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May 4th, 2020
IRS: Forgiven Paycheck Protection Program Loan Expenses Are Not Deductible
On April 30, 2020, the IRS announced in Notice 2020-32 that expenditures of CARES Act Paycheck Protection Program (“PPP”) loan funds that otherwise would be deductible for federal income tax purposes will not be deductible to the extent such loan funds are forgiven pursuant to the PPP.
Under the CARES Act, a PPP borrower is eligible for forgiveness of its loans to the extent of the sum of the following payments during the 8-week “covered period” beginning on the date of receipt of its PPP loan: (1) payroll costs, (2) interest on any covered mortgage obligation, (3) any covered rent obligation, and (4) covered utility payments, although the amount forgiven is reduced if the average number of the borrower’s full-time equivalent employees is reduced during the covered period relative to a specified base period or the salary or wages of certain employees is reduced by more than 25% relative to the last full quarter before the covered period. In addition, no more than 25% of the amount forgiven can be attributable to non-payroll costs. Curiously, the CARES Act expressly provided that the portion of a PPP loan that is forgiven is excluded from the borrower’s taxable income, but did not address whether otherwise allowable deductions for payments of PPP-eligible expenses by a borrower are allowed if the loan is subsequently forgiven under the CARES Act as a result of the payment of those expenses.
In reaching its conclusion, the IRS applied Internal Revenue Code (“IRC”) Section 265(a), under which the deduction of otherwise deductible amounts (including payments of wages and benefits to employees and of interest on a mortgage obligation of a trade or business) is disallowed if the amounts are allocable to one or more classes of tax-exempt income. The IRS noted that the purpose of IRC Section 265 is to prevent a double tax benefit. It concluded that the CARES Act exclusion of forgiven PPP loan amounts from income creates a “class of exempt income” and that payments of any otherwise deductible expenses, including PPP-eligible expenses, are not deductible to the extent of the portion of the loan forgiven because such payments are allocable to tax-exempt income.
IRS Notice 2020-32 will significantly affect the after-tax economic benefits of PPP loan forgiveness and should be taken into account by all PPP loan borrowers in analyzing the tax impact of the use of their PPP loan proceeds. If you have questions about IRS Notice 2020-32, or about any other tax matters, please contact Jeffrey Marks or any other member of the Frankfurt Kurnit Tax Group.