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How PPP Loans Affect Passthrough Deduction Is Unclear

Posted on June 11, 2020

The government’s position disallowing a deduction for the use of forgivable small business loan proceeds has some practitioners wondering if there are strategies to use the loan to increase the passthrough deduction.

The focus is on whether the Paycheck Protection Program (PPP) loan proceeds used for payroll costs will count toward W-2 wages paid to employees that are used to increase the passthrough deduction for some high-earning taxpayers. It’s a gray area, and one that is likely to change as Congress considers reversing Treasury on the deductibility of forgiven PPP loan proceeds.

The PPP, created by the Coronavirus Aid, Relief, and Economic Security (CARES) Act (P.L. 116-136), generally provides loans to businesses with fewer than 500 employees that are forgiven on a tax-free basis if a specified portion of the loans is spent on payroll costs over a covered period.

Initially, the Small Business Administration and Treasury said that for a loan to be forgiven tax free, at least 75 percent of it must be used on payroll costs. But Congress changed that by enacting the Paycheck Protection Program Flexibility Act of 2020 (P.L. 116-142), which extended the covered period from eight weeks to 24 weeks and reduced to 60 percent the amount required to be spent on payroll for loan forgiveness.

Businesses that already received PPP loans and were subject to the eight-week period can choose between staying with the eight-week period or electing the 24-week time frame to spend the proceeds.

Questions were immediately raised as to whether the loan proceeds that were spent on items such as wages and mortgages were deductible by businesses after the loans were forgiven. Treasury stepped in and clarified that businesses wouldn’t get a deduction for the proceeds that were forgiven on a tax-free basis because that would amount to double dipping. Congress is considering whether to legislatively change that outcome.

In the meantime, practitioners are looking to maximize other tax benefits, such as the passthrough deduction in section 199A. The passthrough deduction was added to the code in the Tax Cuts and Jobs Act and provides a deduction for qualified business income earned through partnerships or S corporations, or as a sole proprietor. The deduction is generally available up to specific income thresholds, above which the income from some businesses — including law, healthcare, and accounting — doesn’t count, and the income that does qualify is limited by portions of W-2 wages paid to employees and basis in property.

Some practitioners worry that because the IRS said the PPP loan proceeds used for payroll costs, such as wages, aren’t deductible, there’s an argument that they wouldn’t count toward the section 199A wage limitation.

“It’s an issue that would affect the individual taxpayer who has adjusted gross income in excess of the threshold level for 199A, who has income from that trade or business,” Chris W. Hesse of CliftonLarsonAllen LLP told Tax Notes. “Probably narrow, but a nuance nonetheless.”

“Of course, this issue disappears if Congress overturns the IRS notice to provide specific language to say that the expenses remain fully deductible,” Hesse added.

Not Taking Chances

Adam Markowitz, a Florida tax practitioner, said that theoretically, regardless of whether the wages are deductible, the W-2 wages paid by an employer should count toward increasing the section 199A deduction.

“So theoretically, even if the IRS never gets overruled and these expenses aren't ultimately deductible, we should still get to use the full wages (PPP and otherwise) towards 199A,” Markowitz said. “However, that's not explicitly stated at this point, and I'd prefer to take no chance if given the opportunity.”

Markowitz posited an example in which a taxpayer borrowed $700,000 in PPP loans and over an eight-week period would have to spend nearly $600,000 on payroll costs and $100,000 on non-payroll costs to achieve full forgiveness. However, because of the obligations of the business, the payments under a 24-week period could be divided as follows: $280,000 on non-payroll costs, and $420,000 on payroll costs.

In that scenario, it might make more sense to elect to spend the proceeds under the 24-week period because businesses then have the ability to spend 40 percent of their proceeds on non-payroll costs, Markowitz said. That assumes, of course, that the PPP proceeds used for payroll costs don’t count toward the section 199A wage limitation.

“Most practitioners, I assume, are going to default to just taking a big payroll report for the 24 weeks to prove that the funds have been used, and that should be it,” Markowitz said. “But I'd argue that's not the safer way to go as it pertains to 199A. If you use the 24-week period, you can get in six months of rent, utilities, etc., instead of two months.”

But Damien Martin of BKD LLP said all this concern may be for naught under Rev. Proc. 2019-11, 2019-9 IRB 742, which explains how to calculate W-2 wages for section 199A purposes. In that guidance, the IRS counts as eligible wages that are paid and reported on a W-2. It doesn’t focus on deductibility, he said.

And even if Congress steps in and says the use of the loan proceeds can be deducted by taxpayers, it could hurt the section 199A deduction, Martin said. That would be the case because the deductibility of the proceeds would reduce qualified business income, he said, adding that taxpayers may be better off if Congress doesn’t fix the deductibility issue.

Martin said that in his practice, many clients are planning to stay within the initial eight-week covered period to avoid the other issues associated with a longer covered period, such as reducing employee head count.

Fiscal Year Issue

Hesse said the denial of deductions for the use of loan proceeds raises an issue for taxpayers with a fiscal year that ends on June 30.

“What happens if I have a June 30 fiscal year-end, and at June 30 the PPP is still a loan, but all of the funds have been spent to qualify for forgiveness?” Hesse asked. “I haven’t yet applied for forgiveness at June 30, and I do so in July. How does the IRS propose to disallow the expenses?”

Hesse said that if a fiscal year ended June 30, the expenses are fully deductible because the business hasn’t yet received nontaxable income from the PPP loan debt forgiveness. But in the next year, on June 30, 2021, the business didn’t incur the expenses that led to the forgiveness.

“Will the IRS rule that other expenses incurred in the June 30, 2021, year must be disallowed?” Hesse asked. “Under what authority? There were no expenses in the [fiscal year ending] June 30, 2021, related to the debt forgiveness income, unless the IRS deems it so.”

Hesse pointed to case law such as Healy v. Commissioner, 345 U.S. 278 (1953), which says income must be computed on an annual basis.

“Income is not computed on a transactional basis or for a period in excess of a year,” Hesse said. “Each year stands on its own, and events subsequent to the year-end don’t affect the status of income or expenses at the year-end.” He said it’s not clear how the IRS will approach the issue.

“We know that the PPP loan was intended ultimately as a grant, but only if the taxpayer incurred and paid qualifying expenses, and the loan forgiveness must be applied for and approved,” Hesse added. “If the loan forgiveness has not yet been applied for (or approved) by year-end, what is the treatment of those expenses?”

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