Breaking down the tax implications of PPP loans

J. David Ake/AP

FILE - This April 13, 2014, file photo shows the Internal Revenue Service (IRS) headquarters building in Washington. 2019 was another tough year for the IRS, according to a new federal report. Burdened with years of budget cuts and a recent increase in workload to implement a new tax law, the IRS struggled to deliver on its mission in the past fiscal year. The annual report from the Office of Taxpayer Advocate found that in the 2019 fiscal year, among other problems, the agency failed to collect billions in unpaid taxes. (AP Photo/J. David Ake, File)

By: Kelsey Sheehy, Nerd Wallet

The approaching tax season is raising fresh questions for business owners who received a loan through the Paycheck Protection Program.

Can you deduct expenses paid with your loan funds? Do you need to do anything differently this year? And if your loan is forgiven, is it considered taxable income?

Answers to these questions have been hard to nail down, in part due to shifting guidance from the IRS. But new rules spelled out in the latest round of coronavirus relief help put an end to the confusion.

“Doing your taxes wasn’t easy before COVID,” says Keith Hall, president and CEO of the National Association for the Self-Employed. “The good news is this year isn’t going to be any harder than tax returns you’ve had in the past.”

Forgiven PPP loans are not taxable

“Historically and forever, if you have a business loan and it is forgiven, that automatically is taxable income. It’s been in the internal revenue code forever,” Hall says.

Paycheck Protection Program loans break from that code. Congress specified, and the IRS clarified, that forgiven PPP loans will not count as income. This applies whether your entire loan is forgiven or just a portion.

“If it is forgiven, it will not be taxable income. Period,” Hall says.

You can deduct expenses paid with a PPP loan

This one has been more of a moving target. Initially, the IRS’ position was this: Expenses paid with PPP loan funds can’t be deducted if the loan was or will be forgiven.

However, that changed with the coronavirus relief act signed into law on Dec. 27, 2020, which specifies that deductions shouldn’t be denied simply due to the loan being forgiven.

That means expenses paid with your PPP loan are deductible.

This outcome effectively creates two layers of tax benefits for PPP loan recipients, says Roshani Pandey, financial advisor and founder of True Root Financial in San Francisco.

“The first benefit is making the loan income-tax-free,” Pandey says. “The second is allowing businesses to claim income deductions on expenses paid.”

Business taxes are not an allowable use of PPP funds

The latest round of coronavirus relief also gives business owners more flexibility with how they spend PPP funds. Newly covered costs include protective equipment, property damage and business software.

Business taxes aren’t part of that expanded list. So if you use your PPP loan to pay your business taxes, that amount won’t be forgiven.

You can still claim the Employee Retention Tax Credit

Businesses can now claim the Employee Retention Tax Credit if they meet the requirements. There’s one important caveat: You can’t claim wages paid with a forgiven PPP loan.

You can, however, claim the credit on wages paid above and beyond the amount forgiven.

To qualify for the tax credit, you must continue to pay employees despite being temporarily shut down because of COVID-19 restrictions or suffering a 20% drop in gross receipts compared with the same quarter in the prior year.

These changes were ushered in with the coronavirus relief bill on Dec. 27, 2020, but are retroactive to March 12, 2020. The credit is good on qualified wages paid up to July 1, 2021.