Tax Policy – Senate Passes Additional Funding for Small Business Relief, But Questions Remain on the Deductibility of PPP Expenses
The U.S. Senate on Tuesday passed the Paycheck Protection Program Increase Act, which aims to top off the Paycheck Protection Program (PPP) established in the CARES Act last month. When Congress considers its next options, in so-called Phase 4 economic relief, policymakers should revisit some of the tax questions about the PPP in addition to increasing the funding of PPP.
The PPP Increase Act has also been labeled “CARES 3.5,” referring to the narrow goals of the bill. The House is next to take up the bill. The legislation’s goal is to increase funding for programs established in the CARES Act, rather than provide new forms of relief or structural changes to existing programs like PPP. Instead, the latter may be pursued in Phase 4 negotiations that will begin when Congress comes back to Washington in early May.
The Paycheck Protection Program Increase Act provides an additional $310 billion for the PPP, replenishing the program after it ran out of funds earlier this month. Additionally, the legislation increases the Economic Injury Disaster Loan (EIDL) grants by $60 billion and provides $75 billion in aid to hospitals and $25 billion for coronavirus testing.
The increase in funding for PPP will help the vast majority of small businesses that sought but failed to secure relief from the original $349 billion in loans. While this support will help more small businesses, there is a risk that even this additional funding will not be enough to match small business demand.
In addition to increased funding, policymakers and regulators must clarify tax rules on the forgiveness of PPP loans. Forgiven debt is typically considered taxable income under Section 108 of the tax code. The CARES Act explicitly excludes loans forgiven under the PPP from being included in taxable income at the federal level. However, this change interacts with Section 265 of the tax code, which governs whether business expenses are deductible when calculating taxable income.
Section 265 of the tax code generally prohibits firms from deducting expenses associated with income that is tax-free. This is intended to stop taxpayers from deriving a double benefit from tax-free income, maintaining neutrality in the tax code. However, disallowing deductions in the context of PPP would undercut the goal of the program.
As The Wall Street Journal’s Richard Rubin explains, permitting tax-free loan forgiveness without allowing deductions is identical to permitting deductions but treating forgiven loans as taxable income (excluding the tax benefit associated with having a lower gross income as a result of the loan and forgiveness).
For example, imagine a firm that takes $50,000 in PPP loans and earns a complete forgiveness of the loans under terms of the program, and the loans were spent on deductible business expenses. If the expenses are not deductible under Section 265, this would mean the firm must pay income tax on $50,000 of income that would otherwise have been deducted using those expenses. At a 37 percent take rate, that would yield a tax bill of up to $18,500. Similarly, a firm that can deduct those expenses but must pay tax on the $50,000 of forgiven loans would also pay a $18,500 tax liability ($50,000 in forgiven loans at a 37 percent tax rate). The firm would not have any additional tax bill if the loan forgiveness is not considered taxable income and associated expenses were deductible.
This tax ambiguity has ramifications for state tax treatment of loan forgiveness as well. For example, it is unclear if some (or all) states may unintentionally tax forgiven loans in state income tax codes; this also extends to the ambiguous treatment of deductibility at the federal level.
The sooner federal policymakers or regulators clarify tax questions about the PPP, the more certainty firms will have when they accept the economic relief to keep their businesses afloat. Clarification should be one component of the broader debate over how to improve economic relief by the federal government during this crisis.