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In IRS Notice 2020-32, 2020-21 (May 1, 2020) (the “Notice”), the IRS puts taxpayers on notice that expenses funded with proceeds from a forgiven “covered loan”1 are not tax deductible.
A significant benefit to a PPP covered loan is that it can be forgiven without taxable income (cancellation of indebtedness income) to the participant to the extent that the covered loan proceeds are used for certain qualifying expenses (generally, expenses relating to payroll, mortgage payments, rent, utility costs, among certain other expenses) within the eight-week period beginning on the PPP loan’s origination date.2 Most of these qualifying expenses normally would be tax deductible when incurred as part of the participant’s trade or business. However, a long-standing tax principle prevents taxpayers from getting double tax benefits on expenses allocable to one or more “exempt classes of income” (generally, income excluded or otherwise exempt from taxation).
In the Notice, the IRS sets forth its view that income from the forgiveness of a covered loan is an “exempt class of income” and (therefore) expenses that are paid with proceeds from the forgiven loan are allocable to such income and not deductible. This results in a bit of a “catch 22” for PPP participants, as the PPP covered loan forgiveness is available only to the extent that the proceeds from the covered loan are traceable to qualifying expenses paid within the specified period. Consequently, if a participant expects to benefit from the income exclusion under the CARES Act relating to covered loan forgiveness, the participant cannot take tax deductions on these expenses in the IRS’s view.
A Congressional fix may be forthcoming. Both the House Ways and Means Committee Chair Richard Neal (Mass-D) and Senate Finance Committee Chair Chuck Grassley (Iowa-R) made comments that they are aware of the issue and plan on introducing additional legislation to allow for tax deductions for qualified expenses paid with covered loan proceeds. Until new legislation addressing the matter is enacted, taxpayers will be taking risks with deducting expenses funded with proceeds from a forgiven PPP covered loan.
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2 The CARES Act sets forth various other requirements and adjustments relating to the amount eligible for forgiveness.