- Debt cancelation amounts are generally included in gross income. This may come as a surprise to unsuspecting borrowers.
- Fortunately, Congress has provided some exceptions and special provisions to address taxpayer concerns with COVID-related debt relief.
Under the Consolidated Appropriations Act 2021 (CAA 2021), Congress provided both financial assistance and tax relief. The massive year-end package ― including tax provisions which effectively told Treasury Department and IRS to give debtors a break — is welcome relief to many individuals and organizations.
Unfortunately for most unsuspecting borrowers, however, debt cancelation is generally included in gross income. So although forgiveness may feel like a gift, it is not treated as such for tax purposes. In addition, this unexpected COVID relief income often comes at a time when the taxpayer is struggling, or at least challenged, to meet financial obligations.
The good news is, Congress added some exceptions and special provisions to address taxpayer concerns with COVID-related debt.
Consult with your advisor on the state and local tax treatment of these stimulus provisions; however, because laws differ between jurisdictions and continue to change as more states seek to address this issue.
CAA 2021 reaffirms that income from the forgiveness of Paycheck Protection Program (PPP) loans is not includable in gross income for federal income tax purposes. As expected, Congress took the relief one step further and specified that expenses associated with these loans are fully deductible. The tax relief is without restriction; the size of the loan and the gross receipts do not matter to the issue of forgiveness. For S corporations and partnerships, the PPP forgiveness also increases the owner’s tax basis in the entity, effectively allowing cash distributions and preventing taxation on the forgiveness in the future. (Note: Consult with your advisors on at-risk basis rules, passive loss limitations, stock basis, timing of the basis increase, and other limitations to fully understand your personal tax situation.)
The taxpayer-favorable treatment (both the exclusion from income and the deduction for related expenses) applies to initial PPP loans as well as second draw PPP funding.
The economic injury disaster loans (EIDL) provide economic relief to small business and nonprofits that are currently experiencing a temporary loss of revenue. Early last year before funds were exhausted, many small businesses, private nonprofit organizations, and small agricultural cooperatives that applied for an EIDL loan requested an emergency “advance” of up to $10,000. The pandemic-related grant does not need to be repaid. However, borrowers must have used the funds to pay sick leave to employees unable to work, maintain payroll during business disruptions or slowdowns, meet increased costs on materials, make rent or mortgage payments, and/or repay obligations that cannot be met.
Under CAA 2021, these grants are tax-free to the recipient and do not jeopardize any related tax deductions. Similar to PPP loans, there is also no detriment to the owners of S corporations and partners. The funds are tax-free, no strings attached.
Under the CARES Act, the Small Business Association (SBA) will make six months of payments for loans guaranteed under section 7(a) of the Small Business Act [7(a) loan program] or title V of the Small Business Investment Act of 1958 (504 loan program). The 7(a) loan program is the SBA’s primary program for providing financial assistance to small businesses. The subsidized payments include principal, interest, and any associated fees that are owed on the loan. Similar to PPP loans and EIDL grants, Congress specifically provided full tax relief to the recipients. The payments are tax free, no deduction shall be denied, no tax attribute shall be reduced, and no basis increase shall be denied. In other words, you are not penalized for the “tax-free” treatment of SBA payments on your behalf.
Employer-paid student loans
In response to COVID-19, Congress provided a temporary exclusion of income for certain employer payments of student loans under the CARES Act. The benefit, which was initially limited to payments from March 28, 2020 through December 31, 2020, has now been extended through the end of 2025. To the pleasant surprise of many, loans are not limited to the employee’s use. The loan can be incurred by the employee to pay higher education expenses for their spouse or for any dependent of the employee (at the time the loan was incurred). However, the generous benefit is limited. It is grouped with other education-related costs (such as tuition, fees, books, supplies, and equipment) that an employer can pay “tax-free” to workers up to $5,250 per year.
Emergency financial aid grants
The law clarifies that qualified emergency financial aid grants under the CARES Act are not includible in gross income. This part is not a big surprise. However, Congress took the relief one step further. Taxpayers who received the nontaxable income are allowed to retain any American Opportunity Tax Credit and/or Lifetime Learning credit they would have otherwise received. This “double-benefit” is welcome relief to students facing hardships related to the COVID-19 pandemic. For other nontaxable educational assistance, such as scholarships, a taxpayer generally must reduce their amount of eligible tuition and related expenses in calculating education credits.
Although not specifically tied to COVID-19 stimulus or relief, the exclusion from gross income on certain loan forgiveness related to your principal residence (second homes do not qualify) will continue for another five years. This provision was set to expire at the end of 2020 but was extended until the end of 2025 along with several other “tax extenders.” However, the $2 million limit on the balance of the loan was reduced to $750,000 for loans forgiven after December 31, 2020.
- Melissa Labant, Principal, CLA
Compliments of CliftonLarsonAllen – a member of the EACCNY.