IRS Issues Clarification on Deductibility of Expenses Paid with Forgiven PPP Loans

The Paycheck Protection Program (“PPP”) was established by the recently enacted CARES Act. PPP allows approved lenders to make loans to small businesses operating the United States. The federal government guarantees the repayment of PPP loans while providing borrowers with favorable repayment terms. The loans may be forgiven if the proceeds are expended primarily on employee payroll costs and if certain other employment-related standards are satisfied (we will discuss these requirements in further detail in a future alert following receipt of additional guidance from the Treasury Department). A smaller portion of the loan proceeds may be used to pay interest on mortgage obligations, rent, utilities, and interest on certain other pre-existing debt obligations. Any loan amounts that are not forgiven can be repaid over two years plus one percent interest.

Income tax law normally requires borrowers to recognize income when they are relieved of an obligation to repay a loan. However, the terms of the CARES Act expressly provides that borrowers are not required to recognize income with respect to any PPP loans forgiven.

Unfortunately, the CARES Act was silent as to the deductibility of payments made with the loan proceeds. In Notice 2020-32, the Internal Revenue Service concluded that expenses paid with loan proceeds are not deductible to the extent the loan is forgiven. The IRS based this conclusion on section 265 of the Internal Revenue Code which provides that no deduction is allowable for any expense paid with tax-exempt income. Because the loan is tax-exempt, pursuant to section 265, the use of the funds does not produce a tax deduction.

Notice 2020-32 may not be the final word on this topic. Both Representative Richard Neal (the Democratic chairman of the House Ways and Means Committee) and Senator Chuck Grassley (the Republican chairman of the Senate Finance Committee) have indicated that they would like to pass additional legislation permitting tax deductions for these expenditures. We will update this alert if and when additional relevant legislation is enacted.