The IRS Denies Tax Deductibility of Business Expenses Paid With Forgiven PPP Loans

In Notice 2020-32 (Notice), released on April 30, the Internal Revenue Service (Service) stated that otherwise deductible expenses incurred by businesses that result in the forgiveness of Paycheck Protection Program (PPP) loans are not deductible for tax purposes to the extent the forgiveness of such loans is excluded from gross income.

The Coronavirus Aid, Relief, and Economic Security (CARES) Act, enacted on March 27, established the PPP administered by the U.S. Small Business Administration (SBA). The principal amount of a PPP loan is eligible for forgiveness (subject to submission of proper documentation) up to an amount equal to the total of eligible compensation and other payroll costs, mortgage interest, rent, and utilities costs incurred and/or paid during the eight-week period following the origination of the loan. Loan forgiveness is subject to reduction if the borrower reduces the number of employees, employee salaries or both during the eight-week period following the origination of the loan. The CARES Act provides that any canceled indebtedness will be excludable from gross income.

In addition to the loans granted under the PPP, the CARES Act provides for expansions of the SBA’s Economic Injury Disaster Loan (EIDL) program and loans under Section 7(b)(2) of the Small Business Act. The CARES Act also establishes relief programs for certain industries, including aviation and national security. The CARES Act does not provide for loan forgiveness or similar arrangements for any of these types of relief other than PPP loans to the extent described above. In connection with these relief programs (other than PPP), the CARES Act does not establish any exclusions from gross income for tax purposes. Instead, the amount of any loan forgiveness under one of these other loan programs would presumably be taxable to the borrower as gross income under Section 61 of the Internal Revenue Code of 1986, as amended (the Code), unless excludable under Section 108 of the Code due to the insolvency or bankruptcy of the borrower.

In the Notice, the Service announced that any otherwise deductible expenses that result in forgiveness of a PPP loan will not be deductible in computing the taxpayer’s income. As described above, PPP loan forgiveness is only available to the extent of eligible compensation and other payroll costs, mortgage interest, rent and utilities costs, all of which are generally otherwise deductible. The Notice is intended to prevent the double tax benefit that would otherwise result if funds paid to a taxpayer under the PPP were excluded from gross income and also gave rise to a tax deduction when utilized.

The Service bases its conclusion on Section 265(a)(1) of the Code and related case law and Treasury guidance. Section 265(a)(1) of the Code generally disallows deductions for otherwise deductible expenses that are allocable to tax-exempt income. In addition, case law and published rulings generally deny deductions for otherwise deductible payments for which the taxpayer receives reimbursement. In applying Section 265(a)(1) of the Code, the Notice emphasizes the direct link between the amount of tax-exempt PPP loan forgiveness and the equivalent amount of the otherwise deductible payments made by the PPP loan recipient.

While the Service’s conclusion is arguably in line with established tax principles, as set forth in the Notice, it appears to be directly at odds with congressional intent in providing for the exclusion of the PPP loan forgiveness from income. It is true that the CARES Act is silent regarding the deductibility of payments made using funds from forgiven PPP loans. However, in most if not all circumstances, the exclusion granted by Congress would provide no benefit to the taxpayer if the associated expenses are not deductible. Future federal COVID-19 relief legislation may provide for the tax deductibility of expenses that result in PPP loan forgiveness, notwithstanding the exclusion of such loan forgiveness from gross income. Senate Finance Committee Chair Chuck Grassley, R-IA, has expressed that the Notice is contrary to the intent of the CARES Act, which was to maximize small businesses’ ability to maintain liquidity, retain employees and recover quickly from the COVID-19 crisis. The press reports that Erin Hatch, spokesperson for House Ways and Means Committee Chair Richard E. Neal, D-MA, stated that “We are planning to fix this in the next response legislation.” Absent a legislative fix, it is also possible that Notice 2020-32 may be subject to taxpayer challenge in court.

As for the other CARES Act relief programs described above, neither Congress nor the Service has addressed the deductibility of expenses funded through such programs. Given that the CARES Act does not create any exclusions from the general taxation of such items, otherwise deductible expenses paid using funds from such programs should be deductible for tax purposes.