The Tax Implications of PPP Loans and Forgiveness

Tax implications of PPP LoansBy now, “PPP” has become a common term for most attorneys and business owners. In response to the potential devastating economic impact of the COVID-19 pandemic, the CARES Act was adopted on March 27, 2020 to provide nearly $350 billion of Paycheck Protection Program (“PPP”) loans for businesses. This amount was later increased by an additional $320 billion. The goal of the PPP was to keep employees on payroll. The program was touted as being simple: Use the funds for allowable expenses, and then the loan will be forgiven! But in the months since its adoption, businesses began to see that the program was anything but simple. And now that businesses have begun to apply for this “forgiveness,” the true tax effects of the PPP are being realized.

But first, what is the PPP?

The PPP is a “loan” designed to provide a direct incentive for businesses to keep their employees on the payroll. PPP loans are an extension of the U.S. Small Business Administrations ‘SBA Loans’ and allow businesses adversely impacted by the COVID-19 pandemic to obtain funds needed to continue their business.

We put the word “loan” in quotations because, as part of the program, the funds received are eligible to be fully forgiven if certain requirements are met. The loan will be fully forgiven if at least 60% of the funds are used for payroll costs, and the rest is used for interest on mortgages, rent, and utilities.
The loan bears an interest rate of 1%, and all payments are deferred for the first six months.

Since its implementation, the rules of the PPP have evolved. For example, when the PPP first came out, the loans had a maturity of two years. That was later changed, such that all loans issued after June 5th have a maturity of five years.

Tax Implications of PPP Loans

As of July 6th, the SBA reports that 4,880,943 PPP loans have been approved. As these almost five million businesses continue to utilize the funds received and begin to apply for forgiveness, the tax implications must be considered. Recipients of a PPP loan should be aware of specific tax implications associated with the forgiveness of the loan. These tax implications include disallowance of deductions for expenses if paid by a PPP loan that is forgiven, no cancellation of indebtedness income and impact on payroll taxes.

PPP Loan Proceeds Forgiven Are Not Taxable Income for Federal Taxes

Section 1106(i) of the CARES Act provides that any amounts of income forgiven under the Act are excluded from gross income at the federal level. The amounts forgiven will not be considered cancellation of indebtedness, which normally results in taxable income to the taxpayer, absent applicable exclusions.1 California has not yet conformed to the CARES Act with respect to the tax-free treatment of PPP loan forgiveness. California is currently analyzing the CARES Act and will issue further guidance when ready. Therefore, the possibility of PPP loan forgiveness being treated as taxable income for California tax purposes remains a possibility.

No Double-Dip of Deductions for Business Expenses

After enacting the provisions of the CARES Act, a question remained whether deductible expenses paid with forgiven PPP loan proceeds would remain deductible. The Internal Revenue Service (“IRS”) answered this question of deductibility of expenses. On April 30, 2020, the IRS issued Notice 2020-32 that addresses the deductibility of loan proceeds received under the PPP. The IRS took the position that no tax deduction will be allowed for expenses paid with PPP loan proceeds to the extent such amounts are forgiven under the terms of the CARES Act. Section 1106(i) of the CARES Act provides that “the amount of a covered loan forgiven under section 1106(b) of the CARES Act, the application of section 1106(i) results in a “class of exempt income” under §1.265-1(b)(1) of the Regulations.” Therefore, any payment of an eligible expense,2 is disallowed as an allowable deduction under any provision of the Internal Revenue Code (“IRC”) because such payment is allocable to tax-exempt income. The IRS believes this is consistent with the purpose of IRC Section 265(a)(1) to prevent a double tax benefit.3

Impact on Payroll Taxes

Prior to Notice 2020-32, the expectation was businesses would continue to be able to deduct payroll and rent expenses. Payroll taxes are paid by two sources, the employer and employee. The employer is usually charged with the withholding from the employee’s paycheck for the employee’s portion of payroll taxes. Under the CARES Act, PPP funds are not allowed to be used towards the employee’s and employer’s share of FICA (Federal Insurance Contributions Act) for the covered period of February 15, 2020 through June 30, 2020. However, as of June 5, 2020, Section 2302 was amended to permit employers to defer the deposit and payment of the employer’s share of Social Security tax. Employers need to keep track, carefully, of PPP funds used with specific regard to FICA and deferred Social Security taxes. Misuse of PPP funds may result in denial of forgiveness and obligate the employer to repay such funds pursuant to the loan terms.

What Will Change?

Certain lawmakers have already expressed their discontent with the IRS’s position in Notice 2020-32 regarding the disallowance of expenses paid with PPP funds. They argue the original intent of the CARES Act was to allow for such deductions. Also, given Congress’s statements that further modifications to the CARES Act are a possibility, the final version of the CARES Act is probably yet to be solidified for the 2020 tax year. Furthermore, California has not decided whether to conform to the tax-exempt status of forgiven PPP loans. With the evolving nature of the CARES Act and the Paycheck Protection Program, taxpayers are encouraged to continue to monitor future changes with respect to the tax implications of the PPP program through the remainder of 2020.

[1] IRC Section 61(a)(11).
[2] CARES Act Section 1106.
[3] See also Rev. Rul. 83-3; Burnett v. Commissioner, 356 F.2d 755, 759-60 (5th Cir. 1966); Wolfers v. Commissioner, 69 T.C. 975 (1978); Charles Baloian Co. v. Commissioner, 68 T.C. 620 (1977); Rev. Rul. 80-348, 1980-2 C.B. 31; and Rev. Rul. 80-173, 1980-2 C.B. 60 for prior guidance on nondeductibility of expenses paid by tax exempt income.

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