The general tax rule for debt forgiveness states that the amount of debt forgiven is subject to federal income tax. PPP loan forgiveness is an exception, although from an overall tax perspective it didn’t start out exactly that way.
The CARES Act introduced PPP loans and established that the amount of the PPP loan forgiven was to be treated as tax-exempt income on the borrowers’ federal tax returns. But the IRS initially disallowed deductions for otherwise eligible PPP-related expenses, essentially negating the benefit of the income exemption. All that changed when the rules were revised to allow these deductions.
Unfortunately, the many rule changes have made the forgiveness process confusing for many borrowers. As a result, roughly half of borrowers have yet to apply for forgiveness and a small but significant number have been required to pay back some portion of the loan.
Impact of PPP Loan Forgiveness on Deducting Eligible PPP Expenses
Initially, the IRS disallowed deductions for expenses used to establish PPP loan forgiveness. The CCA also changed the tax treatment for these expenses. It specifically made those expenses deductible.Effective for tax years ending after March 27, 2020, Revenue Ruling 2021-2 allows PPP borrowers to deduct otherwise deductible expenses when these expenses result — or are expected to result — in the forgiveness of a PPP loan.
No amount will be included in the gross income of the eligible PPP loan recipient by reason of forgiveness of indebtedness and no deduction will be denied, no tax attribute will be reduced, and no basis increase will be denied by reason of the exclusion of the PPP loan proceeds from gross income. [IRS]
Revenue Procedure 2021-20 provided a safe harbor for those PPP borrowers who filed their 2020 tax returns on or before December 27, 2020. These borrowers can deduct such expenses on their 2021 tax returns — instead of filing 2020 amended returns — assuming certain requirements are met. These include that the borrower paid/incurred eligible expenses in the 2020 tax year and timely filed a 2020 tax return (including extensions) by December 27, 2020.
Timing Considerations: Basis and At-Risk Limitations
Loan forgiveness increases tax basis, at least in the context of pass-through entities (partnerships and S corporations where taxes are paid at the individual level, not the entity level).For these entities, the deduction for otherwise deductible expenses paid from PPP loan proceeds may be limited by the borrower’s tax basis or amount at risk. It all depends on the timing.
Assume a partner or S corporation borrower with significant PPP expenses and a small tax basis in the business. The borrower received the loan and incurred the expenses in 2020, along with other items of income and expense that affect tax basis in the business for the year. However, the loan was not forgiven until 2021.
That means the borrower may have a timing problem. The tax basis in the business doesn’t increase until 2021 (the year of forgiveness) while the PPP expenses are deductible in 2020. If the total amount of expenses is larger than the borrower’s tax basis, those expenses are limited in 2020 to the amount of tax basis before forgiveness.
It can require a fairly complicated analysis.
The takeaway? If you generally have a small basis in a pass-through entity, it is important to examine the tax year of the PPP debt forgiveness and allowable deductions. When will the forgiveness be considered tax-exempt income for purposes of calculating tax basis? And when will the expenses be deductible?
This timing issue may also impact the purchase/sale of the partnership or S corporation.
Impact of Loan Forgiveness on Federal Taxes
PPP loan forgiveness amounts are not included in taxable income. Further, the tax treatment of forgiven, normally deductible expenses incurred during the covered period is as follows: A PPP borrower can deduct eligible expenses to the extent that those expenses were paid from the proceeds of a PPP loan that was subsequently forgiven.Borrowers with PPP loans that have been forgiven are eligible for the payroll tax deferral. They are not required to wait until after the date the loan was forgiven.
Borrowers with PPP loans are eligible for the employment retention credit. However, they can’t use the same wages in determining both the amount of the employee retention credit and the PPP forgiveness amount.
Impact of Loan Forgiveness on State and Local Taxes
From a state and local tax perspective, it is possible that PPP loan forgiveness may give rise to taxable income. However, an increasing number of jurisdictions have ruled they will conform to the federal treatment regarding the non-taxability of PPP loan forgiveness and not subject the forgiveness to state income tax.Washington State Taxes The impact of federal COVID-19 programs, including PPP loan forgiveness, on Washington taxes has been resolved.
Washington state exempts from B&O tax those grants from governmental entities made during a declared state of emergency.
This includes businesses and not-for-profits that received a federal Paycheck Protection Program (PPP) loan and/or an Economic Injury Disaster Loan (EIDL) advance.
The department has determined that businesses receiving assistance under these federal programs (including the federal Paycheck Protection Program (PPP) program) should not report assistance as gross receipts for B&O tax purposes and should not pay B&O tax on that assistance at the present time. [Washington State Department of Revenue]
The Department of Revenue also addressed their approach to the resulting uncertainty:
The department believes that there may be interest in clarifying the applicable statutes, especially after the various programs at issue have been identified and analyzed more thoroughly. Therefore, the department will delay any final decision on taxability or enforcement actions until after the Legislature has had an opportunity to act. In the meantime, no penalties or interest will accrue with regard to any tax that may be due on such receipts until further notice. [Washington State Department of Revenue]
Other states with income taxes may treat loan forgiveness as income and allow deductions for eligible expenses. It’s a state-by-state determination.
The rules governing PPP loan forgiveness and related tax implications are quite detailed and complex. Get great advice.