The twists and turns in the Paycheck Protection Program (PPP) saga continue this week, leaving many borrowers feeling as though the rug has been pulled out from under them.
Among the latest developments, the Internal Revenue Service (IRS) has issued a ruling that business expenses paid by a PPP loan may not be deducted on an entity’s tax return. The Department of the Treasury (Treasury) continues to press for the return of loan proceeds by entities that it says the PPP was not designed to help. Treasury has also extended the safe harbor deadline for the return of funds to May 14, 2020, and promised that, in the coming days, substantive regulations or guidance will be issued to enable businesses to determine whether they should keep the money they’ve received.
Read on to learn more about these issues.
No Deductions for Expenses Paid with PPP Loan Funds
Ordinarily, if the debt of a business or individual is forgiven, the amount of the forgiven debt must be reported as income on the debtor’s tax return and taxes must be paid accordingly. The Coronavirus Aid, Relief and Economic Security Act (CARES Act),which created the PPP, explicitly provides that forgiven PPP loans will not be included within a borrower’s gross income, and therefore a borrower will not incur income tax liability as a result.
However, a notice issued by the IRS on May 1, 2020 limits the impact of this tax benefit. PPP loan proceeds can only be used to pay rent, utilities, mortgage interest and payroll costs. These expenses are often deductible, and thus reduce an entity’s taxable income. By way of example, if an entity had gross annual income of $200,000 in 2019, but paid $50,000 in deductible expenses, its taxable income would have been $150,000. According to the IRS, this is not so if otherwise deductible expenses are paid with PPP loan proceeds.
What does this mean? Suppose that the same entity described above only has $150,000 in gross annual income for 2020, and acquires a PPP loan for $50,000 which is later forgiven. The forgiven PPP loan is not considered income, and therefore the borrower’s gross taxable income is only $150,000. However, because the expenses paid by the PPP cannot be deducted, the borrower’s taxable income is not reduced by the amount of those expenses and remains at $150,000. If the borrower were able to deduct those expenses, its taxable income would only be $100,000. The end result is that the borrower loses a tax benefit of tens of thousands of dollars, although it gained the benefit of the tax-free PPP loan.
Treasury Secretary Steven Mnuchin has backed the IRS’ ruling, calling it “basically tax 101.” According to Mnuchin, because the PPP loan proceeds are not taxable, it would constitute “double dipping” for companies to deduct expenses that they “didn’t pay for.”
A bipartisan group of senators, including Republican Senator Chuck Grassley, disagree. In a statement, Senator Grassley said, “When we developed and passed the Paycheck Protection Program, our intent was clearly to make sure small businesses had the liquidity and the help they needed to get through these difficult times.Unfortunately, Treasury and the IRS interpreted the law in a way that’s preventing businesses from deducting expenses associated with PPP loans. That’s just the opposite of what we intended and should be fixed.”
In that spirit, on May 6, 2020, this bipartisan group of senators introduced the Small Business Expense Protection Act (SBEPA). Although the text of the bill is not yet available on the Senate’s website, it has been reported that the legislation nullify the IRS’ ruling and restore the right of borrowers whose PPP loans have been forgiven to deduct expenses paid with loan proceeds on their tax returns.
No matter the outcome, the uncertainty that borrowers are currently facing is a problem in and of itself. With many businesses facing serious decreases in revenue, the ever-changing nature of the rules of play makes financial planning incredibly difficult.
Treasury Extends Safe Harbor, Announces Audits
As we discussed in a previous blog post, a blitz of media coverage about large public companies acquiring PPP loans spurred Treasury and the Small Business Administration (SBA) to update its Frequently Asked Questions document (FAQs) to address the issue. The document notes that applicants are required to certify that “[c]urrent economic uncertainty makes [a PPP] loan request necessary to support [its] ongoing operations….” Applicants cannot make this certification in good faith without assessing whether they have access to other funds that can support their ongoing operations without resulting in significant detriment to the business. As an example, the FAQs note that it is “unlikely” that a public company with substantial market value and access to capital markets will be able to make the required certification in good faith.
In acknowledgment of the fact that some borrowers did not have the benefit of this guidance when they acquired their loans, Treasury and SBA instituted a safe harbor period that would allow borrowers to return their PPP funds by May 7, 2020 without penalty. Through updates to the FAQs on May 5, 2020, Treasury and SBA extended the safe harbor period through May 14, 2020, noting that “SBA intends to provide additional guidance on how it will review the certification prior to May 14, 2020.” As of May 7th, that additional guidance still has not been published.
What are the consequences for a business that cannot substantiate its certification of “necessity,” but does not return its PPP loan during the safe harbor period? According to Secretary Mnuchin, such a business’ loan may not be forgiven and it could even face criminal penalties. And, Mnuchin promises that the government will actively seek to root out false certifications by auditing applicants who received loans larger than $2 million, among others, when forgiveness applications are submitted.
Employee Retention Credit
In what amounts to a consolation prize, on May 6, 2020, the FAQs were updated to state that businesses that return their PPP loans will be entitled to claim the employee retention credit provided for by the CARES Act. This is a refundable tax credit for employers equal to 50% of qualified wages paid to employees after March 12, 2020 and before January 1, 2021, up to a maximum credit per employee of $5,000 for $10,000 in wages paid.
Borrowers who thought that all they had to do was retain or rehire their workers using at least 75% of their PPP loan proceeds may be in for a rude awakening. Some who thought they were receiving “free money” may actually find themselves saddled with debt that they would not have acquired if all requirements had been known from the start. Additionally, some borrowers who made calculations based upon the notion that their business expense deductions would remain intact will, at least for now, need to go back to the drawing board. Although the employee retention credit may provide some relief to these businesses, the magnitude of that benefit is substantially less than the one promised by the PPP as it was initially sold to the public.
There are likely to be legal challenges to SBA’s forthcoming rulings on PPP loan forgiveness, and any attempts to impose civil or criminal liability on borrowers who purportedly did not make the required certification in good faith. Forbes has already written extensively about a potential argument that the FAQs’ requirement that the PPP loan be “necessary” for the borrower to maintain its operations is unconstitutionally vague. There may be other arguments that Treasury’s regulations contravene and are trumped by the text of the CARES Act, or that the changes to those regulations cannot properly be applied to borrowers who acquired loans before they were issued. A lawsuit making similar claims has already been commenced by a California company.
At bottom, these technical arguments and the prospect of winning a fight against the federal government for loan forgiveness are likely to be of little comfort to most small businesses. The average PPP borrower should be on the lookout for the additional guidance that Treasury has promised to issue before the end of the safe harbor period. In the meantime, those entities should start considering whether and to what extent their revenues are down, whether some or all of the business in the pipeline has dried up and, ultimately, whether they would have been able to retain their employees without the PPP loan.
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