The Internal Revenue Service (“IRS”) has taken a position withdrawing some of the value provided under the Paycheck Protection Program (“PPP” or the “Program”). In Notice 2020-32 (the “Notice”) released on April 30, 2020, the IRS announced it will deny deductions by PPP loan recipients for otherwise deductible business expenses if the payment of the expense results in forgiveness of a PPP loan and the income associated with such forgiveness is excluded from gross income for federal income tax purposes. This effectively nullifies a separate provision of the CARES Act (the “CARES Act”), which stipulated that the expected loan forgiveness under the Program will not constitute taxable, cancellation-of indebtedness income. As a result, PPP recipients, particularly those whose businesses recover, will be deprived of typical above-the-line deductions, resulting in larger tax bills or smaller net operating loss (“NOL”) carryback refunds.

The PPP is a loan program created by the CARES Act to enable and encourage businesses to keep workers on their payrolls. Borrowers may receive loan forgiveness on indebtedness incurred under the program if borrowers use the loan proceeds for (1) payroll costs, (2) payment of interest on certain mortgage obligations, (3) payment of certain rents, and (4) payment of certain utilities during the eight weeks beginning on the day the borrower receives the loan (the “Covered Period”) and certain other conditions are satisfied.

The expenses that are eligible for loan forgiveness under the Program are normally deductible as ordinary and necessary business expenses under Section 162 of the Internal Revenue Code[1] or interest expense under Section 163. However, the Notice prohibits PPP recipients from deducting these loan-funded expenses if the loan is forgiven. The Notice relies on Section 265(a)(1) and Treas. Reg. §1.265-1, which generally prevents taxpayers from receiving a double tax benefit, by disallowing otherwise permitted deductions when the related expenses are deemed allocable to a class of income that is “wholly exempt” from tax. It also cites selected judicial precedents to the effect that deductions may be disallowed under this Code provision to the extent allocable to tax-exempt income. The Notice concludes that amounts excluded from gross income pursuant to PPP loan forgiveness creates such a class of tax-exempt income. Accordingly, deductions otherwise allowable under other provisions of the Code will be disallowed. This new IRS position will mean an increased tax bill for some taxpayers.

Subject to various exceptions, including one for insolvency,[2] loan forgiveness or cancellation of indebtedness is generally subject to tax as taxable as gross income to the debtor under Section 61. This treatment stems from a common principle, which has several corollaries. For example, the basis of property funded with (tax-free) non-shareholder contributions to capital is generally reduced by the amount of the non-shareholder contribution,[3] and government grants to businesses are now generally now to be included in the gross incomes of those businesses.[4] In contrast, Section 1106(i) of the CARES Act specifically excludes from gross income under the Code any amount of a PPP loan that is forgiven pursuant to the terms of the Program. In sum, the IRS seems to have rejected the implication that Congress intended PPP Loans to provide an added benefit, or stimulus, for (surviving) businesses, in the form of a retained tax benefit.

The CARES Act, in addition to launching the PPP, temporarily restored the right to carry back NOLs, which had been eliminated as part of the Tax Cuts and Jobs Act of 2017. Business taxpayers are again authorized to carry back aggregated NOLs from tax years 2018, 2019, and 2020 for up to five years, which can result in a refund of previously paid taxes (imposed then on corporations at higher than current tax rates). Prior to the Notice, taxpayers receiving loans under the PPP expected that in addition to being able to claim loan forgiveness for certain business expenses paid during the Covered Period, they would also be allowed to deduct the expenses from their business income. For businesses who expect to have an overall loss in 2020, such deductions would increase the size of their NOL. However, based on the Notice that will not be the case.

Much has been made of the importance of a PPP loan recipients keeping adequate records to be able to establish that the recipient has appropriately used the proceeds to qualify for the loan forgiveness. PPP loan recipients would also do well to keep detailed records of all PPP loan expenditures to be prepared to prove to the IRS that any amounts included in their loan forgiveness were in fact excluded from their normal business deductions. The implications of this Notice in the context of taxpayers with interests in fiscally transparent entities, such a partnerships and limited liability companies merits closer examination.

This is a significant development as some in the tax community have argued that the expenses should be deductible despite the expenses resulting in the forgiveness of the PPP loan and many take the position that was the intent of Congress. Since the issuance of the Notice, members of Congress have expressed the same sentiment, voicing their disappointment that the intent of Congress was being thwarted. Accordingly, it does not appear that the Notice is the last word we will hear on this issue. However, if it was Congress's intent to allow PPP loan recipients to benefit from the loan forgiveness and to be able to deduct the expenses attributable to the forgiveness for income tax purposes, it appears Congress will need to take legislative action to accomplish that intent. Nelson Mullins will continue to monitor developments in this area.

The Notice adds yet another substantive tax change to an already complex COVID-19 landscape. It is unclear, for example, how tax preparers will deal with the deduction of the business expenses for tax year 2020 returns, if the tax return is due before the determination is made with respect to the forgiveness of the PPP loan.

If you have any questions or would like assistance in understanding how this new Notice affects you, please contact Will Richmond, Wells Hall, John MacMaster, or Maurice Holloway.