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Is the IRS Undercutting the Goal of the PPP? New IRS Guidance Provides that Forgiven PPP Costs are not Deductible

On April 30, 2020, the IRS released Notice 2020-32 addressing the deductibility of otherwise deductible expenses incurred in in a taxpayer’s trade or business, when the taxpayer receives a Paycheck Protection Program (PPP) loan.

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Insights  <  Is the IRS Undercutting the Goal of the PPP? New IRS Guidance Provides that Forgiven PPP Costs are not Deductible

On April 30, 2020, the IRS released Notice 2020-32 addressing the deductibility of otherwise deductible expenses incurred in in a taxpayer’s trade or business, when the taxpayer receives a Paycheck Protection Program (PPP) loan.

On April 30, 2020, the IRS released Notice 2020-32 addressing the deductibility of otherwise deductible expenses incurred in in a taxpayer’s trade or business, when the taxpayer receives a Paycheck Protection Program (PPP) loan.

Notice 2020-32 provides that for federal income tax purposes, no deduction is allowed for an expense if the payment of the expense results in forgiveness of the PPP loan. More specifically, allowable PPP expenses paid (i.e. payroll costs, mortgage interest, rent, and utilities) will not be deductible for federal income tax purposes to the extent of the resulting PPP forgiveness (up to the aggregate amount forgiven) because such payment is allocable to tax-exempt income.

blum Insight on Notice 2020-32

A particularly attractive feature of the PPP loan was the potential for forgiveness on a tax-free basis. While forgiveness of the PPP loan will still be excluded from taxable income, the IRS’s position on disallowance of the PPP allowable expenses (to the extent of the forgiveness) essentially neutralizes the “tax-free” nature of the forgiveness for federal income tax purposes. While the IRS provides a strong technical argument in support of this position, disallowing deductions in the context of the PPP appears to completely undercut the goal of the program. Excluding the debt forgiveness from gross income but disallowing the deductions for the allowable PPP expenses has the same result for federal income tax purposes, as taxing the forgiveness income but permitting the deductions.

Example: Assume ABC Company receives $100,000 of PPP loan funding. All $100,000 is properly expended on payroll costs and ABC Company receives full forgiveness. ABC Company has $200,000 of other operating receipts in 2020. Based on the IRS’s position, while the loan forgiveness would be excluded from ABC Company’s 2020 income, the $100,000 of payroll costs would not be deductible. As a result, ABC Company would recognize and pay tax on the full $200,000 of other operating income (without reducing it for the $100,000 of payroll costs).

The IRS’s position on the non-deductibility of PPP allowable expenses brings PPP recipients back to the same federal income tax position as if Congress treated the forgiven loans as taxable income. If the debt forgiveness was required to be treated as taxable income, ABC Company would recognize $300,000 of gross income ($100,000 of debt forgiveness income + $200,000 other operating receipts) and $100,000 of deductions for payroll costs resulting in the same taxable income of $200,000.

If the loan forgiveness is excluded from taxable income and the deduction of the PPP allowable expenses is NOT disallowed, ABC Company would recognize $200,000 of other operating income and $100,000 of deductions for payroll costs, resulting in taxable income of only $100,000.

 

The technical rationale behind the IRS’s position rests in IRC §265(a)(1). §265 essentially disallows deductions that are allocable to tax-exempt income. The purpose of §265 is to prevent a double benefit, where taxpayers can receive income on a tax-free basis but take the deductions for related expenses.

As a second argument for disallowance, the IRS provides that case law and published rulings have historically denied deductions for otherwise deductible expenses for which the taxpayer receives reimbursement.

While these arguments certainly have merit, the IRS seems to be disregarding Congress’s intent in specifically excluding the PPP loan forgiveness from taxable income. We will keep you apprised as additional information and guidance is provided and if and/or when Congress reacts to the IRS’s position.

Congressmen Reacting to IRS Position on PPP Deductions Disallowance

As expected, key congressmen have already started to react, expressing their disappointment in the IRS’s position as running contrary to the Congressional intent. A spokesperson for Congressman Richard E. Neal, D-Mass., Chair of the House, Ways and Means Committee has already announced Neal’s intent to fix the issue in the next wave of legislation.

 

We will continue to keep you apprised as additional information and guidance is provided. If you have specific questions, please contact your blum partner or contact us here.

COVID-19 Business ResourcesDisclaimer:  The contents of this resource are for general informational purposes only. While every effort has been made to ensure its accuracy, the information is provided “as is” and no representations are made that the content is error-free. We have no obligation to update any content, comments or other information for retroactive or prospective interpretations or guidance provided by regulators, financial institutions or others. The information is not intended to constitute legal advice or replace the advice of a qualified professional. There are areas of the CARES Act where additional clarification from the Treasury Department and the SBA is needed. Your judgment and interpretation of the act may be needed. Users should consult with their legal counsel and representatives of the lending institution regarding the proper completion of their application and supporting documentation.

Any written tax content, comments, or advice contained in this article is limited to the matters specifically set forth herein. Such content, comments, or advice may be based on tax statutes, regulations, and administrative and judicial interpretations thereof and we have no obligation to update any content, comments or advice for retroactive or prospective changes to such authorities. This communication is not intended to address the potential application of penalties and interest, for which the taxpayer is responsible, that may be imposed for non-compliance with tax law. 

 

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