IRS Clarification on Limited Tax Benefits Determination of PPP Funds

Fri May 1, 2020

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The IRS has deemed that Internal Revenue Code 265 does apply to PPP loan funds that are forgiven.  Therefore, whatever amount is forgiven is “non-taxable” income but all expenses paid by these funds are deemed “non-deductible” for tax purposes.  Therefore, it will increase your taxable income by the same amount.  See below.

The “Payroll Protection Program” Congress created as part of the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) has been quite popular for many reasons, but two in particular. First, if spent properly (on items such as payroll, rent and utilities), amounts received initially as loans can be forgiven under Section 1106(b) of the CARES Act. Second, under Section 1106(i) of the CARES Act, amounts that are forgiven are excluded from gross income, meaning the borrower receives the loan amount (without a repayment obligation) entirely tax-free.

This immediately led to a very important question among tax practitioners: Whether loan amounts that are spent on normally tax-deductible items such as payroll and rent could still be deducted for tax purposes if the loan is ultimately forgiven. The question arises because Section 265 of the Internal Revenue Code provides that a taxpayer cannot take tax deductions, even if otherwise allowable, if the deductions are allocable to income that is exempt from tax. The general purpose of Section 265 is to prevent taxpayers from enjoying a “double” tax benefit (i.e., tax-exempt income generating tax deductions). 

In Notice 2020-32, released today, the IRS clarifies that Section 265 does in fact apply to PPP loans and prevents taxpayers from deducting expenses that lead to forgiveness under the CARES Act. This interpretation will have the effect of negating much (if not all) of the tax benefit Congress provided with the exclusion under Section 1106(i). Given the larger goal of Congress to inject cash into struggling businesses, this result had some wondering (before today) whether the IRS would apply Section 265 to PPP loan forgiveness.

Short of an act of Congress, it appears that taxpayers receiving PPP loans are left with this more limited tax benefit.

For additional information and clarification please contact your tax advisor.

Contact Congress to ask them to make the PPP expenses dedubtible