Will Expenses Paid with PPP Loans Remain Non-Deductible?

May 04, 2020

By Miri Forster

While a second round of Paycheck Protection Program (PPP) loans are being approved, borrowers have moved their attention to forgiveness under the CARES Act and the lack of clarity surrounding the treatment of expenses reimbursed by PPP loans. On April 30, 2020, the IRS released Notice 2020-32 which provides that expenses reimbursed by a forgiven PPP loan are non-deductible. Immediately following release of the Notice, Senate Finance Committee Chair Chuck Grassley and House Ways and Means Committee Chair Richard Neal expressed concern that the treatment was inconsistent with the PPP’s intent.

Background

Under Section 1106 of the CARES Act, borrowers of a PPP loan are eligible for forgiveness of up to 100% for the costs incurred and payments made during the eight-week period (the “covered period”) after the loan origination date for payroll costs and mortgage interest, rents and utilities. Amounts forgiven are excluded from a borrower’s gross income. The amount of the forgiveness may be reduced if, during the covered period, there are reductions in the number of full-time employees and the wages and salaries of certain employees.  In addition, the CARES Act provides that no more than 25% of the amount forgiven can be attributable to non-payroll costs.  Any of the covered loan that is not forgiven remains outstanding under the terms set forth in Section 1102 of the CARES Act.  See the CARES Act Summary provided by EisnerAmper for further details.

Notice 2020-32

Businesses may claim a deduction under IRC Sec. 162 for ordinary and necessary expenses that are incurred in a trade or business. Generally, rent obligations, utility payments and payroll costs consisting of wages and benefits paid to employees are deductible as ordinary and necessary trade or business expenses.  In addition, IRC Sec. 163 provides a deduction for interest paid or incurred on a mortgage obligation of a trade or business. However, IRC Sec. 161 provides that deductions for trade or business expenses and mortgage interest may be subject to certain exceptions.

Specifically, IRC Sec. 265(a)(1) and the accompanying treasury regulations disallow a deduction for an amount otherwise allowable as a deduction to the extent it is allocable to one or more classes of income other than interest (whether or not any amount of income of that class or classes is received or accrued) wholly exempt from federal income tax. The term “class of exempt income” is defined as any class of income (whether or not any amount of income of such class is received or accrued) that is either wholly excluded from gross income or wholly exempt from federal income taxes. The purpose of IRC Sec. 265 is to prevent a double tax benefit.

According to Notice 2020-32, IRC Sec. 265(a)(1) applies to tax exempt income “earmarked for a specific purpose and deductions are incurred in carrying out that purpose. In such event, it is proper to conclude that some or all of the deductions are allocable to the tax-exempt income.”  Looking to case law and prior IRS guidance, the IRS concludes that any portion of a PPP loan that is forgiven under the CARES Act is considered a class of exempt income under IRC Sec. 265.  Therefore, expenses reimbursed by the PPP loan for payroll costs or payments of mortgage interest, rents and utilities during the covered period are not deductible by the borrower.

The IRS further supports its conclusion with case law and prior rulings that disallow deductions under IRC Sec. 162 for otherwise deductible payments when a taxpayer receives reimbursement.  Under this alternative theory, the IRS again concludes that the expenses reimbursed by PPP loan proceeds are non-deductible.

Does Notice 2020-32 Minimize the Value of the PPP Loan?

Consider the following example where the borrower ends up paying tax on the forgiven amount in the form of lost tax deductions. 

  • Company A incurs $100,000 of qualified expenses eligible for forgiveness.
  • The forgiveness of the $100,000 of PPP loan is tax free for federal income tax purposes.
  • As a result, Company A loses its deduction for the qualified payroll and overhead that gets forgiven.
  • Accordingly, Company A is in the same position as if the forgiveness were taxable.

Following the release of Notice 2020-32, Senator Chuck Grassley (R-IA) issued a statement that the notice is contrary to the intent of the PPP, which is “to maximize small business’ ability to maintain liquidity, retain their employees and recover from this health crisis as quickly as possible.” Richard Neal (D-MA) indicated that a fix to the above situation could come with the next legislative response to COVID-19. 

As an alternative to the PPP, and given the non-deductible nature of PPP-related expenses, employers may prefer to claim an employee retention credit under the CARES Act.  Taxpayers should continue to consult with their advisors to evaluate the benefits under each of these options.

EisnerAmper will continue to keep you informed of relevant new developments regarding the tax implications of the coronavirus pandemic.

About Miri Forster

Miri Forster is a Principal and Co-Leader of the Tax Controversy Practice.