UPDATE: PPP Loan Forgiveness & Deductibility of Expenses

More than three months since the IRS issued Notice 2020-32, it is looking increasingly likely that taxpayers will not be permitted to deduct business expenses funded with Paycheck Protection Program (“PPP”) loan proceeds that are ultimately forgiven. Congress came back into session and will need to act soon as it is late in the game not to have finality on the issue, especially with tax planning for year-end looming.

While a forgiven loan is generally treated as income to the borrower, the CARES Act provides that for federal income tax purposes any amount of the PPP loan that is forgiven will be excluded from gross income and therefore from income tax.

With the funds long since spent to keep their businesses afloat, borrowers need to be aware of a potential negative tax risk to seeking loan forgiveness under the PPP. According to IRS Notice 2020-32, business expenses that would normally be deductible in computing taxable income may not be deductible if the taxpayer uses funds from a forgiven loan to pay such expenses. Under the IRS’ position, businesses would be able to exclude forgiven disbursements from gross income but would not be allowed to deduct such expenses for federal income tax purposes.

The language of the CARES Act provision runs counter to the IRS’s interpretation in the Notice. Denying a tax deduction for business expenses associated with the CARES Act PPP Loan eliminates the tax benefit the CARES Act provides. While a business will not have to pay taxes on the income generated by loan forgiveness, the disallowance of the related expenses still results in an increase in taxable income. For a business who received $1,000,000 and meets the criteria for full forgiveness, the result is $1,000,000 of business expenses now becomes non-deductible, which in turn, increases the business’ taxable income by $1,000,000. At the current tax rate of 21% that results in a potential $210,000 tax bill and out of pocket costs for the business receiving the PPP loan forgiveness.

Since the issuance of the Notice, legislators in both the U.S. House of Representatives and the Senate have expressed their displeasure with the IRS guidance, indicating that the CARES Act meant to provide exactly such relief. The House has currently included a legislative fix for the deductibility issue in the recently proposed HEROES Act legislation which is currently stalled in the Senate.

Tax Planning season for year end is upon us and we still have several questions that still need to be answered by Congress and the IRS:

• What happens to a taxpayer who received a PPP loan, spent the money on ordinary business expenses, but will not have received a loan forgiveness determination prior to the date it must file its 2020 return?
• Can the taxpayer deduct its business expenditures funded this year with PPP loan proceeds on the 2020 tax return, and later amend its return when all or part of the loan is forgiven? Or
• Can the taxpayer refrain from deducting these items in 2020 if the taxpayer believes the entire loan will be forgiven, and then amend that return if the lender and/or SBA later concludes that some or all of the loan will not be forgiven?

Based on IRS Notice 2020-32 and what we know today, it appears that taxpayers will not be entitled to take deductions for business expenses paid for with proceeds of PPP loans that are ultimately forgiven. However, there is still time for Congress to act to remedy the problem and provide clarification to small business.