Are Expenses Paid with PPP Loan Proceeds Now Deductible?
Congress created the Paycheck Protection Program as a loan from the federal government that was forgivable as long as the proceeds were utilized for specific expenses. Since forgiveness of debt creates taxable income, the legislation also provided that the amount of the loan that was forgiven would not create taxable income for the borrower.
In conflict with that legislation, after loans were made the IRS issued a procedure that stated that borrowers couldn’t deduct those expenses that were paid with PPP loan proceeds. In short, the PPP loan became taxable.
Many organizations, including the American Institute of CPAs, called on Congress to act, pointing out that this was not the intent of the legislation.
Congress appears to have listened. In the COVID-19 relief bill recently agreed to in principle by the House and Senate, Congress overrode the IRS and provided that expenses paid with PPP loan proceeds that are ultimately forgiven will be deductible.
Though the official vote hasn’t occurred, and the President must sign the legislation, this is the furthest that corrective legislation has come and will go a long way to correct some of the problems with PPP loans.
Beware of the PPP Loan Side Effects
Avoiding the Traps of a “Change of Ownership”
- A change of 20% or more of the ownership of equity of the
- The sale of 50% or more of the borrower’s assets, or
- The borrower merging with another entity.
- Establish an escrow account that is controlled by the lender,
- Fund the account with the full amount of the PPP Loan, and
- Simultaneously make application for forgiveness.
First, many lenders weren’t accepting applications until recently and some still aren’t. There’s no relief if a lender isn’t accepting forgiveness applications.
Second, if the transaction doesn’t result in sufficient cash to fund the escrow account, the seller can’t comply. So, what happens if there is a mandatory change such as where the borrower’s equity is transferred at an owners’ death or at an owner’s retirement buyout? Also, if an investor were to make an equity investment into a PPP loan borrower, they’re not likely to be willing to have all or part of that investment sit in an escrow account rather than working in the business.
Third, because definition of change of ownership is overbroad and will capture situations that are not truly changes in ownership. For example, if a key employee is admitted as an owner -such as when a professional is made a partner in a firm – there’s usually no real transfer of the business. Yet, if 20% or more is transferred during the life of the loan, whether or not it is to one individual, a change of ownership will have occurred.
In the Market Pulse Report, brokers reported that, for businesses valued at $2MM and less, 65% experienced closing problems as a result of having an outstanding PPP Loan.
Of those who experienced problems:
- One third had a closing delayed due to ‘unknown’ PPP Loan status,
- Thirty percent had risk allocation problems that couldn’t be resolved, and
- The buyer’s lender refused to finance the transaction in 12% because of the PPP Loan.
Yikes!
My guess is that all of the above can be traced back to the inability to comply with the safe harbor requirements, whether because the lender wasn’t accepting forgiveness applications, or the transaction did not provide sufficient cash.
This means there are a few key things to keep in mind if your business is a PPP Loan borrower:
First, because the definition of change of ownership is so broad, every business needs to submit the forgiveness application as soon as possible. This is an absolute necessity if the PPP Loan balance is below $50,000 since there’s a short form application the borrower can use. It can take up to 150 days for the application to be processed by the lender and the SBA.
Second, if you know a transaction is on the horizon, make sure the cash component of that deal is sufficient to pay all the expenses and provide sufficient funds for the escrow account. You do not want to sign a contract requiring you to sell under terms that don’t allow you to meet the safe harbor requirements.
Third, many owners are considering gifting ownership interests in the business in light of the tax uncertainty arising from the proposals put forth by the new President. Beware of gifts that constitute a change of ownership and keep in mind that the 20% equity change threshold applies to all transfers since the date of the PPP loan, not just individual transfers.
Finally, remember that, you may not be able to foresee a change of ownership. It could arise because of the death of an owner or based on a transfer required by your shareholders or operating agreement. Consider a temporary amendment to the agreement halting any required transfers until the safe harbor requirements can be satisfied or the loan is forgiven.
What Do You Want to Know?
Your questions, problems, and concerns about the complex world of business law are why we do these articles. If you have a question, please let us know. We’d love to hear it and answer it on a future episode!
