The IRS issued Notice 2020-32, which “provides guidance regarding the deductibility for Federal income tax purposes of certain otherwise deductible expenses incurred in a taxpayer’s trade or business when the taxpayer receives a loan (covered loan) pursuant to the Paycheck Protection Program [PPP] under section 7(a)(36) of the Small Business Act (15 U.S.C. 636(a)(36)).”
In easy terms, the IRS issued its guidance on how the forgiveness part of the PPP loans will be handled by small businesses on their 2020 tax returns.
What’s The Problem?
The CARES Act stipulates explicitly that if the portion forgiven by the PPP loan shall not be considered gross income and the IRS confirms that in their notice, “…any amount that (but for that subsection) would be includible in gross income of the recipient by reason of forgiveness described in section 1106(b) shall be excluded from gross income.”
However, the IRS notice explains there is nothing in the CARES Act addressing the deductibility of payroll expenses if the loan is forgiven.
In IRS language, “Neither section 1106(i) of the CARES Act nor any other provision of the CARES Act addresses whether deductions otherwise allowable under the Code for payments of eligible section 1106 expenses by a recipient of a covered loan are allowed if the covered loan is subsequently forgiven under section 1106(b) of the CARES Act as a result of the payment of those expenses.”
What Does This Mean?
The IRS is saying that the payroll portion of the PPP loan, if forgiven, cannot be deducted as a business expense.
Let’s do some basic math
Assuming the S.B.A. forgives $10,000 of the PPP loan, and your business gross income is $300,000. Your payroll for the year is $100,000, and your other business expenses are $150,000, leaving you with an annualized profit of $50,000.
If the IRS prohibits the deduction of the forgiven payroll expense, assuming all other numbers stay the same, your deductible payroll expense is now $90,000, your other costs are still $150,000, leaving you with a $60,000 profit on the same $300,000 gross sales.
That is an additional $10,000 in taxable income. Wait…! Isn’t that the same amount as the forgiven portion… Exactly!
While the CARES Act excludes the forgiven portion to be considered gross income, the IRS guidance based on its deduction rules says the payroll expense covered by PPP cannot be deducted, which is a scenario not directly included in the CARES Act language.
Why Does It Matter?
You may wonder why this matters, especially if your gross sales are much lower and your business may show a loss this year, then this is all academic, right? Not exactly!
If you record a business loss during a tax year, the IRS allows you to carry forward the business loss to subsequent tax year(s).
While the law on this changed in 2017 with the Tax Cuts and Jobs Act (TCJA) and is now less “abusive,” it is still possible to carry forward business losses to reduce the tax burden in future profitable years.
For those new to running your own business and possibly fortunate in never having had to deal with an operating loss before, this may be unfamiliar territory.
In effect, at some point down the road, based on the guidance by the IRS specific to the PPP loans, the amount of the loan forgiveness will become taxable.
But… That’s Not How This Was “Sold”
For a business to qualify for the PPP loan, the business owner has to certify that the coronavirus emergency had a detrimental impact on their business.
The PPP loan’s big selling point was the “forgiveness” feature, and some business owners may have looked at the PPP program as a “free” method to keep trained and knowledgeable staff employed during this trying time.
It’s a bit of a win-win for employer and employee, even with all the problems surrounding the PPP loan application process.
The only other real option was layoffs, which could be personally challenging for many business owners who have close relationships with long-time employees.
Also, layoffs may come with another cost in higher unemployment contributions for businesses, adding a different expense.
And, it may be more difficult to restart the business if laid-off employees find other jobs or decide not to come back, requiring the business to train new staff.
While the potential tax burden on small business owners is delayed until at least next year, and the “tax cost” for many owners may very likely make it worth keeping employees, it is just another punch to gut now.
Was this really what Congress intended?
Could This Tax Burden Change?
Several options could result in a change to the guidance issued by the IRS on the deductibility of payroll expenses covered through the loan forgiveness portion of a PPP loan.
The easiest way is for Congress to clarify its intent on this issue and expressly allow the deduction of the “forgiven” payroll expense. The AICPA believes that was Congress’s intent in the first place.
“The AICPA believes strongly that the IRS’s interpretation denying deductions of expenses forgiven under the PPP program is contrary to Congress’s intent. Chris Hesse, CPA, chair of the AICPA Tax Executive Committee, said: “In effect, the IRS guidance means that the taxability provision [Section 1106(i)] has no meaning. Why waste the ink to say that for purposes of the Code, the loan forgiveness is not includible in income, if the government will just take away deductions in the same amount?”
It is not uncommon for Congress to make changes to big legislation after the fact to correct unintended consequences or ambiguity in the law’s language. This requires lawmakers to add the change to a future bill that “corrects” the problematic text.
Another option could be through a lawsuit against the IRS challenging its interpretation of the CARES Act regarding the tax burden on PPP loans, claiming congressional intent was not to tax the loan forgiveness portion.
And in theory, there could be other processes such as the Administration providing different guidance to the IRS or through a Presidential Executive Order, but all of these are potentially highly political maneuvers.
Considering the bipartisan nature of the CARES Act, the easiest way for Congress is to clarify its intent. Business owners who are concerned about this hidden tax cost should contact their Senator and Representative in the House to pressure them for clarification.
It appears the IRS is interpreting the law as written, but Congressional intent may have been different.
Update 5/2/2020 4:28pm – Congressional Response
Two lawmakers are now on record stating the intent was to preserve the deductibility of the expenses, contrary to the IRS notice.
“The intent was to maximize small businesses’ ability to maintain liquidity, retain their employees and recover from this health crisis as quickly as possible. This notice is contrary to that intent,” said Senate Finance Committee Chair Chuck Grassley, R-Iowa.
“We are planning to fix this in the next response legislation,” said House, Ways and Means Committee Chair Richard E. Neal, D-Mass through a spokesperson.
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