2020’s Next Small Business Catch-22: Expense Deductions or PPP Loan Forgiveness?

by Prof. Robert Bloink and Prof. William H. Byrnes

Now that the dust has started to settle and employers have moved to reopen, many will have to revisit decisions made during the early-pandemic crisis moments. The paycheck protection program (PPP) loan program provided a vital source of liquidity for many small business clients during the early months of the pandemic. Now that the funds have likely been spent and business clients attempt to return to some level of normalcy, it’s important to remember one important caveat: the loss of valuable business expense deductions. Although it was widely expected that Congress would act to prevent that loss, the basic IRS rule still stands today—PPP loan amounts that are forgiven can cause a loss of business expense deductions.

Now, clients should begin to evaluate whether they can or should opt to repay those loans in order to prevent tax surprises in 2021.

PPP Loan Basics

PPP loan forgiveness is determined based on how the small business client spent the loan proceeds. Importantly, at least 60 percent of the loan must be used for payroll costs. If the borrower meets all applicable requirements and applies for forgiveness, PPP loans can be forgiven entirely.

Under normal circumstances, when a loan or debt is forgiven, the forgiven amount is included in the debtor’s taxable income under cancellation of debt principles. Paycheck protection loans, however, are excluded from the generally applicable COD rules—meaning that amounts forgiven are not included in the recipient’s income when forgiven.

However, loan forgiveness is not without its costs. While amounts forgiven will not be included in income under the usual cancellation of debt rules, business owners are currently not entitled to their typical business expense deductions either.

In Notice 2020-32, the IRS clarified that otherwise allowable deductions are disallowed if the payment of the expense (1) results in loan forgiveness under the PPP loan program and (2) the income associated with the loan forgiveness is excluded from income under the CARES Act. The IRS position is that these payments are allocable to tax-exempt income and, as such, are not deductible under IRC Section 265.

Expenses like salary, rent, mortgage interest and utilities are generally deductible as ordinary and necessary business expenses under IRC Section 162. These are also exactly the types of expenses can be incurred in order for a business to receive loan forgiveness under the CARES Act. To prevent double dipping, the IRS specifically disallows these and other otherwise-allowable deductions.

Do PPP Loan Recipients Have Any Options?

It remains possible that Congress will act to override the IRS position and allow small business clients their business expense deductions despite loan forgiveness. Of course, clients also have the option of foregoing loan forgiveness entirely and taking their usual business expense deductions.

For many small business clients, foregoing loan forgiveness isn’t a viable option—and it’s one that could be a mistake in the long run. Under the express terms of the CARES Act, amounts that would be includable in gross income because of loan forgiveness are to be excluded from gross income. Denying a taxpayer’s otherwise allowable business expense deductions essentially adds the loan amounts back into the client’s taxable income—assuming the amounts were used for their intended purpose.

Most small business owners should be advised to hold off on applying for forgiveness even though the Small Business Administration began accepting applications in August. If the issue isn’t resolved by tax time in 2021, the client might also consider applying for an extension.

Some clients might even opt to apply for forgiveness, take their usual business expense deductions and fight the IRS if they’re challenged next year. As of now, the matter is sufficiently unresolved that it could be possible to win—unless, of course, Congress specifically acts to support the current IRS position.

Conclusion

In the end, clients’ risk tolerance and current ability to repay PPP loans will likely govern how they opt to treat business expense deductions for 2020. Without clarification from Congress, clients’ uncertainty will likely spill over into tax season—meaning that they’ll be forced to make some difficult choices in an already difficult economic climate.