What?! – Expenses paid with PPP loan may not be deductibleApril 28, 2020 | By Erik Lincoln
The Coronavirus Aid, Relief and Economic Security (“CARES”) Act was enacted on March 27, 2020. Included in the CARES Act are details of the Paycheck Protection Program (“PPP”) loan, an opportunity for small businesses to borrow at very favorable terms. Further, a business that receives a PPP loan is eligible to have its loan forgiven, as long as the loan is used for certain “costs incurred and payments made during the covered period” (referred to herein as the “eligible expenses”). See §1106(b) of the CARES Act for full details of when PPP loans are eligible to be forgiven.
Unfortunately, a forgiven or cancelled loan is treated as taxable income according to Section 61(a)(11) of the Internal Revenue Code (“IRC”). However, the CARES Act anticipated this and included wording that overrides this result. Specifically, Section 1106(i) of the CARES Act states the following:
“For purposes of the Internal Revenue Code of 1986, any amount which (but for this subsection) would be includable in gross income of the eligible recipient by reason of forgiveness described in Section 1106(b) shall be excluded from gross income”
This is great news, right?! – PPP loan forgiveness is excluded from taxable income. Not so fast. Congress has yet to specify how the CARES Act income exclusion fits into the Internal Revenue Code. Without further clarification, PPP loan forgiveness may be subject to IRC §265. What does IRC §265 say? It provides generally that no deduction is allowed for expenses related to income wholly exempt from gross income under any provision of subtitle A of the Internal Revenue Code or under the provision of any other law. If expenses related to PPP loan forgiveness are not allowed, this puts taxpayers in the same position as if their forgiven PPP loan were included in income and they were able to deduct all expenses.
There are other possible outcomes, such as if a taxpayer is insolvent (or if one of other provisions under IRC §108 apply), IRC §108 may apply to exclude debt forgiveness from income, instead of §1108(i) of the CARES Act doing so. If this is the case, IRC §108 requires a taxpayer to reduce its tax attributes (i.e., NOL, asset basis, etc…) equal to the amount of debt forgiveness income excluded from income. If IRC §108 applies, IRC §265 does not also apply.
Another possibility is that the IRS claims the US government is effectively reimbursing businesses for their eligible expenses – because loan forgiveness does not happen unless and until the PPP loan is used to pay such amounts. Under similar facts, the IRS determined in PLR 201617002 that where a business was able to exclude from gross income state relocation payments (excludable from taxable income under 42 U.S.C. § 4636), expenses related to moving were not deductible to the extent they were considered reimbursed by the state payments.
If you use your PPP loan to pay eligible expenses and your PPP loan is forgiven, those expenses may not deductible. This may not be what Congress intended, and if so, Congress should provide clarification. We will be closely monitoring this and have begun developing ideas for how to maximize amounts that can be deducted. So, make sure to check back with us on this.