By Joyce Beebe, Ph.D.
Fellow in Public Finance
Over 4.5 million business owners have benefitted from the Paycheck Protection Program (PPP) created by the Coronavirus Aid, Relief and Economic Security Act, also known as the CARES Act (Public Law 116-136). On June 3, Congress passed the Paycheck Protection Program Flexibility Act to provide longer fund disbursement periods, to allow a higher percentage of funds to be used for non-payroll expenses and to extend the number of years for loan repayment. However, PPP recipients need to be aware of certain tax and financial reporting-related compliance issues. This blog post discusses three such issues where the rules are not entirely clear.
Deductibility of Expenses Paid with Forgiven Loan Proceeds
Despite its troubled beginning, the PPP offers generous terms and has extended over $510 billion in business loans. PPP loan recipients are now entering the phase of applying for loan forgiveness. After the passage of the Paycheck Protection Program Flexibility Act, if a borrower uses 60% of funds on payroll expenses over a 24-week period prior to December 31, 2020 and maintains employee headcounts and compensation levels, he or she will be eligible for loan forgiveness. However, the provisions do not discuss federal income tax consequences resulting from loan forgiveness.
In principle, forgiven loans are considered taxable income unless the law specifically excludes them. The CARES Act specifies that the forgiven loan amounts are excluded from gross income; however, it is silent about the deductibility of expenses associated with the forgiven PPP loans. In late April, the IRS issued a notice to clarify that because the forgiven loan amounts are considered tax-exempt income, any corresponding expenses paid for with the funds are not deductible. If businesses are allowed to claim deductions when the forgiven loan proceeds are not included in revenue, taxpayers essentially reap double tax benefits.
This IRS notice immediately created tension between the Department of Treasury and Congress. Several congressional leaders stated that the IRS position is contrary to congressional intent and urged the Department of Treasury to reverse the IRS guidance and allow expense deduction. Several congressional proposals have attempted to provide certainty, including the Small Business Expense Protection Act and provisions in the massive Health and Economic Recovery Omnibus Emergency Solutions Act, but with limited progress.
Some practitioners support the congressional position in that the intention of the law is to provide tax- free income. Some borrowers might have had similar beliefs, but would probably not have applied for the PPP loans knowing the expenses could not be deducted. On the other hand, others believe that because the borrowers do not bear the economic burdens of the expenses, they should not be allowed to deduct them. Under the IRS notice, the tax consequences to a loan recipient would be the same as including PPP loan amounts in the gross receipts and allowing deductions — in the end, there is no additional tax paid. However, both sides recognize the situation is highly unprecedented and have urged Congress to provide further clarification.
State Tax Issues
Whether the expenses are eventually deductible or not, it is clear that the loan forgiveness amounts are not part of the borrower’s gross income and not taxable for federal income tax purposes. However, how the loan forgiveness will be treated for state income tax purposes is less clear. Under current rules, state tax laws link to federal tax laws either on a rolling basis (known as “rolling conformity”), meaning that states’ tax rules update automatically when federal tax rules change, or on a fixed basis (known as “static conformity”), where state legislatures need to specify the date of the federal codes they adhere to. The time gap between current federal rules and the rules states follow can be substantial. For instance, Massachusetts’ individual income tax still follows 2005 federal rules, California’s conformity date is January 2015, New Hampshire uses December 2016 federal rules and Wisconsin conforms to federal rules from December 2017.
For the rolling conformity states, once federal lawmakers address the expense deductibility issue, the state tax consequences associated with the PPP will be clear. However, for the approximately 20 non-rolling conformity states, the state legislatures will need to be diligent and proactively provide clarification for state income tax purposes. In addition, because PPP recipients encompass various entity forms, the tax consequences are not only important to traditional C-corporations that are subject to state corporate income taxes, but also pass-through entities such as limited liability companies (LLC) and S-corporations that are usually subject to state personal income taxes.
Given the current considerations, it is unlikely that the forgiven PPP loan amounts will be taxable at the state level. The technical guidance may not arrive until a later date — possibly not until it’s time for businesses to file their 2020 tax returns next year. However, if states fail to conform by then, or do not issue timely guidance, taxpayers may face additional state income tax bills from PPP loan forgiveness.
Financial Reporting and Disclosure
On the accounting side, the United States’ generally accepted accounting principles (GAAP) provide no guidance on how PPP recipients should recognize and measure potentially forgivable government loans. Based on the features of the PPP, the funds could arguably be treated as government grants or liabilities. However, these treatments have different implications for a company’s financial statements. Recognizing PPP funds as a liability could make a company look more leveraged, whereas a grant makes a company’s balance sheet appear stronger.
Because the legal form of the PPP is debt, a natural starting point is to account for the PPP funds as a liability. This is also a more conservative approach. Accounting practitioners indicate that an entity can recognize the full amount of a loan from the PPP as a liability and accrue interest over the term of the loan. If any amount is ultimately forgiven, income from the cancellation of the liability will then be recognized on the income statement as a gain on loan extinguishment. Some practitioners advise all publicly traded companies with loans over $2 million to follow this approach, given the Small Business Administration’s recent reactions toward public company participation in the PPP.
One could claim that because the congressional intent in the CARES Act was to forgive most PPP loans, they are government grants in substance. As such, if an entity expects to meet the loan forgiveness criteria, it may elect to account for the proceeds as government grants. However, these entities should regularly reassess their ability to satisfy the forgiveness conditions and change the treatment if they no longer meet the requirements.
Regardless of which approach a borrower follows, the company’s financial statements should disclose the PPP funds. Although there is also no authoritative guidance in the U.S. GAAP on disclosure requirements for potentially forgivable government loans, the Financial Accounting Standards Board recommends disclosing the loans in financial statement footnotes, and Securities and Exchange Commission (SEC) registrants should also include information about their PPP loans in public filings. In the disclosure, a company should describe the accounting treatments of its PPP loans, the financial statement line items affected and any relevant information a company believes may influence users’ understanding of its financial condition. In the annual reports, public companies should also discuss the PPP in the management discussion and analysis section and the risk factors section, including topics such as risks related to an entity’s eligibility for PPP loan forgiveness and how the funds affect the company’s liquidity and operations.
In practice, the level of detail disclosed may vary across entities. Some companies may voluntarily report lots of information, whereas others may not reveal much. The potentially inconsistent level of disclosure will be a more prominent issue when calendar year companies file for second quarter results and annual reports. Because most business shutdowns started around mid-March, many analysts expect second quarter results to be worse than those in the first quarter, despite the gradual reopening that started in May. As such, inconsistent levels of disclosure highlight the uncertainty for financial statement users.
The SEC is aware of these issues and has begun to investigate certain cases involving publicly traded PPP loan recipients. Because borrowers need to certify that “current economic uncertainty makes the loan request necessary to support ongoing operations” during the loan application process, the SEC focuses on whether this representation is consistent with companies’ disclosures to investors. They may even potentially review their filings prior to the pandemic, as some companies may attempt to disguise existing, previously undisclosed problems as Covid-19-related. For instance, if a publicly traded company desperately needed PPP funds to survive, it probably should have disclosed such challenges to investors or even declared that the company may no longer be a going concern.
PPP recipients need to be aware of the compliance issues from accounting, financial reporting and tax perspectives. Although the guidance in each of these areas is not entirely clear, the intentions of the governing authorities are clear. Congress and state legislatures should issue rules to align the intentions of the rules and the income tax consequences, providing certainty to taxpayers. In addition, PPP recipients should be diligent about providing sufficient information for financial reporting and disclosure, whereas financial statement users need to be mindful of the potentially inconsistent level of detail in these disclosures.