On April 30, 2020, the IRS released Notice 2020-32 to explain that taxpayers receiving a loan through the Paycheck Protection Program (PPP) are not permitted to deduct business expenses normally deductible, to the extent the expenses are reimbursed by a PPP loan that is forgiven. The guidance follows weeks of debate within the tax community regarding whether the loan proceeds that are used to fund payroll costs, rent, utilities and mortgage interest could still be deducted, because under the CARES Act the loans are forgivable on a tax-free basis. The Act does not say that these “covered” expenses cannot be deducted, but under traditional tax principles taxpayers generally are not permitted to claim deductions for expenses allocable to tax-exempt income. The IRS felt the need to respond, but we suspect that Notice 2020-32 may not be the final word.
The Paycheck Protection Program and Loan Forgiveness
To briefly recap the context to Notice 2020-32, the CARES Act enacted the Paycheck Protection Program allowing businesses with fewer than 500 employees to obtain loans from the Small Business Administration (SBA) for 2 ½ times their average monthly payroll during 2019 (or the prior 12 months), up to $10 million, at 1% interest with a two-year maturity.
We still await further guidance from the SBA addressing how loan forgiveness is calculated. Under the CARES Act, in general PPP loan amounts will be forgiven if they are used to cover payroll costs, rent, utilities and/or mortgage interest during the 8-week period following the loan disbursement. The amount of loan forgiveness will be reduced if, during the 8-week period, there is a decrease in full-time employee headcount, or a decrease in salaries and wages by more than 25% for any employee that made less than $100,000 annualized in 2019. A business has until June 30, 2020 to restore employment and salary levels that were reduced between February 15, 2020 and April 26, 2020. The SBA subsequently ruled that no more than 25% of the loan forgiveness amount can be attributable to non-payroll costs.
Taxation of Loan Forgiveness and Section 265
When a loan is forgiven, ordinarily this results in taxable income (cancellation of debt, or “COD” income) to the taxpayer. There are exceptions to this general rule in cases of insolvency or bankruptcy, but normally cancellation of debt is taxable income. However, the CARES Act explicitly provides that forgiveness of PPP loans does not trigger taxable income, as Section 1106(i) of the Act states that income deemed to arise from the debt forgiveness is excluded from gross income.
While the proceeds of PPP loans may be used to pay amounts that would normally be deducible as ordinary and necessary business expenses, case law has long denied a deduction for an expense when the taxpayer has a right to reimbursement of the expense. Further, Section 265(a)(1) of the Internal Revenue Code denies a deduction for otherwise allowable trade or business expenses that are allocable to tax-exempt income. Revenue Ruling 83-3 explains that the purpose of Section 265 “is to prevent a double tax benefit” by denying deductibility where expenses are “incurred for earning or otherwise producing tax-exempt income … [or] where tax-exempt income is earmarked for a specific purpose and deductions are incurred in carrying out that purpose.”
Notice 2020-32 states that neither Section 1106(i) of the CARES Act nor any other provision of the Act addresses whether deductions otherwise allowable under the Code for payments of eligible Section 1106 expenses by a recipient of a PPP loan are allowed if the loan is subsequently forgiven under Section 1106(b) of the CARES Act as a result of the payment of those expenses. After reviewing Section 265 and applicable case law, the IRS concludes in the notice that to the extent a PPP loan is forgiven, any otherwise deductible expense which was paid with proceeds from the forgiven PPP loan will not be deductible. The notice states that this treatment, in preventing a double tax benefit, is consistent with the purpose of Section 265.
Notice 2020-32 continues by asserting that the Service’s conclusion is consistent with prior IRS guidance addressing the application of Section 265(a) to otherwise deductible payments, such as Revenue Ruling 83-3. Following the analysis set forth in that ruling, there is a direct link between (1) the amount of tax exempt loan forgiveness that a recipient receives pursuant to Section 1106 of the CARES Act, and (2) an equivalent amount of the otherwise deductible payments made by a recipient for eligible Section 1106 expenses, which constitutes a sufficient connection for Section 265(a) to apply to disallow deductions for such payments.
The Response to IRS Guidance
The reaction to Notice 2020-32 within the tax community and on Capitol Hill was immediate. Practitioners commented that the guidance clearly went against the intent of Congress, which meant for the expenses funded with PPP loans to be deductible. Chris Hesse, chair of the AICPA Tax Executive Committee, said, “In effect, the IRS guidance means that the taxability provision [Section 1106(i) of the CARES Act] has no meaning. Why waste the ink to say that for purposes of the Code, the loan forgiveness is not includible in income, if the government will just take away deductions in the same amount?” The AICPA intends to lobby for a legislative fix; “We’re hopeful that we’ll see movement on the legislative front early next week”, said Edward Karl, AICPA Vice President – Tax Policy & Advocacy.
Senate Finance Committee Chair Chuck Grassley was quick to express his disappointment with the IRS guidance and stated that Notice 2020-32 was contrary to Congressional intent: “The intent was to maximize small businesses’ ability to maintain liquidity, retain their employees and recover from this heath crisis as quickly as possible.” Grassley did not commit to make changes to the PPP to reverse the IRS ruling by statute. However, the top House tax writer intends to take legislative action to make expenses funded with PPP loans deductible. “We are planning to fix this in our next response legislation,” Erin Hatch, the spokesperson for House Ways and Means Committee Chair Richard E. Neal, said May 1.
With Notice 2020-32, the IRS confirmed that taxpayers cannot claim tax deductions for the wages, rent, utilities and mortgage interest expense paid with forgivable PPP loans, but practitioners and the AICPA have quickly countered that the guidance appears to conflict with Congressional intent. The CARES Act explicitly states that loan forgiveness does not result in taxable income, but pronouncing the expenses paid from loan funds to be non-deductible effectively makes the amount forgiven taxable income to the borrower. Deductibility would appear to be the more sensible policy option because the CARES Act was intended to provide relief to taxpayers impacted by the unparalleled economic disruption caused by the COVID-19 pandemic.
A “notice” is defined as a public pronouncement that may contain guidance that involves substantive interpretations of the Internal Revenue Code or other provisions of the law. In view of the relatively low position that IRS notices occupy in the hierarchy of tax authorities, could a taxpayer consider taking the position that the CARES Act provides substantial authority for deducting the expenses paid by forgiven PPP loan amounts? Congress has already authorized approximately $650 billion for the Paycheck Protection Program and given the sheer size of this loan program it would seem unlikely for the government to allow the issue of deductibility to be governed by the individual decisions of taxpayers and their advisors. Immediately we are seeing calls for Congress to reverse the Service’s denial of tax deductions for PPP expenses through a statutory change, either by amending Section 265 or perhaps adding a new provision. Therefore, for now we suggest that taxpayers keep an eye out for further developments.
If you have further questions regarding tax deductions relating to PPP loans, or any other concerns regarding loan forgiveness, please contact your Bennett Thrasher tax advisor or call 770.396.2200.