IRS Reverses Position on Deductibility of Paycheck Protection Program Loan Expenses

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Key Points

  • The CARES Act provides that PPP loans may be forgiven without causing the borrower to incur cancellation of debt income, but did not address whether business expenses could be deducted if paid for by PPP loan proceeds.
  • On April 30, 2020, the IRS published Notice 2020-32 clarifying that taxpayers whose PPP loans were forgiven could not deduct business expenses covered by such loan proceeds.
  • As part of the end of the year COVID-19 relief and appropriations legislation signed into law on December 27, 2020, Congress expressly provided that taxpayers may treat expenses paid with PPP loan proceeds as ordinary and necessary business expenses reducing their overall gross income.
  • The IRS subsequently issued new guidance (Rev. Rul. 2021-2), reversing its original position in Notice 2020-32.

The Coronavirus Aid, Relief, and Economic Security Act, Pub. L. No. 116-136, (the CARES Act) modifies several tax provisions in the Internal Revenue Code (the Code). The modifications are designed to provide relief to businesses and individuals adversely affected by the economic effects of the COVID-19 crisis.

In particular, Section 1106 of the CARES Act provides that loans made under the Paycheck Protection Program (the PPP) may be forgiven without causing the borrower to incur cancellation of debt income so long as the loan proceeds were ultimately used for payroll, certain mortgage interest and rent obligations, and utility expenses. However, the CARES Act was silent on whether businesses may deduct expenses paid with loan proceeds, which are ultimately forgiven.

On April 30, 2020, the IRS first addressed this issue in Notice 2020-32. In the notice, the IRS interpreted the principles of Code Section 265 (generally prohibiting a deduction for expenses allocable to tax-exempt income) to determine that "no deduction is allowed under [the Code] for an expense that is otherwise deductible if the payment of the expense results in forgiveness of a covered loan." In our legal alert published on May 1, 2020 (No Deduction for You: Notice 2020-32 Restricts PPP Loan Deductions but Prominent Lawmakers Balk), we noted that, as a result of this notice, a business that accepted PPP loans would potentially have non-deductible expenses which would, in turn, increase such business' tax liability.

The IRS' position was heavily criticized by prominent lawmakers such as House Ways and Means Committee Chair Richard E. Neal (D-Mass.), Ranking Member Ron Wyden (D-Ore.), and Senate Finance Committee Chair Chuck Grassley (R-Iowa). In a letter to the U.S. Secretary of the Treasury, the legislators wrote that disallowing business deductions as provided in Notice 2020-32 "reverses the benefit that Congress specifically granted by exempting PPP loan forgiveness from income" and effectively renders Section 1106 "meaningless." Grassley and other legislators further indicated that Congress intended to allow businesses to obtain a business deduction for expenses paid with PPP loan proceeds.

On December 27, 2020, President Trump signed into law the end of the year COVID-19 relief and appropriations legislation passed by Congress, which includes the "COVID-Related Tax Relief Act of 2020." The legislation clarifies that business expenses paid for with a PPP loan will be treated as deductible for federal tax purposes even if paid with forgivable loan proceeds.

Following the enactment of the COVID-Related Tax Relief Act of 2020, the IRS published Rev. Rul. 2021-2, which reverses their position in Notice 2020-32, noting that such conclusions are "no longer accurate statements of law" and are now "declared obsolete." This change is retroactive and thus applies to PPP loans already funded under the existing PPP loan program during 2020. Taxpayers may deduct eligible business expenses paid for with a PPP loan received during 2020.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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