Expenses paid with forgiven PPP loans are nondeductible, IRS says

The PPP was created as part of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act, P.L. 116-136). The PPP is designed to help small-business taxpayers maintain the functioning of their businesses during the COVID-19 pandemic. Generally, recipients may receive loan forgiveness on eligible expenses paid during an eight-week period beginning on the loan’s origination date. Eligible expenses include payroll costs, rent, utilities, and certain payments of interest on mortgage obligations.   

The expenses that PPP-loaned amounts must be used for in order to be eligible for loan forgiveness (generally, payroll, rent, mortgage interest, or utilities) are regular trade or business expenses under Sections 162 and 163 of the Internal Revenue Code (IRC). These expenses are generally deductible in the year in which the expense is incurred by the taxpayer. 

However, in Notice 2020-32, the IRS determined that no deduction is allowed for these otherwise deductible expenses if the payment is funded through amounts forgiven as part of the PPP loan program. The IRS based this determination on classifying PPP loans excluded from income as a “class of exempt income” under Section 265 rules and the regulations thereunder. 

Generally, the term “class of exempt income” means any class of income (whether received or accrued) that is wholly excluded from income or exempted from tax. Per the IRS, the purpose of Section 265 is to prevent a double tax benefit: receiving tax exempt income on the one hand, and using it for a deduction for tax purposes on the other. 

Relying on caselaw and prior IRS guidance, Notice 2020-32 contends that “where tax exempt income is earmarked for a specific purpose and deductions are incurred in carrying out that purpose…,” Section 265 may apply to preclude the deductions incurred in carrying out that purpose. This means that expenses paid with money that originated from PPP loans that will be forgiven are not eligible for deduction for tax purposes. 

In issuing Notice 2020-32, the IRS set forth a well-reasoned position, grounded on existing authorities, concluding that certain expenses are nondeductible when paid with funds received from a Paycheck Protection Program loan that are ultimately forgiven. Taxpayers should be aware of the tax implications of using money from PPP loans and consult their tax advisors to see how Notice 2020-32 may impact their business(es). Please be aware that top lawmakers have recently commented that they would like this rule changed by the IRS. However, any change in this Notice may require a statutory correction, which may be included in future COVID-19 legislation, so watch our Coronavirus Resource Center for future updates.

Michael Billet,  CPA, JD, National Tax Services

646.601.7717

Travis Butler, CPA, Director, National Tax Services

312.508.5821