With the recent release of much-anticipated guidance, the IRS has confirmed their position that business expenses paid with Paycheck Protection Program (PPP) funds that are forgiven cannot be deducted for federal tax purposes. This guidance now places the responsibility on Congress to take legislative action if their intention was to ensure deductibility of business expenses that are funded with a forgiven PPP loan.
Background on PPP
The PPP was established by the CARES Act to provide low-interest and potentially fully forgivable loans to businesses to help fund payroll costs, healthcare benefits and interest, rent and utility expenses during this difficult economic time. If the PPP loan funds are fully utilized for qualified expenses, a recipient business can apply for complete forgiveness of the loan. The forgivable amount may be reduced for a few reasons, including a reduction in full-time employees, a reduction in salary or wages for certain employees and using more than 25 percent of the funds for non-payroll purposes.
The CARES Act provides that any forgiven PPP loan amount shall be excluded from gross income for federal tax purposes. But the CARES Act did not expressly address the tax treatment of expenses paid with the forgiven funds. Businesses were thus temporarily left to wonder, while practitioners debated, whether they could not only receive tax-free funding but also potentially deduct the expenses paid with that funding for a double benefit.
New Guidelines Provided
Notice 2020-32 outlines the IRS’s position that, based on existing tax law intended to prevent such a double benefit, otherwise deductible business expenses that are paid with forgiven PPP funds will be disallowed as tax deductions in computing the recipient’s taxable income. The nondeductible treatment applies for any payment of eligible PPP expenses to the extent of the loan forgiveness.
- Business with partial loan forgiveness: If a business only has partial forgiveness of its loan, it may still have deductible expenditures attributable to the non-forgiven portion.
- Business with entire loan forgiveness: The net result for a business that has its entire PPP loan forgiven should be tax-neutral for federal tax purposes. The forgiveness is not taxable and the expenses paid with the forgiven funds are not deductible.
GHJ Observation: In the case of partial forgiveness, and thus partial deductibility, it will be important for taxpayers to identify what specific expenses were paid with forgiven funds vs. funds that will be repaid. This distinction may have other tax implications.
For example, otherwise deductible interest expense may be limited by Internal Revenue Code (IRC) section 163(j), and deductible salary expense may be needed to support a section 199A deduction.
GHJ Observation: The CARES Act modified the rules for Net Operating Losses (NOLs) arising in 2018, 2019 and 2020 to allow taxpayers to carry those NOLs back five years to offset prior taxable income. Alternatively, those NOLs may now be carried forward without being subject to the 80 percent of taxable income limitation. With the disallowance of expenses paid by forgiven PPP funds, a taxpayer may now have less of an NOL to carryback/forward than they may have originally been projecting. Even without an NOL, taxpayers should adjust their projected taxable income/loss calculations to account for the fact that they may now have significantly less deductible expenses than originally expected.
GHJ Observation: Some members of Congress have expressed publicly that their intent was to have both tax-free forgiveness and deductibility of the business expenses. Such a result will most likely need to be achieved through legislative action. It is possible that a future economic response bill will attempt to ensure deductibility of expenses paid with forgiven PPP funds.
State and Local Implication: The tax impact of PPP loan forgiveness and deductibility of qualified expenses at the state level will depend on each state’s own determination. Even states with rolling conformity to the Internal Revenue Code (IRC) may need to determine whether or not they will tax the forgiveness, since the CARES Act did not actually amend the IRC when providing the tax exemption for forgiveness.
For California specifically, the forgiven debt is currently considered taxable income. Therefore the expenses paid with forgiven funds should generally be tax deductible, with a tax-neutral result. However, California has indicated that it will be providing additional information on its tax treatment of CARES Act items as it completes its analysis of the CARES Act.
GHJ has been actively monitoring these issues. Please consult your GHJ tax advisor or a member of our COVID-19 Resource Team if you have any questions about this or any other COVID-19-related items.