Member Article

Key Points

• The IRS recently issued guidance (Notice 2020-32) regarding the deductibility of expenses incurred in a taxpayer’s trade or business when the taxpayer receives a PPP loan under the CARES Act.
• Section 1106 of the CARES Act provides that PPP loans may be forgiven without causing the borrower to incur cancellation of debt income.
• Notice 2020-32 clarifies that no deduction is allowed for otherwise deductible expenses if the payment of the expense results in forgiveness of a CARES Act loan and the income associated with the forgiveness is excluded from gross income.

The Coronavirus Aid, Relief, and Economic Security Act (the "CARES Act") modifies several tax provisions in the Internal Revenue Code (the "Code"). The modifications are designed to complement other provisions of the CARES Act and to provide relief to businesses and individuals from the economic effects of the COVID-19 crisis. In particular, Section 1106 of the CARES Act provides that loans made under the Paycheck Protection Program (the "PPP") may be forgiven without causing the borrower to incur income so long as the loan proceeds were ultimately used for payroll and other qualifying expenses. Forgiven debt is typically considered taxable income under Code Section 108 of the Code ("COD Income").

The CARES Act is silent on the question of whether businesses may continue to deduct expenses paid with loan proceeds which are ultimately forgiven. However, Code Section 265 generally prohibits a deduction for expenses allocable to tax-exempt income and these principles have been applied in a variety of situations in order to prevent taxpayers from receiving a windfall or a double benefit.

In Notice 2020-32, the IRS cited to Code Section 265 principles in order to determine that restricting deductibility "is consistent with prior guidance of the IRS that addresses the application of section 265(a) to otherwise deductible payments" and "prevents a double tax benefit." Pursuant to the Notice, "no deduction is allowed under [Code] for an expense that is otherwise deductible if the payment of the expense results in forgiveness of a covered loan...."

As a result of the Notice, a business that accepted $100,000 in PPP loans and managed to avoid $100,000 of COD Income now potentially has $100,000 of non-deductible expenses. At a 21% tax rate, and assuming a sufficient level of income, that business' taxes will increase by $21,000 as a result of the Notice.

Prominent lawmakers were quick to express their disappointment with the Notice. Senate Finance Committee Chair Chuck Grassley, R-Iowa released the following statement: “[t]he intent was to maximize small businesses’ ability to maintain liquidity, retain their employees and recover from this health crisis as quickly as possible. This notice is contrary to that intent.” His counterpart in the House, Ways and Means Committee Chair Richard E. Neal, D-Mass., appears determined to “fix this in the next response legislation.”

We will continue to monitor developments on this important issue and will update or supplement this alert as appropriate.

Interested taxpayers or their representatives should contact Daren Shaver or Fred Weil with any questions.