IRS Says Expenses Paid with Forgiven PPP Loan Proceeds are Not Deductible

May 1, 2020 | Kristine A. Tidgren

Late on April 30, 2020, IRS issued Notice 2020-32, stating that no deduction is allowed for an expense that is otherwise deductible if the payment of the expense results in forgiveness of a covered loan under the Paycheck Protection Program (PPP).

No Double Tax Benefit

This guidance affirms the worst case scenario for the borrower on a question debated since the inception of the PPP. In the Notice, IRS mechanically applies Treas. Reg. § 1.265-1 to find that a forgiven loan under the PPP—excluded from gross income under the CARES Act—results in a “class of exempt income.” This determination leads to the conclusion that IRC § 265(a)(1) disallows any otherwise allowable deduction for the amount of any payment of a forgivable PPP expense, to the extent of the resulting loan forgiveness. This, the IRS explains, prevents a double tax benefit. The guidance negates the benefit of the “exclusion from gross income” Congress provided in the law, instead merely complicating the tax return, and frustrating the loan recipient.

What About the Self-Employed?

The self-employed, however, particularly those with no employees, may fare a bit better. Although we have yet to receive detailed forgiveness guidance, it appears that “owner compensation replacement” is automatically calculated and automatically forgiven based upon 2019 tax return data. Section 265(a)(1) of the Code applies to otherwise deductible expenses incurred for the purpose of earning or otherwise producing tax-exempt income. None of the deductible expenses on a self-employed person’s 2020 return were incurred for the purpose of acquiring the forgiven portion of the owner compensation replacement payment. Section 265(a)(1) also applies where tax exempt income is earmarked for a specific purpose and deductions are incurred in carrying out that purpose. Although mortgage interest, rent, or utility payments made by a self-employed person from proceeds of a forgivable PPP loan fall squarely in this category, the owner compensation replacement payment does not. The nondeductible payment is—as named—intended to compensate the owner for his services to the business. Because business expenses are not directly allocable to this exempt income, the § 265(a)(1) rule would appear inapplicable. If IRS created 2020-32 because it could not ignore the § 265(a)(1) requirement, it should not in future guidance ignore § 265(a)(1)'s limits. This is one of many complications and questions arising from the April 30 guidance. We simply won't know more until we receive further guidance.This has been the disheartening mantra of the PPP.

Is This the Final Word?

Since the Notice was issued, several prominent congressional leaders have stated that it does not express the intent of the law. Senate Finance Committee Chair Grassley urged, “The intent was to maximize small businesses’ ability to maintain liquidity, retain their employees and recover from this health crisis as quickly as possible. This notice is contrary to that intent.” House Ways and Means Committee Chair Neal stated that Congress will “fix this in the next response legislation.” The leaders penned a letter to Treasury on May 5 expressing their concern that the guidance does not conform to congressional intent or to the law and asking Treasury to reconsider. The previous day, Secretary Mnuchin had stated in an interview that the guidance was a "simple rule," basically "tax 101." Many disagree.

While we watch to see if Treasury responds, we continue to wait for forgiveness guidance, and, for now, the PPP loan has become much less beneficial than hoped.

We'll watch for Phase IV.