May 4, 2020

IRS Provides Guidance on Expenses Funded by PPP Loan Proceeds

On April 30, 2020, the IRS issued guidance to change one of the key benefits related to the tax treatment of the Paycheck Protection Program (PPP) loan program. This benefit is that loan proceeds which are forgiven under the program are nontaxable income to the business. With other types of loans, loan forgiveness results in taxable income to the business.

While this key provision did not directly change, it effectively did with this new IRS guidance as the IRS is now disallowing the tax deductions for any expenses paid with PPP loan proceeds that are ultimately forgiven. By not allowing these expenses for tax purposes, many would argue that the IRS has made it as if the loan forgiveness itself is now taxable income.

The Potential Tax Impact

Here is a practical example: A business received a $500,000 PPP loan, and used that amount in the covered eight-week period to pay $400,000 in payroll costs, $80,000 in rent, and $20,000 in utilities. Because this business fully utilized the entire $500,000 loan, the full loan amount could be eligible for forgiveness. Prior to this guidance from the IRS, the loan forgiveness would not be taxable income. Additionally, the $500,000 in expenses would be tax deductions for the company. Now, under the change, the payroll costs, rent, and utilities paid with the loan will not be tax deductions to the company.

The impact of this is quantified based on the company’s tax rate. If this was a corporation with a 21% Federal tax rate, the loss of $500,000 in tax deductions would add $105,000 to their Federal tax liability for the year and greatly impact their cash flow.

What Businesses Can Do

A business owner’s next steps are based on how their cash flow will be affected by the IRS guidelines. The situation may not be as dire for all businesses, which is why careful analysis of this guidance is necessary. For example:    

Businesses with forced layoffs prior to PPP funding. For businesses that used PPP funds to hire employees back, the tax impact may not be as dire. Because employees were laid off, there is no tax deduction for payroll expenses during the layoff period. As such, when the PPP funds are received to bring back employees, the loss of the tax deduction for the new payroll costs paid with forgivable PPP funds puts the company back in the same spot as they were before the PPP loan was received.  In this case, the company will not have a payroll expense tax deduction either way.

Businesses who retained employees prior to PPP funding. Businesses that did not experience a dramatic drop in sales to lay off employees, yet needed PPP funds to continue paying employees, are in a different position. Prior to the IRS change, these companies had payroll costs to deduct for tax purposes. Now, after the change, they can no longer deduction those same payroll costs assuming the PPP loan proceeds used to pay those costs are forgiven. The loss of the payroll expense tax deduction these companies had planned on could significantly impact their taxable income and cash flow.

Businesses in the middle. Some businesses will fall in the middle — they laid off some employees, but not all. In any of these three situations, companies that projected cash flow based on being able to deduct expenses paid with forgiven PPP loan funds will need to revise their cash flow forecasts. This may also change some business owner’s plans to ensure they spend all their PPP funds in the covered eight-week period.  Some may determine that paying back a portion of their funds over two years at 1% interest, which would allow tax deductions for the expenses paid with those funds, may be a better long-term cash flow plan for the business. 

Given the numerous scenarios resulting from the change to the IRS guidance, each business owner should talk with their CPA to discuss how this provision affects their tax liability and cash flow forecast for the short term and long term.

What’s Next?

With the rapidly changing regulatory environment surrounding the CARES Act and the PPP Loan program, there will likely be additional guidance from the SBA and IRS regarding the program. 

Our advisors are closely following COVID-19 relief efforts and will continue to publish insights to keep you informed about potential business impacts and benefits. Learn more about the Paycheck Protection Program or visit our COVID-19 Resource Center for more news, tools and insights you need to know in these uncertain times.

Read more of Dave’s PPP insights in the St. Louis Business Journal.

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