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When Congress passed the Paycheck Protection Program (PPP), a program of small business loans intended to soften the economic blow of COVID-19 as part of the larger CARES Act, it was never intended to come with a catch. Nonetheless, the bureaucrats at the IRS concocted one by issuing a determination that expenses associated with PPP loans would not be tax deductible. This directly contradicted Congress’s intent and now legislators have moved to overrule the agency in the latest COVID relief bill, ensuring that businesses receiving PPP loans won’t face a surprise tax increase come April.

PPP was the main thrust of efforts to provide much-needed liquidity and relief to small businesses under the extraordinary circumstances of the COVID crisis, with more than 5 million businesses receiving over $500 billion in loans through the program. Loans disbursed under the program were structured so that they could be forgiven if the businesses receiving them met certain requirements.

Under normal tax law, forgiveness of government-issued loans qualifies as taxable income. However, Congress had no desire to hit the same businesses it was attempting to provide relief to with an extra tax bill. As such, Congress explicitly clarified in the CARES Act that forgiven PPP loans should not be included in a business’s taxable income.

That should have been the end of the issue, but for the actions of the Internal Revenue Service (IRS). In late April, the IRS issued Notice 2020-32, which effectively contradicted Congressional intent on PPP by administrative fiat.

Notice 2020-32 declared that while the IRS would indeed allow businesses to exclude PPP loans in determining taxable income, it would also not allow businesses to deduct any expenses incurred using those same PPP loans. Congress’s language in the CARES Act ensured that forgiven PPP loans would not increase taxable income, but Notice 2020-32 turned it around and made it so that those same PPP loans would decrease a business’s deductible expenses.

Practically speaking, this has almost the same effect as taxing forgiven PPP loans. Take a simplified example of a business making $400 with $350 in expenses, receiving a forgiven $100 PPP loan that it then spends. If the forgiven PPP loan is taxable, the business makes $500 against $450 in expenses, resulting in it having $50 of taxable income. Under Notice 2020-32, on the other hand, that business only has $400 in income but also only $350 in deductible expenses, resulting in the exact same amount of taxable income — $50.

Congress left no doubt that this was not its intent. Senate Finance Committee Chair Chuck Grassley (R-IA), Ranking Member Ron Wyden (D-OR), and House Ways and Means Committee Chair Richard Neal (D-MA) issued a bipartisan rejection of the IRS interpretation, declaring that the agency ignored the intent of Congress and urging reconsideration. Nevertheless, the IRS doubled down on its stance in November.

Fortunately, the relief bill that appears poised to become law clarifies the wrongheadedness of the IRS interpretation once and for all by stating that PPP loan expenses are deductible. In so doing, it should help small businesses avert an unexpected tax bill.

Nevertheless, the IRS’s actions can still have far-reaching consequences. State revenue agencies may still follow in the IRS’s footsteps, choosing not to allow deductibility of PPP loan expenses. A federal fix to prevent an unnecessary tax hit is a good thing, but that doesn’t mean the problem is fully fixed.

Still, Congress deserves credit for putting in the effort to address a serious problem not of its own making. In the future, the IRS should avoid creating tax hikes where legislators never intended for one to exist.

Andrew Wilford is a policy analyst with the National Taxpayers Union Foundation, a nonprofit dedicated to tax policy research and education at all levels of government. 

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