Is loan forgiveness under the Paycheck Protection Program considered taxable income? Well, that depends on who you’re asking. If you ask Congress then the clear answer is yes, loan forgiveness under the PPP is excluded from taxable income. However, recent guidance issued by the IRS under Notice 2020-32 contradicts legislative intent and effectively makes loan forgiveness taxable. Unless Congress acts to pass additional legislation, as of the date of this post, taxpayers may be on the hook for more than they asked for.
Background
The passage of the CARES Act back in March of 2020 created the Paycheck Protection Program (PPP) which was designed to provide a direct incentive for small businesses to keep their workers on the payroll during the Covid-19 Pandemic. The program was designed to allows small businesses to apply for loans that would be forgiven if the proceeds were used to maintain payroll at pre-pandemic levels for an 8-week period.
The loans were to be administered through the Small Business Administration (SBA) and direct lending would be made available through the taxpayer’s local bank. As it pertains to the specifics of loan forgiveness, the SBA will forgive loans if all employees are kept on the payroll at their pre-pandemic wages for eight weeks and the money is used 75% for payroll related expenses (including wages, 401k match and health insurance) and 25% for rent, mortgage interest, or utilities.
Is Loan Forgiveness Taxable?
Section 1106(i) of the CARES Act specifically addresses the taxability of loan forgiveness, “For purposes of the Internal Revenue Code of 1986, any amount which (but for this subsection) would be includible in gross income of the eligible recipient by reason of forgiveness described in subsection (b) shall be excluded from gross income.”
Generally, loan forgiveness is included in a taxpayer’s gross income under IRC Section 61(a)(11) unless specifically excluded by IRC section 108 or any other relevant code section.
Think about credit cards as an example. If you have an outstanding credit card balance of $10,000 but you make an arrangement with your credit card company to settle the debt for $2,000 then $8,000 is reported as taxable income on Form 1099-C.
However, let’s say that credit card debt was part of a Title 11 bankruptcy; if that is the case then that debt forgiveness would be specifically excluded from gross income under IRC section 108(a)(1)(A).
To make this really simple, loan forgiveness is generally taxable unless Congress says otherwise. In the case of loan forgiveness under the PPP, Congress in fact said otherwise.
Understanding Notice 2020-32
The IRS’ interpretation of Section 1106(i) of the CARES Act can essentially be summarized as: you can have your cake but you can’t eat it too. For anyone who has ever enjoyed a nice slice of cake on occasion understands that if you can’t eat said cake the ownership of the cake in question does not make the situation any better.
What the IRS essentially is saying is that the loan forgiveness is not includable in taxable income but the cost associated with that loan forgiveness (i.e. payroll, rent, mortgage, utilities) are non-deductible. At first you might say, “well that’s fine, as long as the forgiveness is not included in income you should be fine,” however, when you actually think it through with examples you’ll see how you might as well make the loan forgiveness taxable.
Example 1:
Jim owns a small business that is closed due to a state mandated stay-at-home order. Instead of laying off all of his workers Jim decides to get a PPP loan to maintain his payroll for 8 weeks and pay some overhead cost such as rent and utilities. Jim had $200,000 in gross revenue for the year and $100,000 in expenses. Additionally, Jim received $20,000 in loan forgiveness through the PPP.
Jim’s taxable income for the year would be $120,000 ($200,000 income – $80,000 deductible expenses). Since Jim received loan forgiveness of $20,000 the expenses incurred to receive that forgiveness (i.e. paying wages during that 8-week period) is non-deductible.
Example 2:
Same Jim but this time he takes out a $20,000 line of credit instead of a PPP loan. Jim fires all his employees and pays himself a bonus. Months go by and Jim can’t pay back the line of credit, the bank forgives the debt (I know I’m reaching here but go along with me) and issues Jim a Form 1099-C for $20,000.
Jim’s taxable income for the year is still $120,000 ($200,000 income -$100,000 deductible expenses + $20,000 income from discharge of debt on LOC).
As you can see Jim is in the same position regardless if he gets debt forgiveness through the PPP or through other means. The exclusion from gross income only matters if you can take the deductions associated with the PPP loan forgiveness.
What is the IRS’ Reasoning?
Obviously, there is more to this than the non-deductibility of expenses related to the loan forgiveness. Notice 2020-32 is 7 pages long so the IRS must have some solid reasoning which references applicable code sections and relevant court cases. I’ll attempt to make the heavy lift of summarizing 7 pages of guidance in a few paragraphs so you see where they are coming from.
The IRS’ major argument is centered on the applicability of IRC section 265(a)(1) and §1.265-1 of the Income Tax Regulations. The applicability of this code section is often used (and was originally intended) to prevent taxpayers from taking tax deduction for expenses allocable to tax exempt income.
The best example of this code section in action is the limitation of expenses and interest related to tax exempt municipal bonds. Let’s say for example you have a consolidated 1099 with taxable and tax-exempt interest income. On that same 1099 you also have margin interest (investment interest expense) and advisory fees (section 212 expenses formally 2% percent miscellaneous itemized deduction).
If 50% of the income derived from that account is tax-exempt then 50% of the deductions are therefore non-deductible (terrible flashbacks of sticky notes on 1099s with calculations figuring out the deductible portion of advisory fees). This code section itself was written with the express purpose of dealing with this exact situation.
The IRS makes the leap in the application of this section beyond tax-exempt obligations by citing several court cases.
Heffelfinger v. Commissioner, 5 T.C. 985 (1945) – Canadian income taxes on income exempt from U.S. tax are not deductible in computing U.S. taxable income.
Banks v. Commissioner, 17 T.C. 1386 (1952) – Certain educational expenses paid by the Veterans’ Administration that were exempt from income tax, were not deductible.
Christian v. United States, 201 F. Supp. 155 (E.D. La. 1962) – School teacher was denied deductions for expenses incurred for a literary research trip to England because the expenses were allocable to a tax-exempt gift and fellowship grant
Manocchio v. Commissioner, 78 T.C. 989 (1982) – Taxpayer was denied a deduction for expenses related to the attendance of a flight training course that maintained and improved skills required in the taxpayer’s trade or business. As a veteran, the taxpayer was entitled to a non-taxable education assistance allowance which covered 90 percent of the cost incurred. The court held that the reimbursed flight-training expenses were nondeductible under section 265(a)(1) of the Code.
Given all this as reference, one could make the argument that the loan forgiveness is a class of tax exempt income and the expenses incurred to secure that loan forgiveness is therefore non-deductible under section 265(a)(1).
What’s the Fix?
Without consideration for a retraction by the IRS, the only way around this guidance is through legislative action. Congress could simply put in a provision that states section 265(a)(1) does not apply or add some language that would prevent the non-deductibility of the expenses.
The HEROES Act, passed by the House on May 15, includes such language which would give clarification of the treatment of expenses paid or incurred with proceeds from certain grants and loans. In section 20235 of the Act Congress clarifies, “For purposes of the Internal Revenue Code of 1986 and notwithstanding any other provisions of law, any deduction and the basis of any property shall be determined without regard to whether any amount is excluded from gross income under section 20233 of this Act or section 1106(i) of the Cares Act.”
Whether this Act, let alone this provision, gets passed is uncertain. Hopefully Congress can act soon to avoid the unintended consequences of the PPP loans on 2020 tax liabilities.
The information contained herein is is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined though consultation with your tax adviser. This article represents the views of the author only and does not necessarily represent the views or professional advice of this publication or the author’s employer.
What about PPP loan proceeds used to pay a self employed person since such payments are not an expense of the business Likewise payments to a partner If I pay an employee’s salary that will not be a wage/salary expense but when I pay a partner there is no expense deducted so how does the IRS plan to tax payments to a partner