The CARES Act created the Paycheck Protection Program (“PPP”). Under the program, small businesses can take a loan to cover expenses to help get through the COVID-19 pandemic. The funding for the loan quickly ran out leaving many struggling business without the help they desperately need. A second round of funding is on the way, but it is also not likely to be enough considering how fast prior funding was exhausted. Small businesses lucky enough to obtain a PPP loan may now be asking questions about the tax implications.
The CARES Act allows forgiveness of the debt when certain requirements are satisfied. Full details on forgiveness criteria have not yet been released. The Small Business Administration states additional guidance is forthcoming. Here is what has been said by Treasury so far:
You will owe money when your loan is due if you use the loan amount for anything other than payroll costs, mortgage interest, rent, and utilities payments over the 8 weeks after getting the loan. Due to likely high subscription, it is anticipated that not more than 25% of the forgiven amount may be for non-payroll costs. The eight week period begins to run on the first date the lender makes a disbursement to the lender.
The first tax question that comes to mind is will the forgiven amount of the loan be taxed as income? Internal Revenue Code section 61(a)(11) generally requires forgiven debt to be treated as income. It is commonly referred to as “cancellation of indebtedness income” or CODI. The good news for PPP borrowers is that Section 1106 of the CARES Act specifically excludes the forgiven PPP loan amount from taxation. No cancellation of indebtedness income is recognized on forgiveness of a PPP loan. All good, right?
Here is where it gets interesting!
Can expenses paid with forgiven loan funds be deducted? The answer appears to be no. Expenses paid from income exempt from tax cannot be deducted. Simply from the long-standing principles of tax symmetry, there would be an unintended double benefit if a taxpayer did not have to include an item in income and at the same time be allowed to deduct related expenses. I doubt this is what was intended when the CARES Act was passed, but in the haste to pass relief, this detail was overlooked.
Internal Revenue Code Section 265(a)(1) states no deduction shall be allowed:
for any amount otherwise allowable as a deduction which is allocable to one or more classes of income other than interest (whether or not any amount of income of that class or classes is received or accrued) wholly exempt from the taxes imposed by this subtitle, or any amount otherwise allowable under section 212 (relating to expenses for production of income) which is allocable to interest (whether or not any amount of such interest is received or accrued) wholly exempt from the taxes imposed by this subtitle.
There are a number of court cases that reach the same result when analyzing expenses attributable to tax exempt income.
The intent of the statute in providing loans under the Paycheck Protection Program is to help small businesses through an extraordinarily difficult financial time without tax implications. Allowing forgiveness of the loan amount used for specified purposes without imposing tax for CODI does exactly that. However, the benefit is negated if the expenses paid with the loan are non-deductible. This seems to be an unintended consequence of rushing the legislation through. For now, we will have to wait and see if Congress takes steps to correct this. If there is no fix, some PPP borrowers will be caught off-guard at tax time when they find out they can’t take a deduction for some of their normal business expenses.