COVID-19 Response: Tax Update - IRS Disallows Tax Deductions for Expenses Paid from Forgiven Payroll Protection Loans
(May 1, 2020) - If a recipient of a Payroll Protection Program (PPP) loan uses the money to pay eligible expenses, then the borrower stands to reap two benefits. Economically, the loan can qualify to be forgiven. From a tax perspective, the forgiven amount of the PPP loan is excluded from the borrower's taxable income.
This tax benefit of a PPP raises the question: may a borrower also deduct the expenses for which the borrower uses the loan proceeds?
On April 30, 2020, the IRS answered "No." The IRS defended its decision as necessary to prevent a double tax benefit.
Here's what you now need to know about the income tax consequences of having a PPP loan forgiven:
Pertinent Provisions of CARES Act
Under the CARES Act, a recipient of a covered loan can qualify to have all or some of the loan forgiven. The loan generally can be forgiven to the extent that the borrower uses the loan to pay eligible expenses during the eight-week covered period of the loan. Eligible expenses consist of:
- payroll costs
- interest on covered mortgage obligations
- covered rent obligations
- covered utility payments
CARES Act Section 1106(b).
The forgivable amount is subject to reduction if the borrower reduces payroll during the covered period, and various other technical requirements apply. For details, see Lewis Brisbois’ previous alert "CARES Act 3.5 Provides Additional Funding for Small Business and Healthcare Relief Programs."
Any amount of the forgiven PPP loan that otherwise would be taxable is excluded from gross income subject to Federal Income Tax. CARES Act Section 1106(i). This special rule overrides the general rule that, subject to exceptions predating the CARES Act, income from the discharge of indebtedness (commonly labeled “COD income”) normally must be included in a borrower's gross income.
General Tax Treatment of Eligible Expenses
Under tax law generally, eligible expenses paid from a PPP loan generally qualify to be deducted in determining the borrower’s taxable income. For example, a borrower may deduct ordinary and necessary trade or business expenses (Internal Revenue Code (IRC) Section 162(a)) and interest expense (IRC Section 163).
IRS Rationale and Legal Support
The IRS has concluded, however, that borrowers of PPP loans would enjoy an inappropriate double tax benefit if allowed both to exclude a forgiven PPP loan from income and to deduct the expenses for which the borrower uses the loan. To rationalize this position, the IRS relied primarily on IRC Section 265(a), which basically disallows deductions for expenses allocable to income exempt from income tax.
The IRS Notice disallows deductions to the extent of the covered loan forgiveness (up to the aggregate amount forgiven). If less than all of a PPP loan is forgiven, then only the corresponding percentage of associated expenses would be nondeductible.
By taking this position, the IRS essentially has neutralized the Federal Income Tax consequences of a PPP loan. To the extent the loan is forgiven, the forgiven amount is excluded from taxable income, but the associated expenses are nondeductible, providing no net tax benefit to the borrower. This updated tax treatment, however, does not diminish the economic benefits of PPP loans.
Reacting to the IRS’ announcement, influential Congressional tax writers publicly expressed disappointment with it and suggested possibly addressing it legislatively. Consequently, the next chapter on this issue possibly has yet to be written.
IRS Notice 2020–32, released April 30, 2020
Visit Lewis Brisbois' COVID-19 Response Resource Center for more news and alerts on a variety of legal areas impacted by the pandemic.
Michael J. Grace, Partner
John J. Heber, Partner
Sara Jane Holland, Partner