income tax

Taxation of PPP loan forgiveness – redux

This post revisits the issue of taxation of PPP loan forgiveness, defending the IRS’s disallowance of the deduction of expenses paid with forgiven PPP loans. A better use of the money would be to help employees directly or businesses that are so hard hit they aren’t worrying about their tax bills, because they don’t have enough income to pay tax.

I have previously blogged about the taxation of the forgiveness of PPP loans: here and here. To briefly recap, the CARES Act exempted PPP loan forgiveness from taxation (most other loan forgiveness is taxable). But the Act did not exempt expenses paid with the loan proceeds from I.R.C. § 265’s prohibition on deducting amounts paid with exempt income. Thus, the IRS opined that the disallowance still applied, effectively negating most, if not all, of the tax benefit of the CARES Act’s exempting the loan forgiveness. That is so because the CARES Act requires PPP loan proceeds to be spent on deductible items (mainly payroll but also rent and mortgage interest). So, although a forgivable PPP loan is tax exempt, a business receiving a PPP loan must forgo deducting expenses equal to loan that would otherwise be deductible.

The IRS has now put out a Revenue Ruling and Revenue Procedure that explain in more detail how this all works – e.g., when the expenses are paid in one taxable year and loan forgiveness occurs in another year or when the taxpayer files assuming the loan will be forgiven and it is not. All stuff I would have expected the IRS to do in the normal course. It also has generated more political reaction about how the IRS is thwarting Congress’s intent when it exempted the loan forgiveness in the CARES Act, including media coverage by the STRIB.

The House Democrats propose to exempt PPP loan forgiveness from § 265’s disallowance in the Heroes Act (the stimulus bill languishing in the Senate – see section 20235 for the relevant provision). As an aside, that is one of several foolish tax provisions in the Heroes Act in my view. (Full restoration of the SALT deduction is another.) I had not expected it to survive if Trump and the GOP Senate agreed to another round of stimulus because I thought serious policy makers would regard it as a throwaway provision. But I’m probably wrong about that, since both Senator Grassley, the chair of the Senate Finance Committee, and Ron Wyden, the ranking Democrat on Finance, support it according to this Senate Finance press release, which suggests the IRS back off its position on disallowing the expense deductions. Of course, jawboning the IRS isn’t the same as intending to pass legislation, but you get the idea.

In my judgment, doing what the House Democrats and Senators Grassley and Wyden suggest makes little sense. There is no need to pile tax breaks on top of government grants (a more straightforward characterization than “forgivable loans”). Here’s why.

The PPP’s presumed purpose was twofold:

  1. To keep paying employees of small businesses (PPP loans were limited to small businesses), notwithstanding the shutdown and/or slowdown caused by the virus. My assumption flows both from the naming of the program (“Paycheck Protection Program”) and the legal requirement that a high percentage (it changed over time) of the loan proceeds be spent on payroll for the business to qualify for loan forgiveness.
  2. To keep recipient small businesses afloat during the shutdown and subsequent slowdown, so they would be able to continue operations notwithstanding the pandemic.

To meet these purposes, PPP essentially makes a government grant to qualifying businesses that applied and it requires that grant to be used to pay the business’s expenses, payroll, rent, and mortgage interest. Satisfying those purposes does not require layering on an additional tax break because receiving the grant will not itself generate a tax liability. If the grant is taxable (the default rule), the expenses paid with it will exactly offset it. Since net income does not increase, neither does tax. If the grant is exempt (CARES Act approach) and the expenses are disallowed (IRS ruling’s interpretation), there still is no tax liability. Neither the grant (forgivable loan) or the expenses show up on the tax return (simplistically if not technically correct). Disallowing the expense only prevents the business from deducting them as a way to reduce that tax due on other income it may have.

The approach advocated by business groups (e.g., NFIB), the Heroes Act, Grassley, and Wyden allows businesses that have tax liability because they have other income (not from the PPP loan forgiveness) to reduce the tax on that income. That results because they can reduce the amount of other income that is taxable by deducting expenses paid with the PPP loan proceeds.

That seems foolish, because businesses that are still generating current year taxable income are not the businesses that most need government handouts, but they would be the most certain and biggest group to benefit. Many small businesses are losing money because of the pandemic, notwithstanding getting a PPP loan.  Recall that the CARES Act changed the net operating loss rules so that their losses can be carried back to prior tax years, generating tax refunds. So, it is possible that allowing deduction of expenses paid with PPP forgiven loans will generate tax refunds for some of these businesses even though they’re losing money this year. That will depend upon their exact situation – net income and tax in the prior three years in excess of current year losses generated this year after taking the PPP loan into account. But it is a very cumbersome, backdoor way to get money to them. Any small business that didn’t qualify for a PPP loan or that chose not to apply for whatever reason will not benefit obviously.

If the real goal is paycheck protection, none of this would be sure to help pay employees. There is no requirement that the tax savings be used to do so, as is the case for PPP loan proceeds. Given the constrains on the how much money Congress is willing to spend – that is mainly what the months-long standoff between Pelosi and McConnell is all about – using federal budget resources in this way is a poor use of limited moneys.

If the goal is to help employees, give the money to them directly through unemployment or tax credits. If the goal is to keep businesses open, don’t give money to businesses that are still making money, which is what allowing deduction of the expenses would primarily do.

To summarize, adding a small business tax break to the PPP program would:

  • Be uneven in the businesses it benefits; only those with enough other income (not PPP loan generated income) would benefit. Many businesses will not benefit, even though they got a PPP loan. The small businesses that are likely hardest hit by the pandemic (they don’t have enough other income to generate tax liability) would NOT benefit. That seems foolish and unfair.
  • Businesses that do benefit would not be required to use any of their tax savings to keep paying their employees (beyond PPP’s already applicable requirements).
  • Given the limits on available resources, which the GOP members of Congress have made repeatedly clear is their big concern in resisting more stimulus/aid, this money could be more effectively spent on other relief, such as paying bonus or extended unemployment benefits or increased federal funding of state and local government health care spending caused by the pandemic. Forgoing tax revenue under this provision will prevent doing more sensible stuff.

SALT Angle. Passing this will put budget stress on state governments that automatically conform to federal changes. Even for states that opt not to conform, it will complicate tax compliance and administration, an undesirable outcome. This post by Professor Adam Thimmesch makes the former point clearly and persuasively. His post indirectly tends to support my wild idea on conformity in this post (auto conformity with revenue neutral rate adjustment), because it insulates states from the revenue loss while still preventing the complexity, compliance and administrative problems of not conforming.

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