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| Libin Zhang |
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| Xenia Garofalo |
The CARES Act generally provides that amounts due under the PPP loans will be forgiven if the loan proceeds are used for certain payroll costs and other expenses, and if other requirements are met. The CARES Act specifically provides that the forgiven loan amounts are not taxable income.
The IRS released Notice 2020-32 on April 30, to provide that payroll costs and other expenses are not deductible for federal income tax purposes if they are paid with forgiven PPP loan proceeds that are excluded from taxable income under the CARES Act. The notice has generated an adverse reaction from some members of Congress and may prompt new legislation to address the deductibility of those expenses.
Taxpayers should weigh the costs and benefits of the PPP loan program in comparison to certain other relief under the CARES Act, such as employee retention tax credits, which are unavailable if the taxpayer or certain related parties in its aggregate group have a PPP loan.
A taxpayer with a PPP loan might invalidate the employee retention tax credit for any future members of the taxpayer's aggregate group, e.g., in the event that the taxpayer is involved in mergers and acquisitions, absent guidance to the contrary.
Some taxpayers may find the requirements for PPP loan forgiveness to be too onerous, while other taxpayers may still obtain tax benefits from forgiven PPP loans, notwithstanding the Notice.
PPP Loan Forgiveness and Exclusion from Taxable Income
The Paycheck Protection Program provides small businesses with loans to pay covered expenses including payroll costs (including certain employee benefits), mortgage interest, rent and utilities. In general, PPP loan amounts will be forgiven upon the borrower's request if the loan proceeds are used for certain covered expenses during the eight-week period after the PPP loan is made and if certain employee headcount and compensation levels are maintained.
Under generally applicable federal income tax rules, forgiven debt normally results in taxable cancellation of debt, or COD, income. However, Congress specifically provided in the CARES Act that forgiven PPP loan amounts are excluded from gross income for federal income tax purposes.
The CARES Act does not specifically address the deductibility of covered expenses paid with forgiven PPP loan amounts.
Notice 2020-32 Disallowance of Deductions for Covered Expenses
Notice 2020-32 concluded that covered expenses are not deductible if paid with PPP loan amounts that are later forgiven and excluded from taxable income by the CARES Act. The IRS primarily looked to Internal Revenue Code Section 265, which generally disallows deductions for expenses allocable to tax-exempt income.
Section 265 has been applied in the past to disallow deductions for a teacher's research trip expenses paid by a tax-exempt gift and fellowship grant, and for state income taxes allocable to a tax-exempt cost-of-living allowance.
The purpose of Section 265 "is to prevent a double tax benefit," and it applies where (1) otherwise deductible expenses are incurred for the purpose of earning or otherwise producing tax-exempt income, or (2) tax-exempt income is earmarked for a specific purpose and deductions are incurred in carrying out that purpose.[1]
The notice treats the excluded income resulting from PPP loan forgiveness as a class of exempt income under Section 265. Accordingly, under the Notice, the payroll costs and other covered expenses that are allocable to the exempt PPP loan forgiveness income are not deductible.
The notice also notes that its conclusion is consistent with case law and other authorities that deny deductions for reimbursed expenses, on the basis that the taxpayer has not made an expenditure or outlay.
As an example of the application of these rules, assume a small business taxpayer uses a $100,000 PPP loan solely to pay covered expenses and such loan is subsequently fully forgiven. The covered expenses are payroll costs, rent, utilities and mortgage interest, which are typically deductible for a trade or business under IRC Section 162 or 163 (unless required to be capitalized).
If the PPP loan forgiveness were taxable, the taxpayer would have $100,000 of taxable COD income, and a $100,000 deduction for paying the covered expenses, to arrive at a net taxable income of zero.
Under the CARES Act's PPP loan forgiveness exclusion and the notice, the taxpayer has no taxable COD income, but also no deduction for paying the covered expenses, which results in the same net taxable income of zero. The CARES Act's PPP loan forgiveness exclusion has no tax effect in this example, which may be typical, after taking into account the disallowed deduction.
By contrast, if the same taxpayer is also able to deduct the $100,000 of covered expenses, a noncorporate taxpayer may reduce its other taxable income by $100,000 and reduce its federal tax liability by up to $40,800 — or up to $43,400 if the deduction creates a net operating loss, or NOL, that is carried back up to five years to 2017 or earlier, which is otherwise permitted under the CARES Act.
A corporate taxpayer may reduce its federal tax liability by up to $21,000 — or $35,000 with NOL carrybacks to 2017 or earlier. The tax savings may be higher if the deductible covered expenses are also deductible for state and local income tax purposes, or are eligible for certain tax credits.
Senate Finance Committee Chair Chuck Grassley, R-Iowa; House Ways and Means Committee Chair Richard Neal, D-Mass.; and Senate Finance Committee ranking member Ron Wyden, D-Ore., responded to the notice in a series of statements — including in a May 5 letter to U.S. Treasury Secretary Steven Mnuchin — that the notice is contrary to congressional intent.
In contrast, Mnuchin stated that he personally reviewed the notice and that the prevention of a double dip is a basic tax principle that should apply to the forgiven PPP loans.
Taxpayer Decision Making
If the notice is the final word on the deductibility of covered expenses for forgiven PPP loans, there may be consequences for certain taxpayers who have a PPP loan. Other taxpayers may want to reconsider whether to apply for one.
Eligible employers are entitled under the CARES Act to a refundable payroll tax credit, known as an employee retention credit, generally equal to 50% of qualified wages paid to certain employees from March 13 through Dec. 31, with a maximum credit of $5,000 per employee.
The employee retention credit is also available for certain qualified healthcare expenses, including healthcare benefits provided to certain furloughed employees. Employers are not permitted to both claim the employee retention credit and obtain a PPP loan.
Guidance issued by the U.S. Small Business Administration provides that a taxpayer who repaid its PPP loan by May 18 will be treated as though it had not received a PPP loan for purposes of the employee retention credit.
Therefore, a taxpayer who previously received a PPP loan will be eligible for the employee retention credit if the taxpayer is otherwise eligible and the PPP loan was repaid by May 18.
Taxpayers who have applied for or have been approved for a PPP loan, but have not yet received the loan proceeds, may consider withdrawing their loan application if they would like to use the employee retention credit instead.
Furthermore, the choice of whether to obtain a PPP loan or claim the employee retention credit may affect related taxpayers. The employee retention credit uses certain preexisting aggregation rules under IRC Code Sections 52(a), 52(b), 414(m) and 414(o) to treat certain entities as one employer.
These aggregation rules are frequently applied in other tax contexts, such as in connection with retirement plans, IRC Section 263A capitalization rules, IRC Section 471 inventory accounting, and the IRC Section 163(j) business interest deduction, to treat various related entities and entities that provide certain management or other services to each other as an aggregate group.
As a result, if one member of an aggregate group obtains a PPP loan, all members of the aggregate group may become ineligible for the employee retention credit for all of their employees. A taxpayer with a PPP loan might also invalidate the employee retention credit for any future members of the taxpayer's aggregate group, e.g., in the event that the taxpayer is involved in mergers and acquisitions, absent guidance to the contrary.
In addition, the CARES Act allows the deferral of the employer's portion of Social Security taxes (currently, a 6.2% tax on up to $137,700 annualized of employee wages) otherwise due from March 27 through Dec. 31. The deferral ends once a PPP loan is forgiven, which may be an important consideration, given the need for liquidity during the coronavirus pandemic.
The Social Security taxes that have been deferred up to the loan forgiveness date will continue to be deferred, half until Dec. 31 and the remainder until Dec. 31, 2022.
Taxpayers who are modeling the tradeoff between obtaining a PPP loan versus claiming the employee retention credit and continuing payroll tax deferral after the PPP loan is forgiven, might have concluded that the PPP loans were a superior option, based on the assumption that the covered expenses were deductible.
However, they may need to reconsider their options based on the conclusion of the notice that covered expenses are not deductible if paid with forgiven PPP loan amounts that are excluded from taxable income under the CARES Act.
The considerations for taxpayers may be complicated by the fact that not all PPP loans will actually be forgiven. The PPP loan program has specific requirements relating to the taxpayer's employee headcount and compensation levels that must be met for the PPP loan to be forgiven.
PPP loan forgiveness generally will be reduced if a taxpayer decreases its full-time employee headcount or decreases salaries and wages by more than 25% for any employee that made less than $100,000 annualized in 2019, in comparison to certain specific periods.
The forgiveness reduction can be avoided if the taxpayer generally restores by June 30 its full-time employment and salary levels for any changes made between February 15 and April 26.
For some taxpayers, the PPP loan benefit may no longer outweigh the cost of complying with the PPP loan program's employment requirements if the covered expenses are not deductible, especially if the PPP loan does not cover all of the taxpayer's payroll costs in certain circumstances.
Furthermore, on April 28, and after media publicity about certain PPP loan recipients, Mnuchin announced that the SBA will conduct a full audit of all PPP loans over $2 million before offering loan forgiveness.
Some taxpayers may face compliance difficulties if they need to determine whether a covered expense is deductible before it is clear that the associated PPP loan will be subsequently forgiven.
This situation might arise if the taxpayer's tax year ends before the PPP loan forgiveness date or if the taxpayer is a partnership with partners changing their interests that require an interim closing of the books, particularly if the taxpayer is subject to an ongoing audit based on having a PPP loan of more than $2 million.
Benefits to Certain Taxpayers
Certain taxpayers may continue to obtain a net tax benefit from PPP loan forgiveness, notwithstanding the notice. A partnership may effectively treat its active general partners as employees for PPP loan purposes, and the partnership may obtain and use PPP loan proceeds to pay a deemed payroll cost of up to $100,000 annualized for each active general partner.
The PPP loan may be forgiven when the deemed payroll cost is paid to the active general partner. The forgiven loan amounts would normally result in the partnership allocating to the partners taxable COD income and no deduction with respect to the deemed payroll costs, but the result is changed by the CARES Act's PPP loan forgiveness exclusion to tax-free income (and no deduction) for the partners.
The same benefit may apply to a sole proprietor who obtains a PPP loan to cover his or her self-employment income.
In addition, the CARES Act exclusion for forgiven PPP loans and the deduction disallowance in the notice apply only if the forgiven amount is not otherwise excluded from gross income under the IRC.
IRC Section 108 provides that certain COD income may be excluded from the gross income of an insolvent or bankrupt taxpayer, at the cost of reducing any tax attributes such as capital loss carryforwards, passive activity loss carryforwards and tax basis in the taxpayer's assets at the beginning of the following tax year.
An eligible taxpayer may be able to exclude COD income from PPP loan forgiveness under IRC Section 108 and nevertheless still deduct covered expenses, potentially with a corresponding reduction of tax attributes that might otherwise have limited value (e.g., if they are usable only many years in the future).
Further Developments
On May 5, Grassley and Wyden, along with Sens, John Cornyn, R-TX, Marco Rubio, R-Fl., and Tom Carper, D-Del., introduced the Small Business Expense Protection Act of 2020 (S. 3612), which provides with retroactive effect that taxpayers may deduct expenses paid with a forgiven PPP loan.
Specifically, the bill states that "no deduction shall be denied or reduced, no tax attribute shall be reduced, and no basis increase shall be denied, by reason of the exclusion from gross income" of any forgiven PPP loan amount.
Similar provisions are in the Safeguarding Small Business Act (S. 3596), which was introduced on May 4 by Sens Mike Braun, R-Ind., Kelly Loeffler, R-Ga., John Hoeven, R-N.D., and Lisa Murkowski, R-Alaska, and the Health and Economic Recovery Omnibus Emergency Solutions Act (H.R. 6800), or HEROES Act, which was introduced in the House of Representatives on May 12 and passed the House on May 15.
The bill may join the discussions of Phase 4 stimulus legislation that have been ongoing and for which full legislation is expected by the end of June 2020. In the interim, taxpayers may have to handicap the odds of the bill's enactment in deciding whether to repay or seek PPP loans, for which the funding may be exhausted before any new legislation due to the program's popularity.
In addition to clarifying the deductibility of covered expenses paid by a forgiven PPP loan, such legislation may address other areas of uncertainty in respect of the PPP loan program, including whether the program is available for real estate businesses primarily engaged in owning or purchasing real estate, leasing real estate or managing their own real estate.
Furthermore, there is some disagreement over whether the PPP loan program requires that at least 75% of the PPP loan must be used for covered expenses that are payroll costs in order for any part of the PPP loan to be forgiven.
Such a requirement can be challenging for taxpayers who need more relief to meet operational costs like mortgage interest, rent and utilities that are also covered expenses.
Libin Zhang is a partner and Xenia Garofalo is an associate at Fried Frank Harris Shriver & Jacobson LLP.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
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