On March 27, 2020, Congress passed the Coronavirus Aid, Relief, and Economic Security (CARES) Act which was then signed into law by the President. The Act established the Paycheck Protection Program (PPP) which provided loans to small businesses intended to cover payroll costs for up to 8 weeks. The funds could also be used to cover mortgage interest, rent, and utilities.
Under the PPP, if taxpayers used the funds for qualified expenses, employees were retained and salaries were not reduced substantially, the taxpayer could be eligible for total or partial forgiveness of its PPP loan. Subsequent legislation extended the 8-week period to 24 weeks making it easier for borrowers to qualify for full forgiveness.
This program raised two important tax questions. First, is the forgiveness of debt included as taxable income in 2020 or any subsequent year? Second, are any of the otherwise deductible expenses related to payroll costs, mortgage interest, rent, or utilities disallowed due to the loan forgiveness?
Generally, when a taxpayer’s debt is forgiven, they must recognize the relief and include it as income in the year the debt was forgiven unless an exception applies. However, under the CARES Act, any forgiven amount of a PPP loan that would ordinarily be included as income is specifically excluded from taxable income by section 1106(i) of the Act. Therefore, taxpayers don’t have to pick up the PPP loan forgiveness amount as income on their applicable tax return.
Regarding the related expenses, the IRS has issued notice 2020-32, which states that no deduction is allowed for an eligible expense that would otherwise be deductible if the payment of such expense results in forgiveness of the loan. Basically, this means that expenses that qualify for loan forgiveness cannot be deducted in order to arrive at taxable income. On 11/20/20 in Revenue Ruling 2020-27 the IRS reiterates this stance and states that the expenses are disallowed if there is a “reasonable expectation” that the loan will be forgiven. This means that even if the SBA has not actually forgiven the loan by the end of the year, if the taxpayer qualifies for loan forgiveness per the PPP guidelines, then the expenses covered by the loan cannot be deducted when arriving at taxable income. It is also irrelevant whether loan forgiveness was requested by the taxpayer by year end; the key is the reasonable expectation test.
What if the taxpayer later doesn’t qualify for complete loan forgiveness or the taxpayer decides to not request forgiveness? In this case, under Revenue Procedure 2020-51, a taxpayer may elect to deduct some or all of the expenses in the tax year incurred or a subsequent tax year. However, depending on the facts and the taxpayer’s election, the taxpayer may be required to file an amended return.
In summary, for taxpayers who received PPP loans under the Cares Act, if the taxpayer qualifies for loan forgiveness, the IRS position is that any expenses that were paid using proceeds from the loan are disallowed when calculating taxable income. The good news is that the principal that is forgiven on the loan will also be excluded from income.
The IRS guidance does not address withdrawals of self-employment income of sole proprietors or partnerships that qualify for forgiveness without corresponding deductible expenses.
Key members of Congress have harshly criticized the IRS position as being clearly contrary to Congressional intent. Legislation that would make the applicable expenses clearly deductible in the year paid or incurred has been proposed but so far has not been enacted. The prospects of passage are unclear.
We are always happy to help you better understand how this will affect your small business. Please reach out to your Pugh tax advisor with any questions.
 The forgiveness rules contain quite a few special rules and exceptions that have been the subject of earlier communications