Memo – Expenses Paid With Forgiven PPP Loans ARE Deductible

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UPDATE: Expenses paid with forgiven PPP loans ARE deductible. The IRS has reversed a prior ruling. 

This is great news.

This makes invalid the text below. 

IMPORTANT NOTE: If you are a sole proprietor, filing a Schedule C, with no payroll, and only a home office, then this memo does NOT apply to you and your net income will not be impacted if your PPP is forgiven.

Many businesses received PPP (Paycheck Protection) loans, and 99% of them will be forgiven if spent on payroll, rent & utilities.

The IRS code, though, has a section that disallows expensing anything that was paid with a forgiven loan. So that means the payroll, rent & utilities you paid with your forgiven PPP loan are NOT deductible on your tax returns.

I cannot stress enough that you need to include this in your projected business net income and final year end business income for 2020.

For example, have you been posting these expenses in your accounting software to the income statement? If so, you need to add the costs forgiven with the PPP loan to your bottom line and then project your income taxes due with the higher number.

See my example below. Even if these expenses are not deductible, there is still a net cash inflow benefit because the loan was “free money” or forgiven.

I believe that Congress and the IRS will fix this loophole before tax season, but there are no guarantees so we need to plan as if the law will not be changed.

The IRS issued Notice 2020-32 that gives clear direction on this. 

This notice provides guidance regarding the deductibility for Federal income tax purposes of certain otherwise deductible expenses incurred in a taxpayer’s trade or business when the taxpayer receives a loan (covered loan) pursuant to the Paycheck Protection Program under section 7(a)(36) of the Small Business Act (15 U.S.C. 636(a)(36)). Specifically, this notice clarifies that no deduction is allowed under the Internal Revenue Code (Code) for an expense that is otherwise deductible if the payment of the expense results in forgiveness of a covered loan pursuant to section 1106(b) of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), Public Law 116-136, 134 Stat. 281, 286-93 (March 27, 2020) and the income associated with the forgiveness is excluded from gross income for purposes of the Code pursuant to section 1106(i) of the CARES Act.

In addition to 2020-32, the IRS issued 2020-27 giving further clarification. Click this link to see the full narrative.  CLICK HERE

At first, this may upset taxpayers, as your taxable income will be much higher than you expected, and therefore your tax will also be higher. You would be correct if you think this, but we need to look at your true net cash out of pocket and compare a forgiven loan and one that is not.

I created scenario below to compare the two scenarios.

Our example company has $300,000 of income and $200,000 of payroll costs

Take a look at the Without Forgiveness column. Simple math gives us net income of $100,000 and a tax of $20,000 based on a 20% tax rate that I am using for this example.

Now, you will have to pay back the $200,000 PPP as it was not forgiven. This gives us a true cash out of pocket of $220,000, $200,000 for the loan and $20,000 in taxes.

Let’s compare that with the $200,000 being forgiven. We see our net income is $300,000 as the $200,000 is not deductible. This gives us a tax of $60,000! 3 times higher! Again, don’t panic.

Remember, we have to calculate what our true cash out of pocket is. In this case the $200,000 loan never has to be paid back, so our true cash out of pocket is only that $60,000.

Even if the payroll costs, rent & utilities are NOT deductible, it is still better to take the forgivable loan. 

We can see the savings with forgiveness is $160,000 even though the tax is higher.

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Chris Whalen, CPA
(732) 673-0510
81 Oak Hill Road
Red Bank, NJ 07701
www.chriswhalencpa.com

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