PPP Loan Forgiveness is Taxable Income Today
Posted Sunday, November 22, 2020
There has been a lot of activity over the last 6 months regarding PPP loan proceeds becoming taxable income or not. We’ll come right out and say it. Under current law including the recent IRS Revenue Ruling 2020-27, and current interpretations of the law supported by several tax court cases, your PPP loan is taxable. Boom!
However, it is not taxable income per se. So then how is it taxable? Great question! It is taxable in a roundabout way since all the expenses you paid with the PPP loan proceeds are not tax-deductible. Huh?! While PPP loan proceeds are not taxable income directly, your taxable income will generally increase by the amount of the PPP loan since expenses paid with those proceeds cannot reduce taxable income.
Here is a quick table to illustrate someone who received a $14,000 PPP loan-
|Without PPP||With PPP|
As you can see, Wages, Rent and Utilities are lower since a portion of those expenses were paid with PPP funds.
Some Tax Theory
Generally speaking, and with some exceptions, your tax deduction has to be someone else’ taxable income. When you spend $100 on some office supplies, that amount becomes taxable income to Staples. When Staples pays its staff with your $100 and deducts the wage expense on its tax return, that $100 is taxable income to an employee.
At some point this chain is broken and the $100 becomes taxable. This is because it either lands in the lap of an employee who doesn’t have direct expenses like a business, or it becomes part of the taxable profit pool of a business somewhere.
Consider this as well- generally speaking the money you spend and later deduct has to have been taxed along the way. Huh? If you deduct mortgage interest on your tax return, the cash you spent was probably taxable income such as wages. Therefore income used to pay tax deductible expenses must have been eligible to be taxed.
This is called having tax basis. In other words, your expense was paid with funds that had tax basis since they were probably taxed or going to be taxed. And if you have tax basis in the funds used to pay for eligible expenses, then those expenses are tax-deductible.
The argument is that PPP loan proceeds that are not taxable as income therefore do not have tax basis, and as such the expenses paid with the those funds cannot be deducted. Yuck.
Sidebar: Two big exceptions that immediately come to mind are charitable donations and rental income under 15 days. You deduct donations made to charities but they don’t pay income tax on those proceeds. And… the Master’s Rule where rental income for periods under 15 days are not taxable income (rumored to have started with the Master’s golf tournament where people rented out their homes for zillions of dollars for two weeks).
Caution, more theory ahead!
Some Economic Theory
There are all kinds of charts and graphs and other fancy things to describe how a dollar worms its way through the economy, and ultimately increases our country’s gross domestic product. How does this all work?
You have an extra dollar in your pocket because of a tax break. You spend it adding extra cheese to your Big Mac and McDonald’s uses it to buy some real estate. Real estate is massively popular since so many people get paid from a single transaction (that’s why our tax code encourages real estate purchases). McDonald’s buys a piece of land, and the agents, attorneys, title company, appraiser and perhaps a few others get a small money grab.
These people in turn sprinkle their money is various places of the economy. 2 becomes 4, 4 becomes 8, 8 becomes 16, and so on.
What does all this mean? Some economists suggest that an extra dollar available in our economy yields an 8-fold increase in our GDP. This is extremely hard to prove but there are models of course that suggest it.
This theory is the cornerstone to most tax breaks such as the Tax Cuts and Jobs Act of 2017. Give people more money to spend, and the economy will eventually create more taxable income than the “lost tax” from a tax cut at the source (consumer spending). And of course, this is the fodder that red, blue and agnostic economists argue about all day long. Never at night; they are nerds and go to bed early. Super smart nerds, but nerds nonetheless. Like accountants.
How about this for a monkey wrench? Government spending based on tax revenue goes right back into the economy too. But the genesis is not the same as a tax break which creates the feeling of having additional disposable income (i.e., consumer confidence to spend).
This is partly why tax breaks versus tax and spend programs are revered as more successful. The answer? Who knows! Over the course of 100 years, the party affiliation of the President barely had correlation let alone causation to the U.S. economy.
PPP Loan Forgiveness as Taxable Income
Ok, back to the issue at hand. The IRS released Revenue Ruling 2020-27 on November 18, 2020. Here is the summary using their words-
A taxpayer that received a covered loan guaranteed under the PPP and paid or incurred certain otherwise deductible expenses listed in section 1106(b) of the CARES Act may not deduct those expenses in the taxable year in which the expenses were paid or incurred if, at the end of such taxable year, the taxpayer reasonably expects to receive forgiveness of the covered loan on the basis of the expenses it paid or accrued during the covered period, even if the taxpayer has not submitted an application for forgiveness of the covered loan by the end of such taxable year.
Bummer. As such, and using our table above, PPP loan proceeds are essentially taxable income. And, Revenue Ruling 2020-27 basically says even if you have not received PPP loan forgiveness in 2020 yet you reasonably expect to receive formal PPP forgiveness in 2021, you must assume you will in 2020 and therefore not deduct expenses paid with PPP loan proceeds in 2020. Ouch!
Will the IRS Change the Rule
No. Depending on the number you find on the interwebs, over $500 billion was paid out under the PPP programs. Let’s assume a 21% tax rate. That is well over $100 billion in lost taxes. That is a big number of which the IRS nor the Treasury have the authority to wipe off the books. Will Congress change the law? Again, a solid No. There is very little discussion on this and frankly many lawmakers are already stung by the big numbers paid out. And now comes Biden with the typical tax and spend regime, and any hope is fleeting.
WCG has been monitoring this for a while. We were already tax-planning assuming PPP loan proceeds would be taxable. We were already doing this for 2020 regardless of when our clients applied for PPP loan forgiveness since we were advising that any 2020 income tax refund due to receiving loan forgiveness in 2021 would be applied to 2021. Send off the cash now; it isn’t yours sort of thing and you’ll accidentally spend it.
Now with IRS Revenue Ruling 2020-27, this is all moot. Your PPP loan proceeds are taxable. You will be paying tax on your 2020 tax return. Done.
Sure, we can game the system with the words “reasonably expect.” But, keep this in mind. First, all loans under $50,000 are automagically forgiven.
Second, this is such a sore topic with the IRS. Do you really want to challenge this? Not fair? Sure. But is it worth the risk? Probably not. Don’t forget that you got money for nothing like Dire Straits… paying some of it back isn’t the worse thing in the world.
Third, if your loan is over $2M, then perhaps. Those loans will be highly scrutinized and there might be some businesses who won’t have them fully forgiven.
Does it matter if you are cash based versus accrual based? It appears that it doesn’t matter. Either way the IRS is telling you to wipe the liability off your books, and don’t deduct expenses paid with those funds.
Another Side Bar: When WCG prepared its books throughout the year, we added a contra-account to the PPP loan liability as “Probable Forgiveness.” DR Probable Forgiveness and CR Equity Placeholder. We’ll CR a bunch of PPP paid expenses as we DR Equity Placeholder to true up the books to the tax return. Good luck Tina!
Why is the IRS asking for this to affect 2020 tax returns? There is an accounting thing called the matching principle where revenue and expenses must be recognized in the year incurred (generally speaking). So, this is why the “I forgot to deduct something in 2019… can I just do it on 2020?” question is a No. Frankly, the IRS is probably concerned that it won’t get paid if it has to wait until 2022 when it receives 2021 tax returns. Mama didn’t raise a fool over at the IRS.
But… the IRS did create a safe harbor of sorts within IRS Revenue Procedure 2020-51. It’s a bit clunky to synthesize into some clean bullet points, but basically if your PPP loan is not forgiven, in whole or in part, or you choose not to apply for PPP loan forgiveness, you are allowed to deduct otherwise non-deductible expenses. You can accomplish this through an amended tax return or by delaying the filing of your tax returns.
Here are the next steps as we see them-
1. $50,000 or less in PPP loan proceeds, take your hit on your 2020 tax return and file on time.
2. Over $50,000 and up to $2 million-ish in PPP loan proceeds, either
- take your hit with a timely filed tax return or
- if you believe your loan forgiveness is wishy-washy then plan to extend your tax return but make an on-time estimated tax payment assuming non-forgiveness.
3. Over $2 million, we strongly recommend waiting and seeing. In other words, file a tax return extension, make an on-time tax payment assuming PPP loan forgiveness and apply for forgiveness quickly.
Need help? Ask us. Let’s chat!
Jason Watson, CPA is one the Founding Partners of WCG Inc., a business consultation and tax preparation CPA firm located in Colorado Springs, and is the author of Taxpayer’s Comprehensive Guide on LLC’s and S Corps which is available online and from average retailers.