
PPP loans are federal loans meant to help small businesses cover certain operational expenses. Borrowers can apply for loan forgiveness for up to eight weeks of salary costs, plus mortgage interest, office lease, and utilities (electricity, water, transportation, telephone, internet). The forgiven amount could equal the principal amount of the loan or be less, depending on whether total expenses equal or exceed the principal loan. Furthermore, under Section 1106(i) of the CARES Act, the forgiven loan amount is excluded from gross income for tax purposes. The result was previously understood to mean free money for small businesses experiencing financial stress due to the COVID-19 pandemic.
However, the IRS has taken the position that, if a taxpayer receives a PPP loan that is ultimately forgiven, the covered business expenses that would make the loan forgivable cannot be deducted as well. If the PPP loan becomes tax-exempt income, then it would be a double tax benefit for expenses paid with the PPP loan to be deductible as well. For example, for a small business that receives a $1 Million PPP loan and uses the entire amount for wages, employee benefits, rent and utilities, the $1 Million loan will become forgiven tax-exempt income. However, the wages, employee benefits, rent and utilities paid for with the $1 Million loan will be disallowed as deductible expenses. The end result is that recipients of PPP loans whose loans are forgiven will owe federal income taxes on the forgiven amount, in most cases at least 21% on the forgiven amount.
The IRS’s guidance is based on Section 265 of the Internal Revenue Code. While it correctly applies the Code, the guidance contravenes the intent and spirit of the CARES Act. As a result, on May 5, 2020, the Senate introduced Senate Bill 3612 that clarifies that “receipt of coronavirus assistance does not affect the tax treatment of ordinary business expenses.” If passed and enacted into law, the bill will reverse the IRS guidance and correct what will otherwise become a significant tax burden for many recipients of PPP loans. However, until the bill becomes law, the IRS’s guidance must be followed. We will provide updates on this legislation as appropriate.
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