On April 30, 2020, the Internal Revenue Service (IRS) issued Notice 2020-32 (the “Notice”) to address the deductibility of loan amounts received under the Paycheck Protection Program (PPP) of the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”). In summary, the IRS stated no tax deduction will be allowed for expenses paid with PPP loan proceeds to the extent such amounts are forgiven under the terms of the CARES Act. This alert outlines the PPP loan forgiveness provision of the CARES Act, the terms of the Notice, the impact the Notice will have on PPP loans moving forward, and the need for additional guidance on the tax effects of loan forgiveness.
PPP Loan Forgiveness under the CARES Act
The CARES Act provides that recipients of PPP loans are eligible for forgiveness to the extent loan funds are used for certain payroll-related costs (“Covered Expenses”). Under Section 1106(i) of the CARES Act, any amounts forgiven are excluded from gross income. The amount of loan forgiveness may be reduced if a recipient does not meet such conditions as maintaining its full-time employees or the salaries of such employees.
While the CARES Act expressly states forgiven amounts are excluded from gross income, it does not address the interplay between Section 1106(i) of the CARES Act and sections of the Internal Revenue Code (the “Code”) relating to the tax consequences of loan forgiveness. In an effort to provide some clarity, the IRS has now issued guidance outlining the effect of loan forgiveness on the deductibility of Covered Expenses.
IRS Notice 2020-32
In the Notice, the IRS determined loan amounts forgiven under Section 1106(i) of the CARES Act are tax exempt income under Section 265 of the Code and the accompanying treasury regulations. Under Section 265(a)(1) of the Code, a taxpayer is not allowed to deduct amounts allocable to income that is wholly exempt from taxes. As a result, any PPP loan amounts used for Covered Expenses will not be deductible to the extent such loan amounts are forgiven. The tax consequences to a loan recipient will be the same as if the PPP loan amounts received were included in gross income and subject to tax. This guidance is unexpected considering Congress expressly excluded the PPP loan amounts from gross income; if amounts were not excluded from gross income, the tax result would be the same.
Tax Consequences of the Notice
The disallowance of a deduction for Covered Expenses reduces the tax benefit available to PPP loan recipients. In some cases, a prospective loan recipient may be in a better financial position if it does not obtain a PPP loan. The following examples illustrate the varying tax consequences of the Notice:
- Example 1 – Net Benefit. Consider a corporate loan recipient that will pay $1 million in employee payroll costs regardless of whether it receives a PPP loan. The recipient obtains a $1 million PPP loan, and uses the loan to pay $1 million in payroll costs that qualify as Covered Expenses. The loan is fully forgiven. Before the Notice, the recipient does not have any additional taxable income from the loan proceeds and has a net benefit of $1 million. After the Notice, the recipient has in effect an additional $1 million in taxable income, producing a federal tax bill of $210,000. For this employer, the PPP loan still produces a net benefit after the Notice in the amount of $790,000.
- Example 2 – Break Even. Consider the same facts as in Example 1, except the loan recipient will not pay employee payroll costs unless it receives a PPP loan. For this employer, there will be no financial benefit in obtaining a PPP loan. If the employer does not receive a PPP loan it will furlough, or lay-off, employees and avoid payroll costs, which results in no tax impact. Under the Notice, the receipt of a $1 million PPP loan will similarly have no tax impact on the employer. The PPP loan is excluded from gross income and the Covered Expenses may not be deducted. Before the Notice, the employer would receive a net benefit equal to the amount of its deduction—$1 million. This employer will want to weigh the additional costs of obtaining a PPP loan (e.g., time spent on application, attorneys’ fees and risk of audit) against the benefit of retaining employees.
- Example 3 – Loss. Consider the same facts as in Example 2, except the loan recipient uses over 25% of the loan proceeds for non-Covered Expenses. In this case, the employer will be out-of-pocket for the non-Covered expenses. The amounts used for Covered Expenses will not be deductible, and result in no tax impact to employer. The employer will then have to repay the portion used for non-Covered Expenses. In this scenario, the employer is better off if it does not obtain a PPP loan. Before the Notice, the employer would have the added tax benefit of the Covered Expense deduction to help offset costs of loan repayment.
- Example 4 – Pass-Through Entities. Pass-through entities face significant tax consequences after the Notice. Consider an S-corporation that receives a $1 million PPP loan. The S-corporation has 10 shareholders, each of which receive a salary of $100,000. Each shareholder is subject to a 40-percent income tax rate (including both federal and state). After the Notice, the S-corporation receives no deduction for payroll expenses at the entity level. Because an S-corporation is a flow-through entity, the disallowance of deductions results in an additional 40-percent tax on the $1 million. Based on the 40-percent income tax rate and 40-percent effective tax due to disallowance of deductions, the S-corporation will only have a net benefit of $200,000.
After the Notice, a partnership that obtains a PPP loan may now be disallowed deductions for guaranteed payments and partners’ K-1 distributions. For a partner that receives a guaranteed payment and a distribution, this will mean tax liability for income, self-employment and the disallowance of a deduction.
Additional Guidance Needed
In effect, the Notice produces a tax result that seems contrary to the purpose of the CARES Act and adds to the unpredictability surrounding the PPP. Due to this unusual result, we are still waiting for further clarification from Congress on its intent behind the loan forgiveness provisions of the CARES Act. In addition to the deductibility of payroll-related expenses, questions remain as to whether PPP loan forgiveness requires a reduction in net operating losses under Section 108 of the Code or impacts a partner’s basis in a partnership under Code Section 752. For these reasons, businesses should carefully assess the risks surrounding PPP loan forgiveness before applying for and obtaining a loan.
Opinions and conclusions in this post are solely those of the author unless otherwise indicated. The information contained in this blog is general in nature and is not offered and cannot be considered as legal advice for any particular situation. The author has provided the links referenced above for information purposes only and by doing so, does not adopt or incorporate the contents. Any federal tax advice provided in this communication is not intended or written by the author to be used, and cannot be used by the recipient, for the purpose of avoiding penalties which may be imposed on the recipient by the IRS. Please contact the author if you would like to receive written advice in a format which complies with IRS rules and may be relied upon to avoid penalties.