The Coronavirus Aid, Relief, and Economic Security (CARES) Act created a new loan program for struggling businesses. The Paycheck Protection Program (PPP) helps businesses cover payroll, rent, mortgage, and other expenses during the COVID-19 crisis. The estimated $660 billion in loans are quickly streaming out the door of the Small Business Administration, which is working overtime with the Treasury Department assisting to stand up the program. Like many of the policies created by the CARES Act, policymakers are building the airplane while flying it, trying to answer questions from businesses and practitioners as they arise. New guidance has been issued intending to answer a key question: If a business receives a PPP loan and it is forgiven, are its expenses deductible?
Generally, businesses pay taxes on their net income, which is the difference between their revenue and their expenses. Expenses are wide-ranging and can include rent and mortgages, interest, payroll, capital purchases, and more. When a business pays more than it collects in revenue, it generates a net operating loss (NOL). In this case, the company will be receiving revenue (in the form of loan proceeds) to pay key expenses, such as payroll.
If the business meets certain criteria, the federal government will forgive the loan, freeing them of the need to pay it back. Generally, a forgiven loan is considered income to the business, but here Congress made an exception. The CARES Act dictated that a forgiven PPP loan is not considered income to the business, helping to save business owners from large, unexpected tax bills.
Congress, however, was silent on the deductibility question. With the lack of Congressional guidance, the Internal Revenue Service (IRS) has weighed in. The agency acknowledges that Congress did not address the question, but rules are needed for certainty. Following practices in other areas of the tax code, the IRS says deductions are not allowed for expenses generated from PPP loan proceeds.
Within minutes of the IRS’s notice to taxpayers, Senate Finance Chair Chuck Grassley (R-IA) responded, arguing that the agency’s notice is in conflict with Congressional intent for those expenses to be deductible. House Ways and Means Chair Richard Neal (D-MA) seems to agree with Chairman Grassley. A spokesman for Ways and Means told Bloomberg, “we are planning to fix this in the next piece of response legislation.”
Though it may have been Congress’s intent for those expenses to be deductible, there is a logic to the IRS’s position. Allowing deductions, while also removing the loan forgiveness from income, would functionally allow businesses to double dip, generating large NOLs. Additionally, the design of PPP is really such that the business is simply a conduit for relief for employees. The federal government pays their salaries, through the business, to help keep them attached to the labor force and their employer, without forcing the employer to use their own resources.
However, there is a great deal of support for Chairman Grassley’s position too. Loan forgiveness tax rules are found in Internal Revenue Code (IRC) section 108. Then, IRC section 265(a) outlines that the expense deductions would be denied because the income isn’t taxable. However, Congress did not reference section 108 in its PPP loan forgiveness statutes, instead opting to create a new section of the IRC. Arguably, the lack of reference means that Congress considered section 108 and specifically did not want those rules to apply. The IRS might respond that the lack of reference was the result of quickly writing legislation in less than two weeks.
When Congress is sending trillions of dollars out the door to help struggling businesses and individuals, it would make sense for them to have chalked this up as another way to help, to the Chairman’s point. They also made NOL rules more generous in the CARES Act to help with further tax relief for businesses, indicating Congressional interest in expanding NOLs generally for the purpose of easing tax burdens.
Another related issue is how this guidance and the loan forgiveness provisions will intersect with section 199A of the IRC, which provides a 20 percent deduction to many pass-through businesses, many of which likely received PPP loan funds. A business’s qualified business income (QBI) deduction is limited to “50 percent of the W-2 wages with respect to the qualified trade of business” or “the sum of 25 percent of the W–2 wages with respect to the qualified trade or business, plus 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property.” The limit helps ensure that a business owner doesn’t game the provision, providing a safeguard that their wage income and their business income are separate.
Accountant Adam Markowitz wondered on Twitter if the IRS’s position would be to not include wages paid via PPP loan proceeds that are later forgiven in the QBI calculation. Given that the wages would still be taxable on a W-2 to the employee, it is likely. But Congress should go ahead and provide clarity for small businesses across the country.
The ball, then, is back in Congress’s court. Congress is expected to pass another coronavirus-related bill in the next several weeks. If other members of Congress agree with the Chairman’s assessment, clarifying their intent in the new bill is paramount. At a time of economic crisis, taxpayers need certainty.