May 1, 2020 – The Coronavirus Aid, Relief, and Economic Security (“CARES”) Act established the Paycheck Protection Program (“PPP”) that provided loan funding for qualifying small businesses. Under the CARES Act, the proceeds received by a borrower from a PPP loan may be forgiven if the borrower uses the proceeds to pay specified expenses (including payroll costs, interest on qualified mortgage indebtedness, rent under a qualified lease contract, and qualified utilities) during the 8-week period beginning on the loan date. The amount of forgiven PPP indebtedness is excludible from gross income for Federal income tax purposes.
On April 30, 2020, the IRS issued Notice 2020-32 to address the deductibility of the expenditures paid from PPP loan proceeds. Generally, ordinary and necessary business expenses, including the qualified PPP expenses previously mentioned, are deductible. However, the IRS explains in Notice 2020-32 that Internal Revenue Code (“IRC”) Section 265 and the related Treasury Regulations disallow a deduction for expenses that are allocable to a class of exempt income. A “class of exempt income” is any type of income that is either wholly excludible from gross income under any IRC provision or wholly exempt from Federal income tax under the provisions of any other law. The IRS has applied these principles in determining the tax treatment of expenses paid from PPP loan proceeds forgiven under the CARES Act.
The purpose of IRC Section 265 is the prevention of a double tax benefit. In other words, a taxpayer should not be entitled to the benefit of a tax deduction if that deduction is attributable to an item of income that is exempt from taxation. The IRS’ position is that to the extent that debt forgiveness for PPP loan proceeds is excluded from income under the CARES Act, it should be considered a “class of exempt income” under IRC Section 265. Accordingly, any expenses attributable to the forgiven proceeds should be nondeductible.
The release of IRS Notice 2020-32 brings to light the question of the overall Congressional intent regarding the CARES Act provision that provides PPP loan forgiveness is exempt from tax. In other words, did Congress intend for PPP loan proceeds that were spent on qualifying expenses to be effectively treated as a governmental subsidy? If that is the case, IRS Notice 2020-32 is in direct contrast to Congressional intent. Congress will need to specifically address the issue to clarify its intent. Until then, taxpayers are required to follow IRS guidance and treat the expenses attributable to forgiven PPP loan proceeds as nondeductible.
For more information regarding the CARES Act and the SBA loan programs, please see the COVID-19 information page on the Whitley Penn website at “ https://www.whitleypenn.com/covid-19-update/ ”.
Whitley Penn is continually monitoring the tax and economic developments related to the coronavirus pandemic and will send out additional alerts in the future. In the interim, please contact your Whitley Penn tax advisor if you have any questions or require any additional information.