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Tax Deductions Tied to Forgiven Small Business Loans Draw Support

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Bipartisan momentum is building in Congress to let small businesses get tax-free loan forgiveness while also deducting their expenses, a move that would provide clarity and unusually generous tax benefits.

Top lawmakers in both parties asked the Internal Revenue Service Tuesday to reverse a ruling that would deny those deductions. And senior senators backed legislation that would overturn the IRS ruling if the agency doesn’t change its position, though how quickly such a bill could move through Congress is far from certain.

The outcome could have hundreds of billions of dollars of consequences for businesses benefiting from the Paycheck Protection Program, which Congress created in March to help small-businesses weather the economic effects of the coronavirus pandemic.

Under that program, companies can get low-interest loans and then have those loans turn into grants if the money is used to maintain payrolls and pay other expenses. The program has proven exceptionally popular, and Congress replenished it after the money ran out within weeks. PPP is now authorized for $660 billion.

The economic-relief law from March explicitly says that the loan forgiveness doesn’t count as taxable income, as it would under normal tax rules. But that law was silent on whether companies could still deduct the associated wages and other expenses.

Last week, the IRS said it would deny those deductions, citing a tax code section that prevents companies from taking deductions tied to tax-exempt income. Allowing the deductions, the agency argued, would offer a double benefit.

Treasury Secretary Steven Mnuchin has defended the decision.

“If the money that’s coming is not taxable, you can’t double dip,” he said on Fox Business on Monday. “This is basically tax 101.”

If the deductions are allowed, businesses could use them to offset other income. If companies are losing money, they could use the deductions to offset past years’ income and get refunds.

For example, consider a company that gets a $100,000 loan and whose owner has a 22% tax rate. If the business pays $100,000 worth of deductible expenses and has the loan forgiven, that would provide a $22,000 tax benefit on top of the loan forgiveness.

Members of Congress say this benefit is exactly what they intended.

“As was expressed to Treasury during the development of the PPP, we did not intend to deny the deductibility of ordinary and necessary business expenses, nor did these small businesses expect to lose deductions for their business expenses when they applied for a PPP loan,” wrote Sen. Chuck Grassley (R., Iowa), Sen. Ron Wyden (D., Ore.) and Rep. Richard Neal (D., Mass.) in a letter to Mr. Mnuchin.  All are leaders of the congressional tax-writing committees.

Their letter also argued that the IRS misinterpreted the existing tax code section that denies deductions related to tax-exempt income.

Messrs. Grassley and Wyden are also backing a bill from Sen. John Cornyn (R., Texas) that would expressly allow the deductions, according to Mr. Cornyn’s office. Rep. Lizzie Fletcher (D., Texas) is introducing a similar bill in the House.

“This legislation would erase any confusion,” Mr. Cornyn said in a statement.