As Congress continues to negotiate COVID-19 relief legislation, there is one underreported item that could impact thousands of Americans and their businesses and lead to significantly higher than expected tax liability: deductibility of Paycheck Protection Program (PPP) expenses.
PPP loans were a central feature of the CARES Act Congress passed in March 2020 to help businesses cover payroll, rent, mortgage, utilities, and other expenses during the COVID-19 crisis. Businesses who meet certain criteria are eligible to have the loans forgiven. Over 5 million businesses have received loans totaling over $500 billion.
While tax law normally includes forgiven loans as taxable income, Congress explicitly excluded such amounts from gross income in the law that was passed. This ensures, for example, that a business that receives a $100,000 PPP loan to cover ordinary business expenses would not need to include that $100,000 as canceled indebtedness income. This makes sense: Congress was trying to get money out the door to keep businesses open, and none of the projections anticipated recapturing one-third of the amounts paid through later tax collection.
Everyone was therefore surprised on April 30 when the Internal Revenue Service (IRS) issued Notice 2020-32, disallowing ordinary business deductions for businesses that receive forgiven PPP loans. If a class of revenue is excluded from gross income, the IRS reasoned, associated deductions from that revenue ought to be disallowed. So that business with the $100,000 loan will have to add back $100,000 in expenses that the loan covered, putting them in the same situation as if Congress had taxed the forgiven loans to begin with.
The response from Congress was swift: a joint statement by Senate Finance Committee Chair Chuck Grassley (R-IA), Ranking Member Ron Wyden (D-OR), and House Ways & Means Committee Chair Richard Neal (D-MA) rejected the IRS interpretation, arguing that it ran counter to Congressional intent. Their statement said, “[A]s was expressed to Treasury during the development of the PPP, we did not intend to deny the deductibility of ordinary and necessary business expenses, nor did these small businesses expect to lose deductions for their business expenses when they applied for a PPP loan. Providing assistance to small businesses, only to disallow their business deductions as provided in Notice 2020-32, reverses the benefit that Congress specifically granted by exempting PPP loan forgiveness from income.” However, on November 18, the IRS issued Revenue Ruling 2020-27, reaffirming its conclusion that business expenses covered by PPP loans are not deductible.
Admittedly, Congress was silent in the CARES Act and did not explicitly authorize business expenses. This was probably because it didn’t think it had to: the status quo is that businesses can deduct their expenses. As we noted in May, while there is some logic to the IRS position, there is significant evidence for Congress’s intent to allow deductibility. Lawmakers established PPP loan forgiveness as a new section of the Internal Revenue Code rather than shoehorning it into existing rules, subjected it to conditions that mean it is not automatic, and enacted it alongside other provisions that increased the generosity of net operating loss (NOL) deductions.
The IRS seems fixed in its position, leaving it to Congress or the courts to fix. With Republican and Democratic leaders saying for months that PPP deductibility would be restored in the next COVID-19 relief bill, businesses have acted accordingly and used the full proceeds to stay in business and keep people employed. If Congress fails to rectify this issue in COVID relief legislation, it could stick millions of businesses with a $200 billion surprise tax bill that would threaten serious negative economic effects.