The rules governing the Paycheck Protection Program (PPP) have evolved since the passage of the CARES Act on March 27, 2020, and lenders began accepting loan applications on April 3, 2020.

The Small Business Administration (SBA), in consultation with the Treasury Department, has released numerous documents containing guidance for borrowers and lenders. It has also published over 20 draft final rules, over 48 frequently asked questions (FAQs) and two loan forgiveness requests, one long form and one EZ form. All these directives have been published on the Treasury website website, and more is sure to come.

Some have compared the design and execution of PPP to flying an airplane while trying to build it. As the analogies go, it works.

The only thing that has not changed is the taxation of PPP loans and remittances, although the IRS has clarified some of the rules of Notice 2020-32. So what are the tax rules for PPP and loan forgiveness?

This article will discuss various tax aspects of PPP, including receipt of the loan, cancellation of the loan, estimated tax implications, the ability to file amended or replacement income tax returns, and the favorable tax treatment applicable to self-employed and to general partners.

Receipt of the PPP loan

Borrowers are not subject to tax on receipt of the proceeds of the PPP loan as they are required to repay the loan. This results from the application of a conventional tax rule and there is nothing different or unique about how it applies to PPP.

Loan remission

The next part of the equation is the loan forgiveness process. When all or part of a loan is canceled, it results in Debt Cancellation Income (COD). COD income is usually included in gross income because a taxpayer has been released from the obligation to repay and the release of assets is considered an accession to wealth. This principle would have applied to the loan forgiveness under a PPP loan, but Article 1106 (i) of the CARES Act stipulates that the amount of the loan forgiveness under a PPP loan is excluded. of gross income. Thus, borrowers are not subject to tax when they are exempt from their obligation to repay their PPP loans. This is a favorable aspect of the PPP loan program, but it has been confusing.

The confusion does not arise from the tax-exempt nature of COD income, as this is clear from the wording of the CARES Act; rather, it arises from the fact that borrowers will have to pay additional income tax as a result of the loan forgiveness because the payroll and other covered expenses related to the loan forgiveness are apparently not deductible for tax purposes. . The IRS took this position in Notice 2020-32, where it stated that expenses otherwise deductible in a borrower’s business or business are not deductible if they result in a forgiveness of a loan under a loan. ‘a PPP loan.

While most tax professionals do not dispute the IRS’s finding from a technical tax perspective, others believe it flies in the face of Congress’ intent because it negates the benefit of the IRS. income exclusion. Consider this: Without the exclusion, borrowers would have offsetting reimbursement income and deductible expenses; with the exclusion, they would have no COD income or reimbursement of expenses. Either way, the borrowers are economically in one place, which means that the IRS’s interpretation removes the advantage that some argue Congress intended to give borrowers, that is to say., non-taxable income and deductible expenses.

Here’s an example: A borrower with $ 10 in income and $ 6 in expenses would normally have $ 4 in taxable income. This is the basic case – now let’s add a $ 3 P3 loan that is fully forgiven. Without the COD income exclusion, the borrower would have taxable income of $ 7 ($ 10 + $ 3 in income and $ 6 in expenses); with the exclusion and denial of expenses, the borrower would still have taxable income of $ 7 ($ 10 in income and $ 6 – $ 3 in expenses). Either way, the borrower ends up paying tax on the loan forgiveness amount of $ 3. Supporters of the Congressional intention argument would say that the borrower should not have to pay tax on this amount and should have $ 4 in taxable income ($ 10 + $ 0 in income and $ 6 – 0 $ of expenses).

Impact of IRS Notice 2020-32

As noted above, the practical effect of expense rejection is that borrowers are required to pay tax on the loan forgiveness amount. This effect may impact the current fiscal year or other fiscal years by reducing the net operating loss. Consider this example: a borrower with $ 2 million in income and $ 2.4 million in expenses in 2020 would normally have a taxable loss of $ 400,000. The loss has value to the borrower because it can offset income from other tax years, either by carrying back for five years (under a special provision of the CARES Act) or by carrying forward indefinitely. However, if $ 400,000 in expenses were related to a loan forgiveness, those expenses would not be deductible and the borrower would have $ 0 in taxable income ($ 2 million in income minus $ 2 million in expenses) and no loss. taxable to offset income from other years.

Estimated tax payments and amended tax returns

There are tax consequences due to the rule of non-amortization of expenses in Notice 2020-32. Borrowers may need to increase their estimated tax payments during the year to account for the increase in tax payable that will be due for 2020 (and to avoid penalties if they are relying on the estimated safe harbor of tax payments for the current year), and they must decide whether to include the relevant deductions on their 2020 tax returns.

Under the section of the tax code that the IRS relied on in Notice 2020-32, expenses that result in a tax-free loan forgiveness are not deductible “whether or not. [the loan forgiveness amount] is received or accumulated. We expect the IRS to take the position that these expenses are not allowed on the 2020 tax return to the extent of the expected loan cancellation amount, which for the vast majority of borrowers will be 100%. . There is another issue with which expenses to disallow (interest, rent, utilities, or payroll) and this decision may affect a borrower’s deduction for interest payments under Article 163 (j). The IRS did not address this issue as part of the P3.

If a borrower excludes P3 expense deductions on their 2020 income tax return and later learns that they will receive a different loan forgiveness amount, then they can make the necessary adjustments by filing a 2020 income tax return. amended at that time if the due date (including the extension) for that return has passed, or by filing a replacement income tax return if the due date has not passed.

Are these rules going to change?

Legislative efforts are underway to reverse the no-amortization expense rule, as explained in Advisory 2020-32, and to restore the tax deduction for expenses that resulted in loan forgiveness. Anyone can guess if this goes ahead, but unless and until it does, taxpayers are stuck with the notice.

Favorable tax treatment of self-employed persons and general partners

Another key issue regarding the taxation of PPP loans is the disparate and favorable treatment accorded to freelancers and general partners in partnerships. For these two categories of borrowers, they will benefit from a tax-free loan forgiveness like everyone else, but they will not experience expense denials in regards to their homeowner’s compensation replacement amounts because these amounts are not otherwise deductible, that is to say., there is no deduction to refuse.

Thus, a self-employed person completing Schedule C with their 1040 income tax return form will realize tax-free income of up to $ 15,385 if she uses a covered period of 8 weeks on her PPP loan, and up to $ 20,833 if she uses a 24 week covered period on her PPP loan. The same result will be obtained for a general partner in a partnership who receives a drawdown (as opposed to a guaranteed payment) for the replacement amount of his owner’s indemnity. It should be noted that this favorable treatment only applies to the replacement amounts of the compensation for the owners of the self-employed and general partners, and it does not apply to the wage costs of employees.

These favorable disparities (although whether they are seen as favorable or not depend on one’s point of view) are not the result of special tax rules under the PPP. Instead, they flow from general tax principles and from the fact that the amount of the tax-free loan forgiveness is the wages of these people. There is no third party who receives tax-free income and then claims a deduction for the payment of his salary. An employee in a similar situation who works for a corporation, partnership or self-employed person will not benefit from the same beneficial tax treatment because he receives taxable wages from his employer, and the employer is the person who benefited from it. a tax-free loan forgiveness. (and cancellation of expenses). The IRS is aware of this problem and may issue further guidance.

The PPP has changed since its inception, and more changes are expected, especially if new PPP legislation is enacted as part of the next round of stimulus funding. Tax rules may also change, and at least one draft tax PPP legislation has been released. Until we have more information, be sure to buckle up your seat belts on this flight as engineers are still tweaking the plane.

This column does not necessarily reflect the opinion of the Bureau of National Affairs, Inc. or its owners.

Author Info

Daniel Mayo is a Director at Withum and has over 20 years of professional tax experience as well as federal, international and financial product tax experience. He is a member of Withum’s National Tax Services Group and oversees the US federal income tax research, planning and review functions. He is experienced in mergers and acquisitions, capital markets and cross-border transactions.