IRS Sets Limits on Expense Deductions for PPP Loan Forgiveness

Businesses that received loans through the Paycheck Protection Program (PPP) during the initial months of the pandemic are finding that certain expenses allocable to the forgiven PPP loan proceeds are not deductible.

Section 1106 of the Coronavirus Aid, Relief and Economic Security Act (CARES Act) created the PPP, which provides that an eligible recipient of a covered loan could qualify for loan forgiveness if certain criteria are met. Another benefit is that the forgiven loan is not included in taxable income.

Taxpayers were relieved by what appeared to be free money to help them meet payroll and other business expenses resulting from the pandemic. However, the Internal Revenue Service (IRS) threw cold water on their enthusiasm with the release of Notice 2020-32 that ruled that expenses allocable to the forgiven PPP loan proceeds are not deductible.

Although these expenses generally would qualify as ordinary and necessary business expenses, the IRS cited Section 265 of the Internal Revenue Code (IRC) which disallows the deduction of expenses relating to tax-exempt income (this term is broadly defined). This disallowance aims to avoid a double benefit for the taxpayer by preventing a deduction associated with income that was not taxed. The IRS also cited judicial precedent and other guidance that applies Section 265 in different contexts.

Disallowing the related expenses has the same effect as taxing the forgiven indebtedness and it negates the benefit of having the loan forgiveness excluded from taxation. Because most PPP funds were used for payroll costs, treating these expenses as non-deductible also causes taxpayers to miss out on credits and other deductions, such as the qualified business income deduction, that are based on payroll expenses.

Pushback from Tax Professionals and Congress

Tax professionals have raised many arguments against the IRS’s stance on PPP loan forgiveness as detailed in Notice 2020-32. They note that a simple reading of Section 265 weakens the IRS case as it refers to “exempt” income, while the CARES Act “excludes” the income from taxation. As of August 4, 2020, the American Institute of Certified Public Accountants (AICPA) urged Congress in a letter to House Speaker Nancy Pelosi (D-Calif.) and Senate Majority Leader Mitch McConnell (R-Ky.) to “include a technical correction addressing the tax treatment of loan forgiveness under the Paycheck Protection Program (PPP)” in its next round of legislation.

But separate from questions of technical soundness, many believe that Notice 2020-32 is not aligned with congressional intent. In May 2020, Senate Finance Committee Chairman Chuck Grassley (R-Iowa), Ranking Member Ron Wyden (D-Ore.) and House Ways and Means Committee Chairman Richard E. Neal (D-Mass.) requested that Treasury Secretary Steven Mnuchin have the IRS change its flawed interpretation. The lawmakers noted, “Providing assistance to small businesses, only to disallow their business deductions as provided in Notice 2020-32, reverses the benefit that Congress specifically granted by exempting PPP loan forgiveness from income.”

As the pandemic drags on and Congress continues to debate and propose further economic relief to businesses, many wonder whether it will act upon the various requests to allow the deductibility of expenses associated with forgiven PPP loans. In the meantime, taxpayers (especially those with fiscal year-ends) are left wondering if they should defer applying for loan forgiveness until Congress issues further legislation to fix this issue. Taxpayers are advised to stay alert to further actions by Congress and the IRS before deciding what action to take.

We will continually monitor PPP updates and tax matters surrounding it and provide timely updates as information becomes available. If you have any questions please contact your ALL tax advisor or call us at 617-738-5200.