Tom Talks Taxes - October 7, 2022

Tax consequences of PPP loan and unemployment compensation noncompliance

I have no doubt the IRS will take enforcement actions in the near future on taxpayers who abused the various COVID relief programs. While employee retention credit (ERC) abuse will be a primary target, don’t forget about Paycheck Protection Program (PPP) loans and pandemic unemployment assistance. Many people claimed those benefits who were not entitled to them, and there are tax consequences.

In this edition, we’re going to take a look at PPP loans and pandemic unemployment insurance. In a future edition, we will focus on ERC examination issues.

The IRS recently issued Chief Counsel Advice 202237010 on whether a taxpayer whose Paycheck Protection Program (PPP) loan was forgiven, even though the taxpayer did not qualify for the forgiveness, must include the PPP loan proceeds in gross income.

The IRS’s position is yes: the taxpayer does not qualify for the income exclusion and would recognize income equal to the PPP loan amount in the year of receipt under the claim of right doctrine. From the CCA:

These exclusions apply only to a qualifying forgiveness of a PPP loan. Forgiveness of a PPP loan is a qualifying forgiveness only if the use of the loan proceeds satisfies the conditions relating to specified costs (as described in 15 U.S.C. § 636m(b), (d)). To receive a qualifying forgiveness, the loan recipient must apply for the forgiveness in accordance with the specific procedures set forth in the statute and associated regulations. Failure to meet these conditions means that there is no qualifying forgiveness, and thus the exclusions would not apply to the forgiven PPP loan.

The PPP loan forgiveness income would likely be subject to self-employment tax for sole proprietors as there is a nexus between the PPP forgiveness income and the carrying on of a trade or business activity.

A taxpayer whose PPP loan forgiveness exclusion is reversed has three possible mitigation options. First, the CCA, in a footnote, states the following:

If the SBA later determines that Taxpayer X had her loan improperly forgiven and, consequently, Taxpayer X pays back the SBA in a later year, the repayment that Taxpayer X makes may result in a deductible expense under section 162 or a deductible loss under section 165 for the later year. Whether Taxpayer X may claim a deduction under section 162 or 165 for the later year depends on all facts and circumstances.

Another option is §1341, which provides relief from a prior income inclusion due to the claim of right doctrine. If there is a “restoration” (i.e., the taxpayer actually makes a repayment, restoration, or restitution) of the amount received, the taxpayer can receive a tax credit or deduction in the year of restoration. See Treas. Reg. §1.1341-1(a) and Chernin v. U.S., 149 F.3d 805 (8th Cir. 1998).

Another option is §108, which provides various exclusions related to income from the discharge of indebtedness. The insolvency exception is the one most likely to apply in this situation, but that will depend on the assets and liabilities of the taxpayer immediately before the PPP loan forgiveness was granted and not when the taxpayer received the PPP loan. If insolvency is used, the taxpayer must reduce their tax attributes by the exclusion amount — there is an actual cost.

What about individuals who erroneously received pandemic unemployment benefits? Regardless of whether or not the taxpayer was entitled to the benefits, they are included in the taxpayer’s gross income.

The American Rescue Plan Act, passed in 2021, added §85(c) to provide a retroactive one-time unemployment compensation exclusion of up to $10,200 per individual for tax year 2020 only if the taxpayer’s 2020 modified adjusted gross income was less than $150,000.

In my opinion, it is likely the IRS will take a position that fraudulently received unemployment compensation will not qualify for the 2020 exclusion.

Going back in time, prior to 1979, unemployment compensation was not subject to income tax. Starting in 1979, there was an income-based exclusion available for unemployment compensation in §85. The Tax Reform Act of 1986 then made unemployment compensation fully taxable with no available exclusions under revised §85. The Congressional Research Service has an interesting report on the taxation of unemployment benefits that goes more into the history.

In 1980, the IRS issued regulations for §85 to implement the new law partially taxing unemployment compensation. Treas. Reg. §1.85-1(c) discusses limitations to the exclusion that existed at that time. The following provision was in that regulation:

(2) Exception for fraudulently received unemployment compensation. If a taxpayer fraudulently receives unemployment compensation under any governmental unemployment compensation program, then the entire amount of such fraudulently received unemployment compensation must be included in the taxpayer's gross income for the taxable year in which the benefits were received. Thus, the limitation in section 85 and in paragraph (c)(1) of this section, does not apply to such amounts.

This regulation does not apply to the current §85(c); it applied to the old §85(c) that existed before the Tax Reform Act of 1986. However, it strongly indicates what the position of the IRS would be with respect to fraudulently received unemployment compensation and the 2020 exclusion in new §85(c).

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