Deductions for PPP Covered Expenses – Almost There; How Will Your Business Use the Tax Savings?
May 18, 2020
What Did You Do Last Night?
“Friday night, May 15 . . . You didn’t watch the roll call vote in the House? . . . On CSPN . . . The HEROES Act. . . . C’mon, seriously. . . . Really? . . . You had no interest whatsoever? . . . Foregone conclusion? . . . Hmm, probably, but there were a couple of surprises. . . . No, I don’t get a kick out of watching paint dry.”
The House passed the “Health and Economic Recovery Omnibus Emergency Solutions Act,” or the “HEROES Act,”[i] just before 9:30 pm yesterday, by a vote of 208 to 199,[ii] with 23 members not voting.[iii] If enacted, the HEROES Act will represent the fifth piece of major Federal legislation aimed at combatting the domestic health and economic effects of the coronavirus pandemic.[iv]
The bill will now be sent to the Senate, where the Republican majority has already stated that the measure does not stand a chance of being passed in its current form; the majority leader, Senator McConnell, described the proposed legislation[v] as a “liberal wish list,” and the White House has threatened to veto the measure if it somehow gets through the Senate with too many of its “offending” provisions intact.
Truth be told, the scope of the HEROES Act is not limited to dealing with the COVID-19 health crisis and with the economic consequences arising from the government-ordered shutdown of many businesses as part of our effort to contain the spread of the coronavirus.
Indeed, the bill modifies or expands a wide range of other programs and policies, including those regarding Medicare and Medicaid, health insurance, broadband service, immigration, student loans and financial aid, the federal workforce, prisons, veterans’ benefits, consumer protection requirements, the U.S. Postal Service, federal elections, aviation and railroad workers, and pension and retirement plans.[vi]
Glass Half Full?
That being said, the bill also provides payments and other assistance to state and local governments to help them through the financial crisis in which they find themselves as a result of the pandemic; modifies and expands the Paycheck Protection Program (“PPP”),[vii] which provides loans and grants to small businesses and nonprofit organizations;[viii] establishes a fund to award grants for employers to provide pandemic premium pay for essential workers; expands several tax credits and deductions;[ix] allow companies with forgiven PPP loans to defer their payroll tax payments; provides funding and establishes requirements for COVID-19 testing and contact tracing; requires employers to develop and implement infectious disease exposure control plans;[x] and more.
The Act would also suspend the $10,000 cap on the itemized deduction for state and local income taxes for 2020 and 2021.[xi]
In other words, there are enough items in the bill on which both Democrats and Republicans can agree, if they are ready and willing to act reasonably.
Significantly, among these items is a provision that addresses the deductibility of business expenses paid with the proceeds of a PPP loan.
Tax Deductibility of Business Expenses
Under the Code, taxpayers are allowed to deduct any ordinary or necessary trade or business expenses from their gross income.[xii] This would normally include PPP-eligible “covered” expenses like wages or other compensation, paid employee leave and fringe benefits, rent or utility payments associated with a business facility, interest on certain business debt, and state tax payments.
The CARES Act has no language referring to the deductibility of PPP expenses.
This left many tax advisers wondering what Congress intended; specifically, should a business that enjoyed the tax-free forgiveness of its PPP loan[xiii] also be allowed to claim a tax deduction for the expenses paid with the proceeds from the forgiven PPP loan?
Many were troubled by this “double benefit” from a conceptual perspective – it seemed out of balance, as indeed it is. They argued that an express legislative statement would be needed if Congress intended to allow a deduction for covered expenses incurred by a taxpayer whose loan is forgiven under the PPP.
Others pointed out that, if Congress meant to disallow the double benefit, why was the exclusion of the loan forgiveness from gross income explicitly provided in the legislation? If Congress had remained silent, they contended, the forgiveness would have generated cancellation of indebtedness income,[xiv] and the business would have claimed a deduction for the expenses paid with the loan proceeds.
On April 30, 2020, however, the IRS issued Notice 2020-32, setting forth the IRS’s position that recipients of PPP loans cannot claim a deduction for expenses funded from a PPP loan that has been forgiven.[xv] In support of its position, the IRS relied upon that provision of the CARES Act under which forgiven PPP loans are not to be included in the borrower’s gross income and, thus, are not taxable.[xvi]
As explained below, the IRS’s guidance would reduce the economic benefit of PPP loans.[xvii]
Within one week of the issuance of Notice 2020-32, a bipartisan-sponsored bill was introduced in the Senate – S. 3612, the Small Business Expense Protection Act of 2020[xix] – which would add the following language to the end of Section 1106(i) of the CARES Act (which excludes the forgiven PPP loan from gross income): “and . . . no deduction shall be denied or reduced, no tax attribute shall be reduced, and no basis increase shall be denied, by reason of the exclusion from gross income.”
The HEROES Act, introduced on May 12, and passed by the House on Friday, May 15, includes a similar provision, which reads as follows: “notwithstanding any other provision of law, any deduction and the basis[xx] of any property shall be determined without regard to whether any amount is excluded from gross income under section 20233 of this Act or section 1106(i) of the CARES Act.”[xxi]
Although the Senate has not yet passed its version of this provision, I’d wager that the IRS has heard enough from Congress, generally, to realize that the legislature’s intent was to allow the borrower-business to claim a deduction, for purposes of determining its income tax liability, for the business expenses paid with the PPP loan proceeds, without regard to whether such loan is forgiven or not.
Hopefully, the IRS will act on this realization and immediately withdraw Notice 2020-32. There is no reason to hold the deduction hostage to Congressional negotiations on other items in the HEROES Act bill – businesses deserve at least that degree of certainty as they move into an otherwise uncertain future.[xxii]
Double Benefit =’s Reserves?
Speaking of uncertainty or, more accurately, perhaps one way for a business to prepare for its inevitable arrival, is to utilize the double benefit described above to establish a cash reserve. This, in turn, would address, at least in part, a shortcoming of many businesses, one that both accelerated their economic downturns and aggravated the adverse consequences thereof.
This opportunity afforded by the double benefit may be best conveyed with a simplistic example.
First, assume a business receives a conventional loan of $100. The borrower-business receives the proceeds tax-free; they represent a loan, after all. The business uses the $100 loan to pay certain expenses. The lender forgives the loan, and the business realizes taxable income from the discharge of indebtedness. However, because the expenses paid by the business are deductible for tax purposes, the business has no income tax liability at that point.
If the business later realizes a profit of $100 net of related expenses, it will owe income tax thereon. If the business is a C corporation, its Federal income tax liability will be $21, and it will be left with $79.
Now assume the business receives $100 of PPP loan proceeds. These are received tax-free. The business uses the $100 loan to pay certain expenses, as required under the PPP, and the SBA subsequently forgives the $100 loan. Pursuant to the CARES Act, this debt forgiveness is not treated as taxable income to the business and, under Notice 2020-32, the business is not allowed to deduct the expenses paid for purposes of determining its income tax liability. Because the business does not have any income from the discharge of indebtedness, the absence of a deduction has no impact on its tax liability, which is zero.
However, if the business subsequently earns a profit of $100 net of related expenses, it will owe income tax thereon in the absence of a deduction for its payment of the PPP-related expenses – no tax savings are realized from the payment of the PPP-covered expenses. If the business is a C corporation, its Federal income tax liability will be $21.[xxiii] It may retain the remaining $79 as a reserve, subject to establishing that the amount accumulated does not exceed the reasonable needs of the business.[xxiv]
Now assume that the expenses paid with the PPP loan are deductible by the business. In determining its taxable income for the year, the business excludes the forgiven loan from its gross income, as provided under the CARES Act. However, the business may deduct the $100 of PPP-related expenses against the subsequently earned $100 of profit; as a result, the business has no taxable income, nor does it have positive earnings and profits, for that year.[xxv] Thus, the business does not owe income tax on that $100 – a tax savings of $21 – and it may retain the entire amount as a reserve.
It will be a few weeks before the HEROES Act is negotiated to the point that it will pass muster in both the Senate and the House. In light of the clear Congressional intent, the IRS should not wait for a “final” legislative pronouncement regarding the deductibility of covered expenses that are paid with PPP loans before it withdraws Notice 2020-32 and acknowledges this tax benefit.
For the same reason, businesses that have received PPP loans, which they are reasonably confident will be forgiven by the SBA, should not squander the tax savings to be realized. Although many businesses will need the resulting liquidity to get back on their feet, those that can afford to do so should plan to set those funds aside as a reserve. You may recall the loan amount was determined by reference to 2.5 times the monthly “payroll costs” of the business[xxvi] – that’s not a bad place to start.
If the reserve is coupled with cutting fat and waste from a business, and with securing a line of credit, then the business will have placed itself in a much better position for the next economic downturn, whatever the reasons therefor.[xxvii]
[i] H.R. 6800.
Do you ever wonder what comes first, the statute’s full name or the acronym? CARES. HEROES. A reasonably strong argument can be made that some staff member in the Senate Finance Committee or in the House Ways and Means Committee thought of these emotionally-accented acronyms first – suspend for a moment, please, the definitional chicken and egg issue this presents – then found the words to match them in a reasonably coherent manner.
Have we seen the last of names like TEFRA, TRA, OBRA, EGTRRA, and their kind? Speaking as a traditionalist, I hope not.
[ii] One Republican, New York’s Peter King, voted for the bill, in part, because of its support for state and local governments. Mr. King will be retiring from the Congress shortly, after what will be his 14th term. 14 Democrats voted against the proposed legislation – according to the so-called “experts,” some of these were moderates who face a difficult re-election campaign in November and, so, could not support a measure that many described as “too partisan.” One is the Co-Chair of the Progressive Caucus – Ms. Jayapal thought the bill did not go far enough. https://www.rollcall.com/2020/05/15/house-narrowly-passes-3-trillion-coronavirus-aid-bill/
[iii] 12 Democrats and 11 Republicans. I’m not sure why these folks did not vote; given the number of Democrats who refused to follow the party-line, this had the potential to turn a vote that was already relatively close into a nail-biter.
[iv] The first four being (i) the Coronavirus Preparedness and Response Supplemental Appropriations Act, (ii) the Families First Coronavirus Response Act, (iii) the Coronavirus Aid, Relief and Economic Security Act, and (iv) the Paycheck Protection Program and Health Care Enhancement Act.
[v] Over 1,800 pages.
[vii] The Coronavirus Aid, Relief, and Economic Security Act (CARES Act; P.L. 116-136) established the PPP to provide short-term economic relief to certain “small” businesses and nonprofits. The initial authorization of $349 billion for PPP loans was exhausted by April 16, 2020. Congress authorized another $310 billion ($659 billion total) for PPP loans in the Paycheck Protection Program and Health Care Enhancement Act (P.L. 116-139).
[viii] Among other things, it would extend the forgiveness period to cover eligible costs incurred over 24 weeks (rather than the current eight weeks, during which most businesses have been, and will likely remain, closed by government order),
[ix] For example, it would retroactively expand the employee retention credit to cover 80% of as much as $15,000 in compensation per calendar quarter, limited to $45,000 for the year.
For more on the CARES Act’s tax credits, see https://www.taxlawforchb.com/2020/05/opting-out-of-the-ppp-there-are-some-tax-benefits-to-consider/.
[x] It also provides additional direct payments of up to $1,200 per individual; expands paid sick days, family and medical leave, unemployment compensation, nutrition and food assistance programs, housing assistance, and payments to farmers; eliminates cost-sharing for COVID-19 treatments; and extends and expands the moratorium on certain evictions and foreclosures.
[xi] As enacted by the 2017 Tax Cuts and Jobs Act (“TCJA”).
Unfortunately – and ironically – the Act would restore and make permanent the “Republican Tax Act’s” (the TCJA) limit on excess loss deductions for pass-through business losses that was suspended for 2018 through 2020 by the CARES Act. In addition, it would eliminate the CARES Act’s changes to the net operating loss deduction, which allows businesses to carry back losses from 2018 through 2020 for five years; the idea here was to enable qualifying businesses to generate liquidity through tax refunds for earlier years. The TCJA had eliminated the two-year carryback provision that was in effect before 2018.
[xii] IRC Sec. 162.
[xiii] Not a foregone conclusion at the inception of the loan.
[xiv] Subject to IRC Sec. 108, and its “offsetting” reduction of tax attributes; for example, the exclusion of COD from income for an insolvent taxpayer.
[xv] Payments on PPP loans are deferred for the first six months of the loan. Before that period is over, a borrower can apply for forgiveness of the loan for eight weeks of expenses as long as the borrower: (1) maintains the same number of full-time equivalent employees during specified time periods and (2) does not decrease salaries by more than 25 percent for employees that make less than $100,000 in annualized compensation. At least 75 percent of the loan must be used for payroll costs.
Late last week, the SBA issued the Paycheck Protection Program Loan Forgiveness Application, with instructions for calculating the loan forgiveness. OMB Control Number 3245-0407.
[xvi] Section 1106(i) of the CARES Act. In general, forgiven debt (“cancellation of debt income”) is included in the gross income of the borrower and is subject to income taxation. IRC Sec. 61(a)(11).
[xvii] With this said, many businesses could still find that the economic benefits of PPP loans outweigh the potential costs. https://www.taxlawforchb.com/2020/05/ppp-loan-forgiveness-and-the-denial-of-deductions-for-covered-expenses-whats-wrong-with-the-irss-position/
[xviii] It ain’t over till the tax lawyers sing.
[xx] Both S. 3612 and H.R. 6800 refer to basis in case an otherwise deductible expense paid with PPP loan proceeds has to be capitalized. See, for example, IRC Sec. 263A.
[xxi] Sec. 20235 of the Act.
[xxii] For many years now, we have been living with temporary measures. The Code is full of expiration dates. That’s no way to legislate. Business needs certainty; tax decisions should not be made primarily because a provision is expiring – they have to make sense from a business perspective. It’s bad enough that we’re in a general election year, with all the posturing which that entails.
[xxiii] IRC Sec. 11.
If the corporation wanted to eliminate its tax liability, it could make a deductible payment to its shareholders – for example, as “reasonable” compensation – but that would not reduce the aggregate tax liability of the corporation and its shareholders; rather, it would merely shift the tax burden to the shareholders. If the shareholders are individuals, the deductible payment would increase the aggregate tax liability because individuals are currently taxed at a higher maximum rate (37%) than the corporation.
[xxiv] The accumulated earnings tax under IRC Sec. 531 et seq. A corporation with no current or accumulated earnings and profits is not subject to this tax; its distribution of the accumulated funds would not be treated as a dividend for tax purposes. IRC Sec. 301, 312 and 316.
[xxv] Which “eliminates” its accumulated earnings tax problem.
[xxvi] Section 1102(a)(2)(E) of the CARES Act.