Now that Paycheck Protection Program (PPP) funds are landing in business accounts, it’s time to dig into how PPP loan forgiveness is taxed. Tonkon Torp attorneys have detailed how PPP loans work in our firm’s COVID resource page, but in short, when a borrower uses PPP loan proceeds to pay payroll and certain other business expenses (PPP Expenses), all or a portion of the PPP loan may be forgiven.

Generally, debt forgiveness results in cancellation of debt (COD) income. The CARES Act, however, provided that PPP loan forgiveness would not result in COD income. Otherwise taxable COD income was effectively exempt from income taxes. This was presumably intended to further assist businesses and workers. However, the Internal Revenue Code also provides that otherwise deductible expenses become nondeductible if those expenses are allocable to tax exempt income.

There was a lively debate in the tax community over whether this would make otherwise deductible PPP Expenses nondeductible to the extent they result in PPP loan forgiveness and exempt COD income. This would arguably take away the tax benefit Congress intended by making the COD income exempt.

On Thursday, April 30, perhaps not surprisingly, the IRS issued a Notice concluding that such expenses are indeed nondeductible. On Friday, May 1, also to no surprise, the leaders of the House and Senate tax-writing committees cried foul. “The intent was to maximize small businesses’ ability to maintain liquidity, retain their employees and recover from this health crisis as quickly as possible,” Sen. Grassley said in a statement. “This notice is contrary to that intent.”

To say the situation is fluid is to state the obvious. Will the IRS reverse course? Will Congress reverse the IRS in the next round of coronavirus legislation? Stay tuned.