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.
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.
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.
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:
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.
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.
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