On April 30, 2020, the Internal Revenue Service (IRS) issued Notice 2020-32, which asserts the non-deductibility of certain expenses funded by a loan under the Paycheck Protection Program (PPP) of the Coronavirus Aid, Relief, and Economic Security Act (the CARES Act). This guidance responds to the tax community's requests for IRS direction regarding the treatment of ordinary business expenses funded by PPP loans that receive tax-free forgiveness.
Benefit of Loan Forgiveness Offset by Deduction Disallowance
The CARES Act established the PPP as a loan program designed to provide a direct incentive for small businesses to keep workers on their payroll. Under the PPP, a loan recipient may use the proceeds for payroll costs, certain employee healthcare benefits, rent, utilities, and interest on mortgage and other existing debt obligations. Additionally, loan proceeds used to fund the first eight weeks of qualifying expenses may be forgiven, with any forgiven amounts being excluded from the gross income of the loan recipient. The CARES Act does not explicitly address the deductibility of eligible expenses funded by loan proceeds that are subsequently forgiven under the terms of the PPP.
After weeks of debate among tax practitioners and analysts, the IRS issued Notice 2020-32 to address the effect of covered loan forgiveness on the deductibility of corresponding business expenses. Specifically, the IRS opted to classify income resulting from loan forgiveness under the PPP as "exempt income" under Section 265. Accordingly, to prevent a double tax benefit, any deduction otherwise allowable as business or interest expense will be disallowed to the extent the expense is funded by such exempt income. This treatment effectively offsets the tax benefit of the tax-free loan forgiveness and creates a simple acceleration of cash flow that would otherwise be deferred until the filing of the corresponding tax return.
Possibility of a Legislative Fix
In response to Notice 2020-32, tax analysts have asked why Congress would explicitly exclude loan forgiveness from a taxpayer's income if the government intended to take away a deduction of the same amount. In fact, members of the House and Senate have described this IRS guidance as contrary to the PPP's goal of providing economic stimulus during the COVID-19 crisis. Additionally, because loan recipients under the PPP must forgo the payroll tax credit and other programs established by the CARES Act, many taxpayers may regret the decision to take part in the PPP. Though a disconnect remains between legislative intent and the IRS's interpretation, one thing remains clear – any fix must come from Congress.
How Can Venable Help?
The tax consequences of the PPP and other relief opportunities established by the CARES Act are complex, and additional guidance from the IRS and Congress is likely forthcoming. Venable's international tax team can help clients analyze the financial considerations arising from these programs in order to determine their optimal tax strategy moving forward.