No Deduction Allowed for Expenses Relating to Forgiven PPP Loans

(Parker Tax Publishing May 2020)

Last week, the IRS addressed the deductibility for federal income tax purposes of certain otherwise deductible expenses incurred in a taxpayer's trade or business when the taxpayer receives a loan (covered loan) pursuant to the Paycheck Protection Program, which was enacted as part of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act). The IRS concluded that no deduction is allowed for an expense that is otherwise deductible if the payment of the expense results in forgiveness of a covered loan pursuant to Section 1106(b) of the CARES Act and the income associated with the forgiveness is excluded from gross income pursuant to Section 1106(i) of the CARES Act. Notice 2020-32.

Background

The Paycheck Protection Program (PPP) was established by Section 1102 of the CARES Act. Under the PPP, a recipient of a covered loan may use the proceeds to pay (1) payroll costs, (2) certain employee benefits relating to healthcare, (3) interest on mortgage obligations, (4) rent, (5) utilities, and (6) interest on any other existing debt obligations. Under Section 1106(b) of the Cares Act, a recipient of a covered loan can receive forgiveness of indebtedness on the loan (covered loan forgiveness) in an amount equal to the sum of payments made for the following expenses during the 8-week "covered period" beginning on the covered loan's origination date: (1) payroll costs, (2) any payment of interest on any covered mortgage obligation, (3) any payment on any covered rent obligation, and (4) any covered utility payment.

However, Section 1106(d) of the CARES Act provides that the amount of the covered loan forgiveness is reduced if, during the covered period, (1) the average number of full-time equivalent employees of the recipient is reduced as compared to the number of full-time employees in a specified base period, or (2) the salary or wages of certain employees is reduced by more than 25 percent as compared to the last full quarter before the covered period. In addition, pursuant to an interim final rule issued by the Small Business Administration, no more than 25 percent of the amount forgiven can be attributable to non-payroll costs.

Section 1106(i) of the CARES Act addresses certain federal income tax consequences resulting from covered loan forgiveness. Specifically, that provision provides that, for purposes of the Internal Revenue Code, any amount that (but for that provision) would be includible in gross income of the recipient by reason of forgiveness described in Section 1106(b) "shall be excluded from gross income." Thus, Section 1106(i) of the CARES Act operates to exclude from the gross income of a recipient any category of income that may arise from covered loan forgiveness, regardless of whether such income would be (1) properly characterized as income from the discharge of indebtedness under Code Sec. 61(a)(11), or (2) otherwise includible in gross income under Code Sec. 61 of the Code.

Neither Section 1106(i) of the CARES Act nor any other provision of the CARES Act addresses whether deductions otherwise allowable under the Code for payments of eligible Section 1106 expenses by a recipient of a covered loan are allowed if the covered loan is subsequently forgiven as a result of the payment of those expenses.

Notice 2020-32 - Deductibility of Eligible Section 1106 Expenses

On April 30, in order to address the effect of covered loan forgiveness on the deductibility of payments of eligible Section 1106 expenses, the IRS issued Notice 2020-32. The IRS began by noting that Code Sec. 161 provides that, in computing taxable income, deductions are allowed for certain items, such as trade or business expenses or certain types of interest expense. However, Code Sec. 161 also provides that the allowance of these deductions is subject to exceptions, such as Code Sec. 265.

Under Code Sec. 265(a)(1), no deduction is allowed to a taxpayer for any amount otherwise allowable as a deduction to such taxpayer that is allocable to one or more classes of income other than interest (whether or not any amount of income of that class or classes is received or accrued) wholly exempt from income taxes. Reg. Sec. 1.265-1(b) provides that the term "class of exempt income" means any class of income (whether or not any amount of income of such class is received or accrued) that is either wholly excluded from gross income under any income tax provision of the Code or wholly exempt from income taxes. The purpose of Code Sec. 265, the IRS stated, is to prevent a double tax benefit.

Code Sec. 265(a)(1) applies to otherwise deductible expenses incurred for the purpose of earning or otherwise producing tax-exempt income. It also applies where tax-exempt income is earmarked for a specific purpose and deductions are incurred in carrying out that purpose. In such event, it is proper to conclude that some or all of the deductions are allocable to the tax-exempt income.

In Notice 2020-32, the IRS stated that, to the extent that Section 1106(i) of the CARES Act operates to exclude from gross income the amount of a covered loan forgiven under Section 1106(b) of the CARES Act, the application of Section 1106(i) results in a "class of exempt income" under Reg. Sec. 1.265-1(b)(1). Accordingly, the IRS concluded that Code Sec. 265(a)(1) disallows any otherwise allowable deduction under any provision of the Code, including Code Sec. 162 and Code Sec. 163, for the amount of any payment of an eligible Section 1106 expense to the extent of the resulting covered loan forgiveness (up to the aggregate amount forgiven) because such payment is allocable to tax-exempt income. Consistent with the purpose of Code Sec. 265, such treatment prevents a double tax benefit.

This conclusion, the IRS said, is consistent with prior IRS guidance that addresses the application of Code Sec. 265(a) to otherwise deductible payments. In particular, the IRS cited Rev. Rul. 83-3, which provides that, where tax-exempt income is earmarked for a specific purpose, and deductions are incurred in carrying out that purpose, Code Sec. 265(a) applies because such deductions are allocable to the tax-exempt income. In accordance with the analysis set forth in Rev. Rul. 83-3, the IRS observed, 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 Code Sec. 265(a) to apply to disallow deductions for such payments under any provision of the Code, including Code Sec. 162 and Code Sec. 163, to the extent of the income excluded under Section 1106(i) of the CARES Act. The deductibility of payments of eligible Section 1106 expenses that result in loan forgiveness under Section 1106(b) of the CARES Act is also subject to disallowance under case law and published rulings that deny deductions for otherwise deductible payments for which the taxpayer receives reimbursement.

For a discussion of the nondeductibility of expenses relating to tax-exempt income, see Parker Tax ¶85,125. For in-depth reporting on the PPP, see the April 7, 2020 and April 23, 2020 issues of Parker's Federal Tax Bulletin (PFTB 2020-04-07 and PFTB 2020-04-23).

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com

We hope you find our professional tax research articles comprehensive and informative. Parker Tax Pro Library gives you unlimited online access all of our past Biweekly Tax Bulletins, 22 volumes of expert analysis, 250 Client Letters, Bob Jennings Practice Aids, time saving election statements and our comprehensive, fully updated primary source library.

Try Our Easy, Powerful Search Engine

A Professional Tax Research Solution that gives you instant access to 22 volumes of expert analysis and 185,000 authoritative source documents. But having access won’t help if you can’t quickly and easily find the materials that answer your questions. That’s where Parker’s search engine – and it’s uncanny knack for finding the right documents – comes into play

Things that take half a dozen steps in other products take two steps in ours. Search results come up instantly and browsing them is a cinch. So is linking from Parker’s analysis to practice aids and cited primary source documents. Parker’s powerful, user-friendly search engine ensures that you quickly find what you need every time you visit Our Tax Research Library.

Dear Tax Professional,

My name is James Levey, and a few years back I founded a company named Kleinrock Publishing. I started Kleinrock out of frustration with the prohibitively high prices and difficult search engines of BNA, CCH, and RIA tax research products ... kind of reminiscent of the situation practitioners face today.

Now that Kleinrock has disappeared into CCH, prices are soaring again and ease-of-use has fallen by the wayside. The needs of smaller firms and sole practitioners are simply not being met.

To address the problem, I’ve partnered with a group of highly talented tax writers to create Parker Tax Publishing ... a company dedicated to the idea that comprehensive, authoritative tax information service can be both easy-to-use and highly affordable.

Our product, the Parker Tax Pro Library, is breathtaking in its scope. Check out the contents listing to the left to get a sense of all the valuable material you'll have access to when you subscribe.

Or better yet, take a minute to sign yourself up for a free trial, so you can experience first-hand just how easy it is to get results with the Pro Library!

Sincerely,

James Levey

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com