Yes, Small Businesses, Expenses Paid with Forgiven PPP Loans Are Deductible
The small businesses were worried, restless in their beds, as nightmares of tax liabilities danced in their heads. Then, in the late-night hours of Monday, December 21, 2020, a little holiday spirit was sprinkled over small businesses when Congress passed the Consolidated Appropriations Act, 2021. The President did not sign the bill into law until Sunday, December 27, 2020. The appropriations act includes the COVID-related Tax Relief Act of 2020, which provides for the full deductibility of ordinary and necessary business expenses that were paid with a forgiven or forgivable PPP loan.
In March 2020, the CARES Act was signed into law, and the Paycheck Protection Program (PPP) was created to provide much needed economic relief to small businesses struggling under the weight of state and local stay-at-home and business closure orders put in place to stem the tide of the coronavirus pandemic. The CARES Act provided for forgiveness of PPP loans that were used to cover payroll and other enumerated expenses, and specifically stated that a forgiven PPP loan was not taxable income. The legislation did not speak to the treatment of business deductions paid with such loans. One month later – after millions of dollars of PPP loans had been distributed – the IRS published Notice 2020-32, which provided guidance on the agency’s position that otherwise deductible business expenses paid with forgiven PPP loans would not be deductible because under section 265 of the Internal Revenue Code they flowed from a class of tax-exempt income – a forgiven PPP loan. Treasury Secretary Steven Mnuchin publicly stated that such “double-dipping” was not allowed. Although Congress informed Treasury directly that its position was contrary to the congressional intent of the PPP and the tax community and small business stakeholders also voiced their concerns with the agency’s position, the IRS released additional guidance in November that reaffirmed its position that otherwise deductible business expenses paid with a forgiven PPP loan, or one with a reasonable expectation of forgiveness, were not deductible.
On December 4, 2020, the Office of Advocacy (Advocacy) held a roundtable to discuss the federal and state tax issues surrounding the PPP, which approximately 150 people attended. The roundtable speakers, representatives of KPMG and the Tax Foundation, both opined – and the majority of small business stakeholders in attendance agreed – that the IRS guidance on the deductibility of expenses paid with forgiven PPP loans missed the mark and undercut the purpose of the PPP. Advocacy conveyed the need for a legislative fix for the issue to the House and Senate Small Business Committees in a December 15, 2020, letter.
Without a legislative fix, small businesses with forgiven PPP loans or those with a reasonable expectation of forgiveness were facing likely tax increases of up to 37 percent for 2020. For many small businesses, such an increase would be devastating to their financial health and create an insurmountable deficit in the uncertain economic times the pandemic has created. Finally, Congress stepped in and clearly stated that business expenses paid with forgiven PPP loans are deductible. Section 276 of the bill states:
For purposes of the Internal Revenue Code of 1986—
‘‘(1) no amount shall be included in the gross income of the eligible recipient by reason of forgiveness of indebtedness described in subsection (b),
‘‘(2) no deduction shall be denied, no tax attribute shall be reduced, and no basis increase shall be denied, by reason of the exclusion from gross income provided by paragraph (1), and
‘‘(3) in the case of an eligible recipient that is a partnership or S corporation-
‘‘(A) any amount excluded from income by reason of paragraph (1) shall be treated as tax exempt income for purposes of sections 705 of the Internal Revenue Code of 1986, and ‘‘(B) except as provided by the Secretary of the Treasury (or the Secretary’s delegate), any increase in the adjusted basis of a partner’s interest in a partnership under section 705 of the Internal Revenue Code of 1986 with respect to any amount described in subparagraph (A) shall equal the partner’s distributive share of deductions resulting from costs giving rise to forgiveness described in subsection (b).’’
The deductibility of business expenses paid with forgiven PPP loans is effective for subsequent PPP loans, as well as for business expenses paid with emergency Economic Injury Disaster Loan (EIDL) grants and targeted EIDL advances. This legislative fix makes the PPP a true lifeline for small businesses who are struggling during the pandemic. The holiday wishes of many small businesses have been granted, and Congress could be heard saying as they drove off the Hill, “A better tax season to all, and to all a good night!”
Charles Jeane is an Assistant Chief Counsel for Advocacy whose portfolio includes tax policy. Charles can be reached at Charles.Jeane@sba.gov.