IRS Releases New PPP Guidance on Deductibility of Covered Business Expenses

IRS Releases New PPP Guidance on Deductibility of Covered Business Expenses

By: D. Keith Dunnagan, Esq.

December, 2020

We remember those days just a few months back when the weekly unemployment numbers showed millions of new filings each week. Businesses were shuttered and revenues were coming to a screeching halt. The government put money into the market to help businesses keep employees on the payroll without placing even more burdens on the already strained state unemployment systems.

In March 2020 as COVID-19 shutdowns began to shutter small businesses, Congress passed the CARES Act creating the PPP loan and making billions of dollars available to small businesses. Under this program more than 5 million loans were funded and hundreds of billions of dollars of relief was distributed. One of the key components of the PPP program was the availability of the tax forgiveness. Under 1106(b) of the CARES Act, a borrower is entitled to forgiveness of loan when the money was used for covered costs (payroll costs, utility payments, lease payments and interest payments) during the covered period.

As businesses were seeing dramatic shifts in revenues and mass layoffs were occurring, this program was seen as a way to keep workers employed and provide relief on the strained unemployment benefit systems as well as provide relief for small businesses that were struggling with employee costs. In most small businesses, employee costs are the largest costs for the business.

The next question that naturally occurred was what about taxability. Normally, when a loan is made and then forgiven the amount forgiven is treated as taxable income. This is colloquially known as the debt forgiveness tax. The purpose is that when money is borrowed, the borrower receives the cash. When they do not have to pay that money back, there is a benefit conferred on the borrower that creates a taxable liability. The borrower received the cash and did not have to pay it back thereby creating income. Under 1106(i) of the CARES Act, the statute stated that the amount of the forgiven principal would be excluded from gross income for tax purposes. The benefit to the borrower was that they could borrow money with the expectation of receiving some, if not all, of the debt forgiven and then not be penalized by having to pay taxes. A good outcome. The PPP functionally becomes a grant.

However, there is more to the story. Normally, all business expenses, which include payroll costs, lease payments, utility payments and interest payments (covered expenses for PPP purposes) would be tax deductible under sections 161 – 163 of the Internal Revenue Code. The idea is that income does not include those costs which are incurred in carrying on any trade or business. Great. Sounds good. However, there has been concern how expenses that were paid for by the PPP loan would be treated. Would those expenses still be deductible as business expenses, or would those expenses not be deductible because the forgiven PPP loan was used to pay those expenses. Recently, the IRS released Notice 2020-32 to provide guidance on this issue.

The CARES Act is silent on the deductibility of the covered expenses. Consequently, the IRS has determined that those expenses paid for by a forgiven PPP loan are not deductible expenses. The law suggests that by not taxing the forgiven PPP loan and by allowing the expenses to be deducted the businesses would be receiving a double tax benefit. However, this seems to not be within the spirit of the law. The purpose of the law was to provide relief to small businesses without punishing them for accepting the relief. This notice which comes more than 2.5 months after the PPP program ended and more than 5 months after the bulk of the PPP loans were funded stands for the proposition that business expenses that are normally tax deductible will not be tax deductible. Meaning people that normally may have deducted $100,000 in payroll costs, will not be able to deduct those costs and that will increase the income which the business may have to pay taxes on.

This Notice is particularly difficult to stomach in a time when many businesses are being shut down again with surging COVID-19 cases. These businesses have costs that they just can’t support.

There is at least one potential legal issue with the timing of this Notice that came out on Nov. 19, 2020. Under 1106(k), the Administrator (referring to the SBA) was required to issue this guidance and implementing regulations within 30 days of passage of the CARES Act. This new guidance from the IRS may be subject to legal challenges based upon its non-compliance with the timing constraints in the statute.

Additionally, there appears to be bipartisan support for amending the CARES Act to allow the tax deductibility of the covered business expenses. However, that will literally require an act of Congress to put the relief in place. One such bill already introduced is the Small Business Expense Protection Act of 2020 that has broad bipartisan support in the Senate. It is a simple bill that is less than one page that would make the necessary amendments to protect the tax deductibility of the covered PPP expenses.

Time will tell if this oversight is corrected. But as business move towards the end of the year, they should be consulting with their tax and legal professionals on the impacts of the PPP loan and taxability.

The information contained in this post is informational in nature and not to be construed as legal advice. Each person’s scenario is different. If you are facing a legal issue of any kind, get competent legal advice in your state immediately to determine your best options.

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