8561 / What are the tax consequences of loan forgiveness under the paycheck protection loan program?

Editor’s Note: The IRS released a safe harbor for taxpayers who did not deduct otherwise deductible expenses paid or incurred during the tax year ending after March 26, 2020, and on or before December 31, 2020 (the 2020 tax year) that resulted in, or were expected to result in, loan forgiveness. Under the safe harbor, these taxpayers could deduct the expenses on the taxpayer’s original federal income tax return or information return for the first tax year following the 2020 tax year rather than filing an amended return or AAR for the 2020 tax year.¹

Under normal circumstances, when a loan or debt is forgiven, the income is included in the debtor’s income under cancellation of debt principles. Paycheck protection loans, however, were excluded from these generally applicable rules—meaning that amounts forgiven were not included in the recipient’s income when forgiven.

Late in 2020, Congress clarified that business owners were entitled to their typical business deductions even if the expenses were paid out of loan proceeds that were forgiven.² This overrides earlier IRS guidance contained in Notice 2020-32, which provided that otherwise allowable deductions were to be disallowed if the payment of the expense (1) resulted in loan forgiveness under the PPP loan program and (2) the income associated with the loan forgiveness was excluded from income under CARES Act Section 1106(i).

Expenses like salary, rent, mortgage interest and utilities are generally deductible as ordinary and necessary business expenses under IRC Section 162. These were also exactly the types of expenses could be incurred in order for a business to receive loan forgiveness under the CARES Act.

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Planning Point: The 2020 year-end stimulus package clarified that federal tax deductions were be available even if the business used PPP loan proceeds that were forgiven to cover the expenses. However, state tax issues may still arise. While some states, like New York and Illinois, generally conform to federal laws on these issues, others do not. For example, Kentucky and North Carolina both announced that for state income tax purposes, business expense deductions were not allowed if the expenses were paid for with forgiven PPP loan funds. Small business clients should make sure to pay close attention to changing local laws on this subject when determining whether to seek loan forgiveness.

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Original IRS Safe Harbor Rules

The IRS safe harbor rules for certain taxpayers whose application for forgiveness was denied or who opted to forgo applying for forgiveness are now less relevant, as business owners could take their typical business deductions regardless of whether the loan is forgiven.

The safe harbors allowed a taxpayer to claim a deduction in the 2020 tax year for certain otherwise deductible eligible expenses. The deduction was allowed if (1) the eligible expenses were paid or incurred during the taxpayer’s 2020 tax year, (2) the taxpayer received a PPP loan, which at the end of the 2020 tax year the taxpayer expected to be forgiven in a subsequent tax year, and (3) in a subsequent tax year, the taxpayer’s request for forgiveness of the covered loan was denied, in whole or in part, or the taxpayer decided not to request forgiveness of the covered loan. Taxpayers could elect to use one of two safe harbors, depending upon their situation.

Safe Harbor 1: Eligible taxpayers could deduct non-deducted eligible expenses on the taxpayer’s timely filed, including extensions, original income tax return or information return for 2020, or amended return or AAR for 2020, as applicable.

Safe Harbor 2: Eligible taxpayers could deduct non-deducted eligible expenses on the taxpayer’s timely filed, including extensions, original income tax return or information return, as applicable, for a subsequent tax year. Taxpayers whose loan forgiveness was denied could, but were not required, to use this safe harbor to deduct non-deducted eligible expenses in a subsequent tax year because those taxpayers could deduct the non-deducted eligible expenses in the year that the loan forgiveness was denied under general tax principles, assuming that the taxpayer did not elect to deduct the expenses in 2020.

Taxpayers relying on either safe harbor could not deduct an amount of non-deducted eligible expenses in excess of the principal amount of the taxpayer’s covered loan for which forgiveness was denied or was not sought.

The taxpayer was required to attach a statement to the return on which the expenses are deducted. The statement was titled “Revenue Procedure 2020-51 Statement,” and included: (1) The taxpayer’s name, address, and Social Security number or employer identification number; (2) A statement specifying whether the taxpayer is an eligible taxpayer under either safe harbor in Revenue Procedure 2020-51; (3) A statement that the taxpayer is applying section 4.01 or section 4.02 of Revenue Procedure 2020-51; (4) The amount and date of disbursement of the taxpayer’s covered loan; (5) The total amount of covered loan forgiveness that the taxpayer was denied or decided not to seek; (6) The date the taxpayer was denied or decided not to seek loan forgiveness; and (7) The total amount of eligible expenses and non-deducted eligible expenses that were reported on the return.³

Note also that, under the CARES Act rules, taxpayers were entitled to take advantage of payroll tax deferral options under the CARES Act until the borrower received notice from the lender that the loan has been forgiven. After that notice was received, employers could no longer defer payment of payroll tax deposits without penalty. The amounts already deferred continued to be deferred and due by the otherwise applicable payment dates (i.e., 50 percent by December 31, 2021 and the 50 percent by December 31, 2022).⁴