Typically, you can't deduct business expenses you pay with tax-free government grants or loans. But does this rule apply to the hugely popular PPP loans?
One of the most popular economic relief programs begun during the COVID-19 pandemic has been the Paycheck Protection Program. Millions of small businesses, including many self-employed individuals, obtained Paycheck Protection Program (PPP) loans through the Small Business Administration (SBA).
PPP loans are low-interest loans designed to help small businesses weather the COVID-19 economic downturn. A business with fewer than 500 full-time employees could borrow up to 2.5 times its average monthly payroll costs for 2019 or 2020, up to $10 million. Self-employed people without employees could borrow 2.5 times their average gross monthly income, up to $20,833.
PPP loans proved so popular Congress expanded the program to allow two separate loans: first-round PPP loans and second-round loans for those who already received a PPP loan. However, second-round PPP loans were only available for businesses that experienced at least a 25% reduction in gross receipts between comparable quarters in 2019 and 2020.
The SBA stopped making new PPP loans in May of 2021 when the program ran out of funding. For more information, see the SBA Paycheck Protection Program page.
PPP loans are two-year loans with a 1% interest rate. But what made them so popular is that they can be forgiven by the SBA. "Forgiven" means you don't have to pay them back.
To obtain such forgiveness, you must file an application with the bank or other financial institution that processed your PPP loan for the SBA. Businesses with employees qualify for forgiveness if they spent at least 60% of the PPP loan on employee payroll during the 8 week or 24 week period after receipt of the loan and also maintained the number of employees on their payroll. If you're self-employed without employees, you qualify for PPP loan forgiveness if you certify that you used the loan to pay yourself as the owner of your business.
Under normal tax rules, when a lender forgives or cancels a debt the amount forgiven becomes taxable income—that is, it must be included in the borrower's income. This is called "discharge of debt" income. However, Congress enacted a special tax rule making forgiven PPP loans completely tax-free for the businesses that receive them. (COVID-Related Tax Relief Act of 2020, Section 276(a)). So, for example, a self-employed person who has a $15,000 PPP loan forgiven doesn't have to include the money in their income for the year.
Under normal tax rules when you use tax-free government money to pay business expenses, you don't get to deduct the expense from your taxes. For example, under the regular rules, a business that uses forgiven PPP loan money to pay employee salaries and rent could not also deduct those expenses from its taxes. This makes sense because if you deduct expenses paid with tax-free government money, you are "double dipping"—benefiting twice tax-wise from the forgiven loan money.
The IRS originally wanted to apply the normal rules to forgiven PPP loans and make expenses paid with them not deductible. However, this caused an uproar in the business community and Congress. As a result, Congress enacted a special tax rule allowing businesses to fully deduct all expenses paid with forgiven PPP loans. This rule has been fully implemented by the IRS. (Revenue Ruling 2021-02).
You don't have to list the PPP loans in your business tax return. In addition, lenders that process PPP loans do not have to file with the IRS, or furnish to borrowers, a Form 1099-C reporting the forgiven amount of PPP loans.
Most of the 42 states that have state income taxes are following the federal government's lead and are not taxing PPP loans that are forgiven by the IRS. They are also allowing business expenses paid with forgiven PPP loans to be deducted for state income tax purposes.
However, there are special rules in some states. For example, in California, forgiven PPP loans are tax-free for all businesses, but the expense deduction is disallowed for publicly traded companies and businesses that did not experience a 25% year-over-year decline in gross receipts between 2019 and 2020. Virginia allows an expense deduction for only up to $100,000 in forgiven PPP loans.
Check with your state tax agency to see how it's treating forgiven PPP loans.