Deductibility of Expenses Paid for with PPP Loans and Other Relief Provisions

January 12, 2021 - The “Consolidated Appropriations Act, 2021 (CAA, 2021)” was signed into law on December 27, 2020. The new bill provided a number of provisions designed to financially help out businesses affected by COVID-19.  Among the tax provisions in the new bill, CAA, 2021 overruled the Internal Revenue Service by providing for tax-free forgiveness of PPP loan proceeds and by allowing businesses to deduct eligible expenses paid with PPP funds.  In addition, CCA, 2021 extends the eligible loan subsidies, and reestablishes the Economic Injury Disaster Loan Advances.

PPP Loan Forgiveness

The Internal Revenue Code broadly defines gross income as “all income from whatever source derived.”  Generally, loan proceeds are not considered gross income and are not taxable as long as the loan is required to be repaid and is deemed to be bona fide debt.  However, a loan could become taxable if it is forgiven by the lender, or was repaid by someone else. The Paycheck Protection Program (PPP) established by the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) provided for loans to eligible businesses affected by Covid-19.  These loans would not be required to be repaid, to the extent the proceeds were used to pay for eligible expenses, as defined in the Act.   

Congress knew that relief from an obligation to repay a PPP loan could create taxable income. With this in mind, Congress specifically put a section within the CARES Act stipulating that any amount that would otherwise be considered taxable income by reason of forgiveness “shall be excluded from gross income.” This provision excludes from a borrower’s gross income any income arising from the forgiveness of a PPP loan, regardless of whether the income would otherwise be characterized as income from the discharge of indebtedness or includible in gross income under any other code section.

Normally ordinary and necessary business expenses, such as salaries and rent, are deductible in determining taxable income. The IRS agreed that the income related to a forgiven PPP loan was not considered taxable, as stipulated by Congress. However, the IRS took the position that expenses paid with PPP loan proceeds that would generally qualify as ordinary and necessary business expenses were nondeductible.

Notice 2020-32 stated the IRS position that deductions for expenses paid with PPP loan proceeds are disallowed when the income associated with the forgiveness is excluded from gross income as the payment of those expenses is allocable to tax-exempt income.  The IRS further cemented their position with Revenue Ruling 2020-27.

Members of Congress realized the unintended tax burden this could put on individuals and businesses that were already being hit hard by the Coronavirus restrictions.  As a result, Congress continuously criticized the IRS’s position.  Congress argued that the denial of deductions related to the tax-free forgiveness of a PPP loan undermines the legislative intent of the PPP.

The Consolidated Appropriations Act, 2021 (the CAA, 2021), signed into law on December 27, 2020 addressed this issue and stated Congress’ original intent. CAA, 2021 retroactively amends the CARES Act to provide that no amount should be included in the gross income of a PPP participant, no deduction shall be denied, and no tax attribute should be reduced, by reason of any PPP loan forgiveness.   In addition, CCA, 2021 clarifies that any amount forgiven will be treated as tax-exempt income and will increase a partner’s basis in a partnership and a shareholder’s basis in an S corporation.          

CAA, 2021 also clarifies that gross income does not include forgiveness of EIDL loans, emergency EIDL grants, and certain loan repayment assistance.  In addition, the provision clarifies that no deduction will be denied, no tax attribute will be reduced, and basis will be increased, if one of these specified loans is forgiven.   

Eligible Loan Subsidies

The CARES Act included a provision that states the SBA will pay for a six-month period, the principal, interest, and any associated fees that small businesses owe on previous 7(a) loans, 504 loans, and microloans.  CAA, 2021 extends the period that the Small Business Administration will make these principal and interest payments for an additional three months beginning in February of 2021.  

EIDL Advances

The CAA, 2021 also reinstates the EIDL Advance.  This will allow businesses suffering a substantial economic injury to apply for an advance that does not need to be repaid or up to $1,000 per employee limited to $10,000 total.

In order to qualify for the full “Targeted EIDL Advance” of $10,000 a business must:

  • Be located in a low-income community, and
  • Have suffered an economic loss greater than 30%, and
  • Employ not more than 300 employees

In addition, the business must qualify as an eligible entity as defined in the CARES Act: 

  • A small business, cooperative, ESOP Tribal concern, with fewer than 500 employees
  • An individual who operates under as a sole proprietorship, with or without employees, or as an independent contractor; or
  • A private non-profit or small agricultural cooperative.
  • The business must have been in operation by January 31, 2020
  • The business must be directly affected by COVID-19

The $10,000 “Targeted EIDL Advance” that the borrower might be eligible for under the CAA 2021 shall be reduced by any Economic Injury Disaster Loan advance previously received under the CARES Act.

Prior law under the CARES Act stated that any EIDL Advance received would reduce PPP Loan Forgiveness, essentially requiring the EIDL Advance to be repaid.  This provision has been repealed, so the receipt of an EIDL Advance will have no impact on PPP loan forgiveness and essentially would not be required to be repaid.  It is yet to be determined if a borrower has already applied for forgiveness of their PPP loan if the SBA will automatically forgive the $10,000 EIDL advance or if the borrower will have to amend their forgiveness application.

Although very complex and extensive, the “Consolidated Appropriations Act, 2021 (CAA, 2021)” included a lot of provisions designed to give some relief to businesses that were hit hard.  If you have any questions or if you would like to discuss any of these provisions, please contact your tax professional at Dermody, Burke & Brown, CPAs.

 

The information reflected in this article was current at the time of publication.  This information will not be modified or updated for any subsequent tax law changes, if any.