IRS Notice Provides Expenses Paid with Paycheck Protection Program Loans are Not Tax Deductible

May 1, 2020

On April 30, the IRS issued IRS Notice 2020-32 (the “Notice”), which provides that expenses paid using forgivable loan funds obtained under the Paycheck Protection Program (the “PPP”) are not tax deductible. The Notice has the effect of significantly reducing the economic benefit of PPP loans to taxable recipients.

Background

PPP loans received by a borrower may be forgivable by the Small Business Administration provided that, among other requirements, the loan proceeds are used for certain specified purposes, including payroll and rent.

Under the regular income tax rules, if a loan to a taxpayer is forgiven, the taxpayer will recognize cancellation of indebtedness income (“COI”). However, the CARES Act, which established the PPP, provides that a taxpayer will not recognize income from the forgiveness of a PPP loan.
Section 265 of the Internal Revenue Code provides that expenses allocable to tax-exempt income are not deductible for U.S. federal income tax purposes. Section 265 normally applies in the context of expenses used to carry tax-exempt bonds.

The Notice

The Notice provides that Section 265 applies to expenses paid for with the proceeds of a PPP loan. Therefore, the payment of payroll and rent with the proceeds of a PPP loan are not deductible for U.S. federal income tax purposes. Given that many states conform to federal treatment of taxable income, the deductibility of such expenses is likely to be disallowed for income tax purposes in many states also.

The Notice has the effect of reducing the after-tax economic benefit of a PPP loan to a borrower. For example, assume a corporate borrower receives a $1 million PPP loan which it uses for payroll expenses in 2020 and the borrower has $1.5 million of taxable income after deducting such expenses. In the absence of the Notice, the borrower would have $1.5 million of taxable income and would owe $315,000 of federal income tax in 2020. After the application of the Notice, the borrower would have $2.5 million of taxable income and would owe $525,000 of federal income tax in 2020. As a result, the economic benefit of the PPP loan is reduced from $1 million to $790,000, prior to the application of state income taxes.

The Notice has the same effect as making the loan forgiveness taxable to the borrower which appears to be contrary to the intent of Congress in enacting the PPP. The Notice has already been criticized by legislators and Congress may consider reversing the Notice by legislation in the next round of legislative relief.

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If you have any questions regarding these new regulations, please contact James C. Cofer (212-574-1688), Jonathan P. Brose (212-574-1615), Ronald P. Cima (212-574-1471), Peter E. Pront (212-574-1221), Daniel C. Murphy (212-574-1210), Brett R. Cotler (212-574-1269) or Tyler Combest (212-574-1472).

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