Deductions Disallowed for Expenses Related to Payroll Protection Program Loan Forgiveness

On April 30, 2020 the IRS released Notice 2020-32 (the Notice) answering a major tax question involving the Paycheck Protection Program (PPP); understandably, taxpayers will not like the answer.  The IRS has concluded that otherwise allowable expenses allocable to the use of proceeds from PPP loan forgiveness will not be deductible in computing the taxpayer’s income.  This conclusion is irrespective of the language in the CARES Act (the Act) under Section 1106(i) that the cancellation of indebtedness of a PPP loan, under the provisions of Section 1106(b), “shall be excluded from gross income” in computing the taxpayer’s taxable income.  The IRS points out in the Notice that while the Act provides that PPP loan forgiveness is not taxable income, no provisions of the Act address the ability to deduct eligible expenses paid from such loan proceeds.

In summary, the IRS reached their conclusion by analyzing Internal Revenue Code Section 265 (Expenses and Interest Relating To Tax Exempt Income), underlying regulations and rulings, and IRS favorable case law.  Under their analysis, the IRS determined that the PPP loan forgiveness is a class of tax exempt income that requires expenses associated with that income to be disallowed as a deduction for federal income tax purposes.  The IRS states this conclusion is consistent with prior guidance that addresses the application of Section 265(a) to otherwise deductible payments.

In particular, the IRS notes that Rev. Rul. 83-3 provides that where tax exempt income is earmarked for a specific purpose, and deductions are incurred in carrying out that purpose, Section 265(a) applies because such deductions are allocable to the tax-exempt income.  Following the analysis set forth in Rev. Rul. 83-3, the IRS believes there is a direct link between (1) the amount of tax exempt covered loan forgiveness that a recipient receives pursuant to Section 1106 of the Act, and (2) an equivalent amount of the otherwise deductible payments made by a recipient for eligible section 1106 expenses (payroll costs, certain employer paid healthcare benefits, certain interest, rent, and utilities) constitutes a sufficient connection for Section 265(a) to apply.  Accordingly then per the IRS, tax deductions for such payments under any provision of the Internal Revenue Code, to the extent of the income excluded by the application of Section 1106(i) of the Act, are disallowed.

Is this Notice the final word on this issue?  Maybe not; first, it is possible a taxpayer could decide to challenge this position in court.  Whether a taxpayer would or would not prevail is open to question.  Another option would be for Congress to act in the next Coronavirus bill (assuming there will be such a bill) to enact an amendment to make clear that expenses used to justify PPP loan forgiveness are specifically deductible.  The IRS could also be pressured into withdrawing the notice under demands from Congress, the Administration, and the public that the outcome was not the intended understanding when the law was enacted.  Time will tell.

Unfortunately, The IRS position is clear at this time that deductions are not allowed related to the forgiveness of the PPP loan.  In the meantime, if you have any questions, or need assistance modeling the cash flow affects of this decision, please contact your Schneider Downs tax advisor.

Please visit our Coronavirus Resource Center for related content.

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