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IRS Issues Guidance Regarding PPP Loan Forgiveness and Deductibility of Expenses

May 1, 2020

Overview

On April 30, 2020, the Internal Revenue Service (“IRS”) issued Notice 2020-32 (the “Notice”) in which it substantially changed the common understanding of the tax consequences of Payroll Protection Program (“PPP”) loan forgiveness. Taxpayers who obtain a PPP loan should be advised to carefully consider the Notice and its effects on their 2020 taxable income because this guidance may lead to an increased 2020 tax obligation

As background, Section 1106 of the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) provides that certain eligible taxpayers may obtain a PPP loan in a principal amount of up to $10M. To the extent the taxpayer uses the PPP loan proceeds on certain business expenses (payroll costs, certain employee benefits relating to healthcare, interest on mortgage obligations, rent, utilities, and interest on any other existing debt obligations), the taxpayer may have the entire amount of the PPP loan balance forgiven.

Significantly, Section 1106(i) of the CARES Act provides that any amount of forgiveness “shall be excluded from gross income.” This provision had cleared up the most pressing tax concern related to the forgiveness—namely, whether the forgiveness would be treated as cancelation of indebtedness or “COD” income—by providing it would not be COD income. That left open the question of whether the taxpayer may also deduct the business expenses, the money spent on which formed the basis of the PPP loan forgiveness. Some commentators noted the “shall be excluded from gross income” language was a clear statement of intent that no other income event should occur, while others noted permitting the taxpayer to avoid COD income and claim deductible expenses could result in a “double benefit.”

The IRS resolved this debate in the Notice by concluding taxpayers may not claim a deduction for otherwise deductible business expenses that might have been generated by the use of PPP loan proceeds in respect of forgiven PPP loans. The impacts of that conclusion cannot be understated. For example, if a taxpayer uses 100% of the PPP loan proceeds on eligible expenses such that the entire amount of the PPP loan proceeds is expended, the taxpayer will have no cash remaining. On the upside, the taxpayer will be able to have the PPP loan forgiven, so at least the taxpayer will not have a debt on its books to repay in its entirety (with interest). On the downside, however, the taxpayer that could have deducted the amounts spent on the eligible expenses now will be unable to deduct those amounts from taxable income. Essentially, this means the taxpayer will end up paying income taxes—at ordinary rates—on the amount of the forgiveness; however, the taxpayer will have to pay that tax from other funds because the taxpayer will have spent 100% of the PPP loan proceeds.

With that in mind, taxpayers who obtain PPP loans with an eye toward having all or a portion of those loans forgiven must consider this collateral tax consequence of that forgiveness. To the extent a taxpayer would have deducted from the taxpayer’s income amounts spent on eligible expenses, the taxpayer should begin planning now for how the taxpayer will pay the taxes due on those expenditures. Taxpayers will also want to separately account for those expenditures so they are easy to pull out and identify in preparing their 2020 (or fiscal year) tax returns affected by the Notice.

Of course, Congress could act or a court could rule in favor of taxpayers in a manner that would overrule the conclusion of the Notice; however, that could take time. In the meantime, taxpayers would be best served analyzing the potential tax consequences of the Notice and preparing for those tax consequences now.

We continue to closely monitor the developments around PPP loans and their forgiveness. For more information, please refer to our COVID-19 resources.

If you or your clients have questions specifically about the Notice or about PPP loans in general, please contact Dan Eller at deller@schwabe.com or 503-796-3762.

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