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Loans under the Paycheck Protection Program (PPP) of the Coronavirus Aid, Relief, and Economic Security (CARES) Act may be forgiven if the borrower spends the funds for qualified expenses. In other words, the borrower does not have to repay the loan. Also, the amount of the loan forgiven is not included in the taxable income of the borrower.

The borrower, however, may have a higher income tax bill in 2020 because expenses paid with PPP loan proceeds cannot be deducted. The Internal Revenue Service (IRS) has issued Notice 2020-32 to explain the nondeductibility issue, which was not addressed in the CARES Act. The notice states that because of the forgiveness, the loan proceeds constitute a “class of exempt income” and that Internal Revenue Code (IRC) Section 265 disallows the deduction of expenses paid with such exempt income.

For example, a self-employed owner of a small service business has $150,000 of revenue. He has one employee and total monthly labor expenses of $3,000. His other expenses are $4,000 per month. His net income would be $66,000 as shown in table 1.

Table 1. Profits and Loss without CARES Loan

IncomeExpensesNet Income
$150,000
Labor = $36,000
Other = $48,000
$66,000

Under the CARES Act, he qualifies for a $7,500 loan (2.5 times average monthly labor expenses). If he used the loan proceeds to pay covered expenses ($6,000 of labor cost and $1,500 for rent), he would not have to include the $7,500 in his income, but he would not be able to deduct the $6,000 of labor expenses or $1,500 in rent. His net income would be an additional $7,500 because of the loan forgiveness as shown in table 2.

Table 2. Profit and Loss with CARES Loan

IncomeExpensesNet Income
$150,000
Labor = $30,000
Other = $46,500
$73,500

The concern is that the borrower will have to pay tax on the additional income. If the business owner was in the 15 percent marginal tax bracket, it would cost him an additional $1,125 in federal tax and possibly an additional 5 percent in Alabama income tax. This makes the forgiven loan taxable to the borrower. Although loan forgiveness ordinarily results in taxable income, this does not appear to be the intent of Congress and may be addressed in future legislation.

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