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Client Alert: IRS Will Determine Whether PPP Loans Properly Forgiven, Treat Improperly Forgiven Amounts as Income

Date: September 28, 2022
As one of the authors noted in a previous alert, “the CARES Act provided that the forgiven amounts of Paycheck Protection Program (“PPP”) loans would not be includable in a PPP borrower’s gross income at the federal level, and subsequent legislation provided that expenses paid with PPP funds would still be tax deductible.”  Recent non-precedential guidance from the IRS’s Office of Associate Chief Counsel, however, has concluded that only properly forgiven amounts will not be treated as gross income by the IRS.  In short, the IRS intends to reach its own determination regarding the propriety of the decision of the U.S. Small Business Administration (“SBA”) to forgive PPP loan amounts.

The Pandemic Response Accountability Committee reports that as of July 4, 2022, more than 11.5 million PPP loans, representing approximately $793 billion in loans, had been issued by the SBA.  Of that amount, approximately $742 billion, or 93.5 percent, had been forgiven, representing partial or total forgiveness of 10.2 million of those loans.  The average amount forgiven totaled approximately $72,500, although 625 of the 707 loans for $10,000,000 (the maximum amount) have been partially or fully forgiven.  Many taxpayers, therefore, potentially face substantial tax liability, if the IRS second guesses the SBA’s determination.

In guidance entitled “Proper Treatment of Improperly Forgiven PPP Loans,” the IRS advises that “a variety of fact patterns may establish that the taxpayer was not eligible for forgiveness under the statute and related regulatory guidance.” That is because a number of facts affect the multi-pronged determination that the taxpayer was both an “eligible recipient” or “entity” of the PPP loan in the first place, used the proceeds thereof on “eligible expenses,” and otherwise qualified for forgiveness of the PPP loan.  These include the requirement that at least 60 percent of the PPP loan amount was used to meet payroll costs, and that all of the proceeds were used only for “eligible expenses.”  Given the fungibility of money and the challenges presented to business by the COVID-19 pandemic, demonstrating these facts to the satisfaction of an IRS auditor may be challenging.

One of the scenarios where the IRS is likely to challenge forgiveness is in instances where the business incurred an unpaid payroll tax liability during quarters for which it received PPP loan funding.  Other cases are likely to arise in the context of an income tax audit where the IRS simultaneously audits business expenses along with the use of the PPP loan funds.

As the IRS guidance indicates, any representations about qualification for PPP loan forgiveness that are erroneous in fact mean that the amounts forgiven “may not be excluded from . . . gross income under 15 U.S.C. § 636m(i),” and the taxpayer “must include the forgiven amount” as gross income.  Failure to do so subjects the taxpayer to tax liability for the amounts not reported as income, as well as penalties and interest.  As noted in the IRS guidance, this tax liability is in addition to and separate from any civil and criminal liability that the taxpayer may face should the SBA determine that the PPP loan was improperly forgiven.

Recent legislative developments suggest that the risk of a contrary determination by the IRS, following a favorable determination from the SBA, has increased for many PPP loan recipients.  On August 16, 2022, the Inflation Reduction Act (“IRA”) was signed into law, which, among other things, provided nearly $80 billion of additional funding over ten years for the IRS.”  According to the Tax Foundation, approximately $45.6 billion represented increased funding for tax enforcement. 

While IRS Commissioner Charles P. Rettig and Treasury Secretary Janet L. Yellen have sought to assure taxpayers that this funding was “absolutely not about increasing audit scrutiny on small businesses or middle-income Americans,” they have also made it plain that businesses with revenue above $400,000 will face an increased risk of audit.  Recent data suggests, in fact, that individuals and small businesses with far less income may expect to face an increased risk of audit relative to the last few years.  Even before adoption of the IRA, the IRS reported substantial increases of audit rates since September 30, 2021, for all income brackets above $25-50,000/year.  This data also demonstrates that a return to 2010 audit rates would be a far greater increase.

That said, it is not clear from the IRS’s recent guidance whether the IRS will audit a taxpayer on the basis of their PPP forgiveness as an independent matter, or will make adjustments based on a full audit of a taxpayer’s income tax return.

In short, taxpayers who received substantial PPP loan forgiveness may be well advised to proactively evaluate their compliance with the PPP loan forgiveness criteria and to be prepared to demonstrate that compliance in the months and years ahead.
The information contained here is not intended to provide legal advice or opinion and should not be acted upon without consulting an attorney. Counsel should not be selected based on advertising materials, and we recommend that you conduct further investigation when seeking legal representation.