Editor's note: Congress on Dec. 21 passed the Consolidated Appropriations Act, 2021, which includes language that clarifies the tax treatment of forgiven PPP loans allowing for small businesses to deduct their expenses. For details, please read Good News! Business Owners Who Took PPP Will Get to Deduct Expenses After All.
Struggling business owners who took advantage of the government’s Payroll Protection Program (“PPP”) lifeline this year are now caught in the middle of an ugly fight between Congress and the IRS. At stake: Business owners’ ability to deduct several business expenses on this year’s tax returns.
The Coronavirus Aid, Relief, and Economic Security (CARES) Act was passed with overwhelming, bipartisan support to help defray the economic effects of COVID-19 and the government-mandated shutdowns. With a goal of providing fast, direct economic assistance to small businesses, the PPP was a key component of the CARES Act. The PPP provides small businesses with a dischargeable loan equal to 2.5 times the business’s average monthly payroll costs (up to $10 million). (For full details on the PPP program, please see this excellent online tutorial by attorney Paige L. Minch (opens in new tab), a colleague of mine.)
The CARES Act allows PPP loan proceeds to be forgiven if used for certain business expenses, including payroll, mortgage interest, rent and utilities, during the “covered period.” The covered period was triggered upon disbursement of the loan to the recipient and could end on the earlier of 24 weeks or Dec. 31, 2020.
The Understood Tax Benefit of PPP Loans
As my partner, tax attorney Gary A. Forster (opens in new tab) explains, “a significant benefit to small businesses is the tax treatment of the PPP loan.” Section 1106(i) of the CARES Act excludes forgiven PPP loan proceeds from taxable income:
Taxability: any amount which (but for this subsection) would be includible in gross income of the eligible recipient by reason of forgiveness described in subsection (b) shall be excluded from gross income.
Without this key feature, forgiven loan proceeds are subject to U.S. income tax.
The IRS Steps in with Its Own Take on the Policy
The Act does not expressly address tax treatment (i.e., deductibility) of business expenses paid with PPP loan proceeds. But as Forster explains, “If the proceeds used to pay the expenses are not taxable as income, then the only logical reading is that the expenses paid must be deductible.” Otherwise, the non-deductibility completely unwinds the tax benefit provided by 1106(i). Nevertheless, the IRS has seized upon the silence as an apparent loophole (opens in new tab), by announcing that expenses paid with forgiven PPP loan proceeds are not deductible. The IRS’ position would frustrate the intended tax benefit of the PPP loan by effectively taxing discharged PPP loan proceeds.
It seems senseless to forgive tax on $100 of PPP loan proceeds – if and only if used for deductible business expenses – only to turn around and disallow a deduction on the very same $100 expenses paid for with the forgiven loan. The IRS position negates the taxability language of section 1106(i) of he CARES Act by eliminating the tax savings on expenses paid with the PPP loan.
Senators Fire Back, But IRS Stands Firm
In response, Senate Finance Committee Chairman Chuck Grassley (R-Iowa), Ranking Member Ron Wyden (D-Ore.) and House Ways & Means Committee Chairman Richard Neal (D-Mass.) wrote a letter to Treasury Secretary Steve Mnuchin (under whose authority the IRS operates), explaining congressional intent. They wrote (opens in new tab) that the IRS position essentially renders the tax language in the CARES Act meaningless and stressed that:
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 …
Undeterred, the IRS recently doubled-down on its position in Revenue Ruling 2020-27 (opens in new tab) by stating that a taxpayer may not deduct eligible PPP expenses in the year 2020 if the taxpayer reasonably expects the loan to be forgiven later. In response, Sens. Grassley and Wyden issued a joint statement on Nov. 19 (opens in new tab):
Since the CARES Act, we’ve stressed that our intent was for small businesses receiving Paycheck Protection Program loans to receive the benefit of their deductions for ordinary and necessary business expenses. We explicitly included language in the CARES Act to ensure that PPP loan recipients whose loans are forgiven are not required to treat the loan proceeds as taxable income. As we’ve stated previously, Treasury’s approach in Notice 2020-32 effectively renders that provision meaningless.
Government agencies must carry out congressional laws as Congress intends. When considering the propriety of an agency’s interpretation of law, courts consider two factors: first, whether Congress directly spoke to the issue in the law; and, next, whether the agency’s interpretation is based on a permissible construction of the law. Government agencies, like the IRS, are granted interpretive deference, but remain constrained by congressional intent.
The CARES Act is silent regarding the details of tax deductibility, but the Act speaks quite loudly and clearly on the broader question of taxability. The only expenses for which payment results in PPP forgiveness are those which are normally deductible. In other words, you can only get the forgiveness – and the tax benefit – by using the money for payment of normally deductible expenses. Otherwise, the loan is not dischargeable. Disallowing the deduction contradicts the tax benefit. Had Congress intended for forgiven PPP funds to be taxable, it could have said so; or it could have remained silent on the issue. Instead, Congress made its intent quite clear by inserting section 1106(i).
Any doubts about Congress’ intent are addressed by the bipartisan statements (opens in new tab) of Congressmen Grassley, Wyden and Neal:
… as 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.
What May Happen Next? And What about Business Owners?
Congress could enact additional legislation in direct response to the IRS. Identical bills have been introduced in both the Senate and House of Representatives, titled the “Small Business Expenses Protection Act of 2020 (opens in new tab).” The law would amend section 1106(i) to leave undisturbed the tax deductions for business expenses paid with forgiven PPP loan proceeds. If such clarifying legislation is not passed, then it remains to be seen who, if anyone, will defy the IRS by deducting the expenses and take the challenge to court. Any court deciding the issue will undoubtedly look to congressional intent.
What Should Business Owners Do Now?
Congress’ failure to act before tax filings begin could set up a fight between taxpayers and the IRS. While business owners should seek and rely upon the advice of tax advisers and legal counsel, they are likely to face tough choices. A business might forgo the deductions and simply pay the tax. Another option would be to take the disputed deductions but file a Form 8275 Disclosure (opens in new tab) with the IRS, relying upon the statutory language and congressional intent to contradict the IRS’ stated position. This should not be done without professional guidance and may set up a deficiency lawsuit in U.S. Tax Court or a federal district court; one with the potential to garner national attention.
In the meantime, we should expect that many business owners will delay filing until the last possible moments. In any event, business owners should proceed with caution and should not proceed without competent guidance from professional advisers and counsel.
Eric Boughman is a founding partner of ForsterBoughman, a Central Florida law firm, where he leads the firm's health care and technology practices. He helps solve complicated legal issues for health care professionals and medical groups, businesses and business owners, investors and entrepreneurs.
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