Paycheck Protection Program: Tax Treatment of Receipt and Use of Funds

May 4, 2020

The Paycheck Protection Program (PPP) provides clarity on Section 1106(i) of the CARES Act, specifically stating that the forgiveness of the loan proceeds does not constitute taxable income. Whether or not the expenses paid with those funds could be deducted was left unaddressed. However, the Internal Revenue Service (IRS) announced in Notice 2020-32 that the business expenses covered by the PPP funds are NOT deductible.

The IRS is basing its position on IRC 265(a)(1), which provides that any otherwise allowable deductions that are attributable to a “class of exempt income” are not deductible. A “class of exempt income” is defined as income that is either excluded from gross income or exempt from tax. The rationale for this position is that allowing both an income exclusion and a deduction results in a double benefit for the taxpayer.

Because the PPP proceeds are restricted use funds, the forgiven loan amount can be easily traced to payroll costs, rent, utilities, and certain interest paid. Thus, these targeted expenses would not be deductible to the extent the loan is forgiven.

Left unclear is any timing issue. As a loan program of this magnitude is unprecedented, there is no telling how long it will take the banks to work through the forgiveness calculation for every loan. What happens if forgiveness occurs in the subsequent taxable year? Until a loan is forgiven, it is bona fide debt on the books. Expenses paid from the use of debt proceeds is deductible. The timing difference is typically addressed via the discharge of indebtedness rules, which make forgiven debt taxable to solvent companies. If the loan is not forgiven in the same year it was granted, should the taxpayer treat the related expenses as nondeductible for the amount that is expected to be forgiven, or hold their tax return open until the forgiveness is completed? We anticipate future clarity on this matter.

Even with the non-deductibility of the related expenses, the loan is still a lifeline and a good deal for most businesses. Below is an example of two types of businesses, each having the same costs, but one business is able to operate and generate revenue with a cut in workforce, while the other business is shut down and has laid off all of their employees.

  Operating Business   Shut Down Business
  With PPP Without PPP   With PPP Without PPP
Revenue 120,000 120,000  
Payroll costs 100,000 30,000   100,000
Employer taxes 7,650 2,295   7,650
Rent, utilities 15,000 15,000   15,000 15,000
Portion of expenses paid by PPP (115,000)   (115,000)
Net expenses 7,650 47,295   7,650 15,000
Net cash flow (deficit) 112,350 72,705   (7,650) (15,000)

Under both scenarios, the business comes out ahead by taking the PPP funding. The loan is subsidizing certain expenses, which frees up cash to be used for other expenses not otherwise covered. Each business should go through the exercise of modeling this, since each business has its own set of facts and circumstances.

Should the business conclude that the PPP funds are not going to be to its advantage, loan disbursements should not be taken or any loan proceeds should be immediately repaid.

As a separate matter, it is unclear at this time how the replacement compensation for partners and sole proprietors will be treated. Clarification will likely be forthcoming that will require the partner or sole proprietor to pick up the replacement compensation in income, subject to self-employment tax. It is very unlikely that this will be tax-free; thus, such recipients should plan to set aside sufficient tax to meet this eventual obligation.

For further information on the PPP and other government relief programs, please visit our COVID-19 resources hub or contact your Aronson advisor at 301.231.6200.