Small businesses that get their loans forgiven cannot accept tax deductions for wages and other associated expenses, the IRS said in a ruling that downgrades the potential value of the popular paycheck protection program.
The IRS decision has cleared ambiguity in the $660 billion programs, which aims to support struggling employers during the coronavirus pandemic.
"This treatment avoids the benefit of double taxation," the IRS said in a statement it released.
The Economic relief law that created the program states that loan cancellation does not create taxable income. But the law does not mention whether normal payroll deductions and other ordinary expenses are allowed. Tax experts have asked the IRS to clarify how the law works, and if Congress intends to provide this double benefit, it should be explicitly mentioned in future laws.
The Small Business Program has been extremely popular with employers and Congress. Lawmakers have already terminated the program once the money runs out and could run out.
The program offers low-interest loans to employers through banks and the Small Business Administration. If they use that money for a specific purpose, primarily to keep their salary, they can qualify for loan forgiveness.
Usually, salaries are deductible expenses, and canceled debts are taxable income. But the Economic relief act had a special provision stating that this canceled debt was not taxable income.
This language has created a tax problem and a big problem with hundreds of billions of dollars at stake.
Without deductions, the program will help businesses survive, but it becomes tax laundering, limiting its potential value. Employers will earn tax-free income if their loans are forgiven but lose the associated losses.
If businesses could deduct these expenses, the program would have a much greater benefit than just forgiving loans, as they could earn tax-free income and deductible expenses.
If that happened, a business that gets $50,000 in loan forgiveness to cover $50,000 in deductible expenses would be left with no income and $50,000 in deductions that it could use against other income. With a tax rate of 22%, that would be worth about $11,000.
Instead, according to the IRS notice released, that company would have no income or deductions to use for other income.
To deny the deductions, the IRS relied on section 265 of the Tax Code, which provides that deductions can only be made if they relate to a certain category of exempt income.
In a sense, this seems to be a contradictory result. The IRS ruling largely makes the tax exemption for the loan forgiveness largely redundant, although Congress has specifically included this exemption in the law.
But the IRS has clearly given the right answer under current law. Whatever the motivation, they had to answer the question about deductibility.
Congress could overturn the IRS decision by passing a law that specifically allows deductions. In other cases, it has done so, allowing religious and military leaders to deduct property taxes and mortgage interest even though they have received non-taxable housing allowances.
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