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Expenses paid by forgiven PPP loan not deductible

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Tax Hot Topics newsletterThe IRS has issued guidance (Notice 2020-32) requiring taxpayers to reduce their deductions by the amount of any loan proceeds that are forgiven under the Paycheck Protection Program (PPP). The IRS’s conclusion is very unfavorable, and effectively eliminates the benefit Congress provided by excluding the debt forgiveness from gross income. Congressional leaders are already pledging a legislative fix as part of the next stimulus bill.

The PPP, which was enacted as a part of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, provides forgivable loans to certain businesses if they keep all of their employees on payroll for eight weeks and the funds are used to cover payroll costs, healthcare benefits, interest on a mortgage or other existing debt obligations, rent and utilities.

The CARES Act explicitly provides that the debt forgiven under PPP is excluded from the business’s gross income. The question arose whether this debt forgiveness would create tax-exempt income that would require taxpayers to reduce deductions under Section 265 for business expenses paid using the loan proceeds.

Section 265 generally disallows a deduction for an amount allocable to income that is wholly exempt from federal income tax. The IRS concluded that Section 265 is triggered when tax-exempt income is earmarked for a specific purpose and that PPP loan proceeds are effectively earmarked to deductible expenses because they must be spent in specific ways in order to be forgiven. The IRS therefore ruled that taxpayers must reduce deductions for business expenses by the amount of any loan proceeds used to pay those expenses if the loan is forgiven.

The legal analysis leading to the conclusion is controversial, and against Congress’s clear intent. It erases the benefit of excluding the debt forgiveness from income in the first place and makes Congress’s provision to that effect essentially meaningless. Top lawmakers immediately expressed disappointment in the IRS guidance and pledged to fix the problem in future legislation. The outlook for legislative relief appears promising, but the legislative process always involves uncertainty.

Contacts:
David Auclair
National Managing Principal
Washington National Tax Office
T +1 202 521 1515


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