Over the last few months, we have instructed many of our clients that, even when their banks begin accepting PPP loan forgiveness applications, to hold off on submitting theirs. One of the reasons for that advice has been to allow the forgiveness process to continue ‘shaking out’ while the legislature and IRS wrestle over specifics.

One of those specifics is the ability of forgiveness recipients to truly realize the forgiven funds as ‘tax-free’. Section 1106(i) of the CARES Act made it clear that forgiven loan proceeds should be excluded from the recipient’s taxable income. However, in the haste with which the CARES Act was drafted, Congress failed to address, specifically, all the tax ramifications of forgiveness. The IRS, ever one to get a dollar where one can be found, pounced on the situation.

Typically, when a debt is forgiven, the creditor issues a 1099-C to the debtor, which obligates the forgiven debtor to realize the forgiven debt as income. When the IRS released its Notice 2032, while it accepted that no 1099-C ‘Cancellation of Debt’ needs to be issued by lenders forgiving PPP balances, it clarified its position that all forgiveness recipients will not be able to include the business expenses paid with the forgiven funds as deductible business expenses. The bulk of the acceptable uses of PPP funds fall clearly within the conventional ‘deductible business expense’ umbrella, but the IRS has assumed the position that, because the forgiven loan proceeds are already exempt from taxation, it is only fair for the IRS to get its hands on some portion of that money by requiring forgiveness recipients to have to realize, as taxable income, all of the business expenses paid with PPP proceeds.

The IRS assumes this position based on its belief that business owners would be receiving a ‘double’ benefit if they did not have to pay taxes on the forgiven amount or on the business expenses. In all actuality, the position of the IRS removes all of the intended Section 1106(i) tax shield by making business owners pay an exact income tax on every PPP dollar spent. This unintended effect clearly falls outside of what Congress wished, but, to date, Congress has not passed any legislation correcting the CARES Act to avoid the IRS position.

Many groups have written letters to their representatives in Congress to encourage a change. To date, the House has introduced some corrective legislation, but that legislation has stalled. As there is no immediate rush to apply for forgiveness (time is plentiful), it may be in PPP fund recipients best interest to hold off on applying for forgiveness until Congress brings some clarity to the matter.

Phocus Law represents small- to medium- sized businesses throughout Arizona and California. If there are any questions, please feel free to reach out via email to mick@phocuscompanies.com or via phone (602)457-2191.