Federal Loans, Forgiveness and Taxes in the Time of Corona
Updated: Jun 14, 2021
By: William Bricker, Linda Galler and Juliya Ismailov
The Paycheck Protection Program (“PPP”) is a popular feature of the CARES Act enacted on March 27. The PPP seeks to help cash-strapped small businesses survive the Covid-19 pandemic by offering low-interest loans, which ultimately can be forgiven if used for qualifying purposes.
The loan program was initially funded with $349 billion, but quickly ran out of funds and was subsequently replenished with an additional $310 billion under the Paycheck Protection Program Increase Act enacted on April 24 (sometimes referred to as “CARES 3.5” as a funding supplement to the third phase of federal coronavirus relief).
The PPP was added under section 7(a) of the Small Business Act (“SBA”) (15 USC §636), which already provides for various types of loans to small businesses. The uniqueness of the PPP is that any portion that is ultimately forgiven effectively becomes a government grant.
The PPP loan application period runs from April 3 through June 30, 2020.
Qualifying borrowers include: (i) those with fewer than 500 employees; (ii) those with over 500 employees who satisfy the industry-based employee or revenue levels of a “small business concern” under section 3 of the SBA (15 USC §632); and (iii) those qualifying under the SBA’s “alternative size standard” as of March 27, 2020, defined as: (a) $15 million maximum tangible net worth, and (b) average net income of not more than $5 million.
The maximum loan amount is up to 2 months of the borrower’s average monthly payroll costs for the prior year plus an additional 25% of that amount, subject to a $10 million cap. The loan can be used to cover payroll, mortgage interest, rent, and utility costs for an 8-week period.
Loans are offered at a fixed 1% rate of interest, which begins to accrue immediately, but payments are deferred for 6 months. The principal must be repaid in 2 years and can be paid earlier without penalty. In addition, no fees can be charged on this loan, and no collateral or personal guarantees are required.
Application for the program can be made through an existing SBA 7(a) lender or through any participating federally insured depository institution, federally insured credit union, Farm Credit System institution, or other regulated lenders enrolled in the program.
A PPP loan can be forgiven, in whole or in part, based on a statutory formula heavily focused on employee compensation. In computing the loan amount, payroll costs are capped at $100,000 annualized for each employee. In addition, the SBA has issued guidance that a sole proprietor or a partner is considered an employee (subject to the $100,000 annual limitation) for purposes of the PPP. Payroll costs include parental, family, medical, and sick leave benefits. However, the CARES Act excludes qualified sick and family leave wages for which a credit is allowed under sections 7001 and 7003 of the Families First Coronavirus Response Act (FFCRA).
Proceeds of a loan are not treated as income for federal income tax purposes. However, forgiveness of a loan (in whole or in part) generally results in taxable cancellation of debt (“COD”) income. Notwithstanding these general principles, forgiveness of a PPP loan is specifically excluded from a recipient’s gross income (and therefore is not subject to tax) under section 1106(h)(i) of the CARES Act.
While the CARES Act is clear on the income side regarding the treatment of the forgiven portion of a PPP loan, it is not clear whether section 265 of the Internal Revenue Code applies on the deduction side to the business expenses paid for by such forgiven funds. Section 265 prevents “double dipping” by disallowing deductions for business expenses that are paid out of nontaxable income. While some have argued that Congress did not intend for section 265 to apply to disallow deductions for business expenses that a PPP loan is expressly intended to fund, the IRS has yet to issue clarification.
In addition, federal tax relief related to a PPP loan (at least on the income side) does not apply at the state level unless the taxpayer’s state, like New York, adheres to “rolling conformity” with federal law. In these states, consistent with federal treatment, COD income from a forgiven PPP loan is likely to be excluded from income. On the other hand, in states with “static conformity,” like California, affirmative legislative action is required to conform state tax law with federal legislation. Unless and until these states act, COD income will likely be subject to state tax in those jurisdictions.
From our recent experience, the PPP loan application process can be tricky, with lender processing delays, requests for additional information and perfunctory denials. We recommend applying through a smaller lender to receive timely individual attention during the application process.
We welcome the opportunity to help with any questions you may have.