The Deductibility Of Expenses Paid With Forgiven PPP Loan Proceeds

McCarter & English, LLP

McCarter & English, LLP

On April 30, 2020, the Internal Revenue Service (the “IRS”) released Notice 2020-32. The Notice sets forth the IRS’s position that no deduction is allowed for federal income tax purposes for any expense paid with loan proceeds that are received and forgiven under the Paycheck Protection Program (“PPP”), provided for by the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”). The Notice has been criticized by members of both houses of Congress, and there appears to be bipartisan support to enact legislation that will override the Notice.

By way of background (discussed more fully here), the PPP was established by the CARES Act to provide loans to eligible small and midsize businesses to maintain payroll (including benefits), hire back employees who have been laid off, and cover applicable overhead, such as mortgages, rent, and utilities. Under the PPP, a recipient of such a loan may use the proceeds to pay, among other things: certain “payroll costs,” as detailed herein; interest on mortgage obligations; rent; utilities; and interest on other debt obligations (collectively, “Covered Expenses”). For purposes of a PPP loan, “payroll costs” consist of: compensation to employees, including salary, wages, commissions, or similar compensation; cash tips or the equivalent; payment for vacation, parental, family, medical, or sick leave; severance for dismissal or separation; payment for employee benefits, including group health care coverage and insurance premiums; retirement benefits; and the payment of state and local taxes assessed on an employee’s compensation.

One of the key features of the PPP is loan forgiveness, under which a recipient of a PPP loan may, subject to meeting the specific requirements under the CARES Act, be excused from repaying up to the full amount of that loan, inclusive of principal and interest, if the loan proceeds are used to pay for Covered Expenses incurred over an eight-week period generally beginning on the date the PPP loan is originated. Generally, federal income tax law requires the amount of a forgiven debt to be recognized as gross income. For federal income tax purposes, the CARES Act specifically excludes from the gross income of a recipient of any PPP loan the amount of forgiven PPP loan proceeds.

Generally, federal income tax law permits a tax deduction for all ordinary and necessary business expenses paid or incurred during the taxable year in carrying on any trade or business. However, a taxpayer generally may not claim a tax deduction with respect to an otherwise tax-deductible expense where the expense is paid using tax-exempt income. The Notice acknowledges that Covered Expenses constitute typical trade or business expenses for which a tax deduction is generally appropriate, but concludes that because the CARES Act excludes from gross income any PPP loan proceeds that are forgiven, such income is tax-exempt income and the related Covered Expenses are nondeductible. As a result of this position, the IRS essentially negates a benefit arguably bestowed by the CARES Act: while the business does not recognize the additional income resulting from the loan forgiveness, it loses the deduction related to the payroll costs and other expenses paid with the proceeds of the PPP loan.

As we previously noted, the IRS’s position in the Notice has received significant criticism from certain legislators. For example, in a bipartisan letter to Treasury Secretary Steve Mnuchin dated May 5, 2020, Senator Chuck Grassley (R-IA), Senator Ron Wyden (D-OR), and Congressman Richard E. Neal (D-MA) stated that Congress “did not intend to deny the deductibility of ordinary and necessary business expenses.” The following day, on May 6, 2020, Senator Grassley, Senator Wyden, Senator John Cornyn (R-TX), Senator Marco Rubio (R-FL), and Congressman Tom Carper (D-DE) introduced the Small Business Expense Protection Act to clarify that expenses paid with a forgiven PPP loan are tax-deductible. Congresswoman Lizzie Fletcher (R-TX) announced that she too will be introducing legislation to ensure that employers with forgiven PPP loans are allowed a deduction for wages and other expenses paid during the period of the loan.

It remains to be seen whether bipartisan congressional support will provide taxpayers with legislative relief from the positions set forth in the Notice. Nonetheless, we suggest that taxpayers who received a PPP loan continue to monitor this developing situation and, prior to filing their 2020 income tax return, consult with their tax advisor to determine whether legislative relief has been enacted and, if not, whether there are opportunities to challenge the IRS’s position in the Notice. We will update this alert as this rapidly developing situation continues to unfold.

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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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