The IRS has ended the debate on whether business expenses funded with forgivable small business loans are tax deductible, placing the ball squarely in Congress’s court if it intended a different outcome.
With Notice 2020-32, 2020-21 IRB 1, released April 30, the IRS said that to the extent the income resulting from loan forgiveness under the Paycheck Protection Program (PPP) is excluded from income, it’s considered a “class of exempt income” under regulations promulgated under section 265.
“Consistent with the purpose of section 265, this treatment prevents a double tax benefit,” the IRS said.
The guidance comes after weeks of debate in the tax community on whether the loan proceeds that were used to fund ordinary business expenses that could typically be deducted under sections 162 and 163 could still be written off, because the loans are forgivable on a tax-free basis.
The loan program was created by the Coronavirus Aid, Relief, and Economic Security (CARES) Act (P.L. 116-136), enacted March 27, and gave employers options to keep paying their workers during the coronavirus pandemic.
Those options include the PPP and an employee retention credit that provides a fully refundable credit against the employer’s portion of payroll taxes. However, only $10,000 in wages per employee can be counted for all calendar quarters, and the credit is capped at $5,000 per employee.
An employer must forgo that credit if it wants to apply for a PPP loan, and jump through several other hoops to qualify for the loan. But if an employer does qualify and a specific portion of the proceeds is used to fund payroll costs over the eight-week period after receiving the loan, it will be forgiven on a tax-free basis.
Cornell University law professor Richard L. Reinhold told Treasury officials April 8 that if Congress’s intention was to allow a deduction for the use of the loan proceeds, it needs to put that into legislation.
Other practitioners disagreed, arguing that employers’ deductions for expenses shouldn’t be affected by the CARES Act regardless of whether they’re funded with PPP loans that were later forgiven tax free. Tax Notes’ Lee A. Sheppard also recently analyzed the issue, concluding that the IRS “should philosophically accept that a legislatively intended subsidy is a subsidy.”
The IRS felt the need to clear the air and issued the notice. According to the government, its position is consistent with prior guidance that addresses the application of section 265(a) to other deductible payments; specifically, it pointed to Rev. Rul. 83-3, 1983-1 C.B. 72.
“In accordance with the analysis set forth in Rev. Rul. 83-3, the direct link between (1) the amount of tax exempt covered loan forgiveness that a recipient receives pursuant to section 1106 of the CARES Act, and (2) an equivalent amount of the otherwise deductible payments made by a recipient for eligible section 1106 expenses, constitutes a sufficient connection for section 265(a) to apply to disallow deductions for such payments under any provision of the Code, including sections 162 and 163, to the extent of the income excluded under section 1106(i) of the CARES Act,” the notice states.
Chris Hesse of CliftonLarsonAllen LLP told Tax Notes it was strange that the IRS issued the notice.
“In effect, the IRS guidance means that the taxability provision has no meaning,” Hesse said, referring to section 1106(i) of the CARES Act, which makes the loan forgiveness tax exempt. “Why waste the ink to say that for purposes of the code, the loan forgiveness is not includible in income, if the government will just take away deductions in the same amount?”