The IRS Asserts that Expenses Funded by a Forgiven PPP Loan are Not Deductible – Chairmen of Congressional Tax Writing Committees Disagree

The Internal Revenue Service (“IRS”) released Notice 2020-32 on April 30, 2020 to clarify its position that no deduction is allowed for an otherwise deductible expense if the payment of the expense results in forgiveness of a Paycheck Protection Program (“PPP”) loan pursuant to the Coronavirus Aid, Relief, and Economic Security Act, Pub. L. 116-136, 134 Stat. 281 (the “CARES Act”) and the income associated with such loan forgiveness is excluded from gross income under the CARES Act.  The CARES Act implemented the PPP to provide forgivable loans to cover certain expenses (including payroll costs and rent).  In light of Notice 2020-32, the IRS may not respect a taxpayer’s deduction of covered expenses (as defined below) to the extent that the taxpayer’s income from forgiven PPP loans is excluded from gross income.

Background for the Issues Addressed by Notice 2020-32

The CARES Act allows a taxpayer to apply for a PPP loan, which is eligible for loan forgiveness under certain circumstances.  A taxpayer is eligible for PPP loan forgiveness to the extent the loan is used for certain expenses (e.g., payroll costs, interest on mortgage obligations, rent and utilities) (“covered expenses”) during an eight week period beginning on the loan’s origination date.  However, the amount of the loan forgiveness is reduced if the taxpayer does not sufficiently avoid labor force reductions and pay cuts. 

If a taxpayer receives debt forgiveness on a PPP loan, the CARES Act provides that the amount of such debt forgiveness is excluded from the taxpayer’s gross income (even if the amount would typically be included in income as cancellation of indebtedness income or otherwise).  However, the CARES Act does not address whether deductions that otherwise would be allowable for payments of covered expenses are allowed if the PPP loan is subsequently forgiven.

In general, ordinary and necessary business expenses are deductible under Section 162 of the Internal Revenue Code of 1986, as amended (the “Code”).  Payments of rent, utilities, and payroll costs consisting of wages and benefits paid to employees are typically considered ordinary and necessary business expenses that qualify for a deduction.  However, Code Section 265 denies a deduction for otherwise allowable expenses that are allocable to a class of income that is wholly exempt from tax.  General tax principles similarly deny a deduction for expenses when no net economic outlay is associated with the expense (e.g., when expenses are reimbursed). 

Due to the lack of guidance in the CARES Act regarding the deductibility of expenses, it is unclear whether covered expenses are deductible if a PPP loan is ultimately forgiven.  Some practitioners note that Code Section 265 may not apply to disallow a deduction because covered expenses are funded initially by loan proceeds (which are not inherently exempt from tax).  In addition, practitioners argue that Congress may have intended to specifically exempt income from PPP loan forgiveness and also allow a deduction for covered expenditures funded initially by the loan. 

Notice 2020-32

Notice 2020-32 clarifies the IRS’s position that a taxpayer may not deduct an expense funded by a PPP loan if the PPP loan ultimately is forgiven and the income associated with such loan forgiveness is excluded from gross income under the CARES Act.

The IRS explained that the deduction of expenses funded by a forgiven PPP loan is disallowed under both Code Section 265 and general tax principles.  The exclusion of PPP loan forgiveness from gross income under the CARES Act creates a class of income that is wholly exempt from tax within the meaning of Code Section 265.  Accordingly, Code Section 265 disallows any otherwise allowable deduction for the payment of any covered expenses funded by a PPP loan that is ultimately forgiven.  The IRS noted that the direct link between the amount of loan forgiveness and the amount of otherwise deductible expenses is a sufficient connection for Code Section 265 to disallow deductions for such expenses.  In addition, general tax principles disallow a deduction for expenses funded by a PPP loan that is ultimately forgiven.  The IRS explained that case law and rulings that deny deductions for otherwise deductible expenses for which the taxpayer is reimbursed apply to deny a deduction for expenses funded by a forgiven PPP loan.

The Notice represents a pronouncement of the current position of the IRS and does not represent new law.  It is possible that we could see additional guidance on the deductibility of expenses funded by a forgiven PPP loan if a taxpayer files a lawsuit to challenge the IRS position in the Notice or if Congress enacts an amendment to provide that expenses covered by a forgiven PPP loan are deductible (regardless of the IRS position). 

Congressional Reaction and Ongoing Debate

Shortly after the IRS issued Notice 2020-32, Senate Finance Committee Chair Chuck Grassley and Ways and Means Committee Chair Richard E. Neal expressed their disappointment with the deduction disallowance in the Notice.  Mr. Grassley stated: “The 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.”  Mr. Neal’s spokesperson Erin Hatch noted: “We are planning to fix this in the next response legislation.”

On May 4, 2020, Secretary of the Treasury Steven T. Mnuchin defended the IRS position in Notice 2020-32.  Secretary Mnuchin explained that because a forgiven PPP loan is not taxable, a taxpayer cannot “double dip” by deducting expenses funded by such loan. 

On May 5, 2020, Mr. Grassley, Mr. Neal and Ron Wyden (U.S. Senator and Ranking Member of Senate Finance Committee) wrote a letter to Secretary Mnuchin explaining their disagreement with the IRS position in the Notice.  The letter states that the IRS position in the Notice ignores the intent of the PPP and Congress’ intent to allow PPP recipients to deduct related expenses.  The letter also asserts that Code Section 265 does not apply to disallow a deduction for expenses funded by a forgiven PPP loan.  Code Section 265 only denies a deduction if it is allocable to a class of income that is “wholly exempt” from tax.  The letter argues that the deductions for expenses funded by a PPP loan are allocable to the income produced by a taxpayer’s business rather than the PPP loan forgiveness and that, therefore, Code Section 265 does not deny a deduction for these expenses.

Notably, Kevin Brady (U.S. Representative and Ranking Member of House Ways and Means Committee) did not sign the May 5^th letter to Secretary Mnuchin.  It is possible that there could be a difference of opinion within Congress regarding the IRS position in Notice 2020-32.

On May 6, 2020, a bipartisan group of Senators (including Mr. Grassley) introduced the Small Business Protection Act of 2020 (S. 3612).  If enacted, the act would clarify that expenses funded by a forgiven PPP loan are deductible as ordinary business expenses.

Please reach out to us with any questions about the CARES Act and its implications for the availability of tax deductions.