Is a forgiven PPP loan taxable? Are business expenses paid with the loan deductible?

Question of the week: My client’s PPP loan was partially forgiven. Is the forgiven debt taxable? Can she still deduct business expenses paid with the loan?

July 15, 2020

Q. My client’s PPP loan was partially forgiven. Is the forgiven debt taxable and can she still deduct business expenses paid with the loan?

My client Janet owns a small retail interior decorating store. With the help of a Paycheck Protection Program (PPP) loan, she has been able to continue paying her few employees and cover other expenses. A little over half of the loan proceeds were spent on payroll costs. She also used the proceeds to pay rent, utilities, storage, delivery charges, and other basic expenses while her business operation was severely curtailed. Most, but not all of the PPP loan was forgiven. How will the loan forgiveness affect her 2020 taxes? Is the forgiven amount subject to tax? Can she deduct business expenses in full?

A. Although the forgiven PPP loan is not taxable, your client cannot deduct business expenses paid with proceeds from the forgiven loan.

The forgiven PPP loan is not taxable, but expenses paid with forgiven loan proceeds are not deductible.

The CARES Act introduced the Paycheck Protection Program, later modified by the Paycheck Protection Program Flexibility Act (PPPFA), to help businesses such as Janet’s pay their employees and handle other expenses during the COVID-19 pandemic. Generally, borrowers may seek loan forgiveness if they use proceeds for payroll and certain other costs over a 24-week covered period. At least 60% of proceeds must be spent on eligible payroll costs to obtain full PPP loan forgiveness; otherwise, forgiveness is limited.

IRS Notice 2020-32 provides guidance on business expenses paid with forgiven PPP loan proceeds. The notice explains that under the CARES Act any forgiven PPP loan debt is not included in gross income. However, §265(a)(1) and related regulations disallow otherwise allowable deductions paid with tax-exempt income. Notice 2020-32 concludes that PPP forgiven debt is a “class of exempt income” under the regulations. Therefore, even though Janet used the loan for ordinary and necessary business expenses, the expenses that she paid with proceeds from the forgiven PPP loan are not deductible.

Note that business expenses paid with PPP loan proceeds, or the proceeds of any other type of loan that is not forgiven, will be fully deductible. For example, say that Janet received a $100,000 PPP loan, $75,000 of which is forgiven and the remaining $25,000 of which must be repaid. In that case, $25,000 of business expenses paid with the loan are deductible. The $75,000 forgiven debt is not taxable.

Also, Janet appears to be eligible to defer payment of the employer’s share of social security taxes during the period beginning on March 27, 2020 and ending December 31, 2020. One-half of the taxes must be paid by December 31, 2021 and the remainder by December 31, 2022. A provision of the PPPFA allows employers to continue to defer employment taxes even if payroll was paid with forgiven PPP loan proceeds. See Deferral of employment tax deposits and payments through December 31, 2020.

See the SBA’s Paycheck Protection Program for more information on PPP loans, including loan forgiveness.

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