When the Coronavirus Aid, Relief and Economic Security Act was signed into law this past March, it was evident that Department of the Treasury and the Small Business Administration would be called upon to provide a substantial amount of guidance for one of the act’s primary features: the Paycheck Protection Program. The PPP allows borrowers to use the loan funds to pay payroll costs, retirement contribution costs, health care costs, interest costs related to mortgage obligations, rent and utilities. Subject to established limitations involving the use of the proceeds, reduction in number of employees and reduction in employees’ compensation, a borrower can apply for all or a portion of the loan to be forgiven.
While this forgiven loan might otherwise be treated as income to the borrower, the CARES Act provides that for federal income tax purposes, any amount of the PPP loan that is forgiven will be excluded from gross income. Unfortunately for borrowers, on April 30, the Internal Revenue Service issued Notice 2020-32 in which deductions for expenses paid using loan proceeds from the PPP are disallowed to the extent of loan forgiveness and exclusion of the loan proceeds from gross income. In Notice 2020-32, the IRS applied IRC §265, which provides that no deduction is allowed to a taxpayer for any amount otherwise allowable as a deduction to such taxpayer that is allocable to income which is exempt from federal income tax.
Legislators were quick to express disappointment in this conclusion by the IRS. In a joint letter to Treasury Secretary Steven Mnuchin, Sen. Chuck Grassley (chairman — United States Senate Committee on Finance), Sen Ron Wyden (ranking member — United States Senate Committee on Finance) and Rep. Richard E. Neal (chairman — United States House of Representatives Committee on Ways and Means) disagreed with both Notice 2020-32’s interpretation of Congressional intent stating, “Providing assistance to small businesses, only to disallow their business deductions as provided in Notice 2020-32, reverses the benefit that Congress specifically granted by exempting PPP loan forgiveness from income,” and it’s the conclusion regarding the application of tax law stating, “In additional to disregarding congressional intent, we believe that Notice 2020-32 is flawed its analysis of the applicability of Section 265(a) of the Internal Revenue Code.”
While several federal legislators have indicated a willingness to legislatively alter the conclusion reached in Notice 2020-32 and a spokesperson for Neal stated that the Committee on Ways and Means intends to “fix this in the next response legislation,” it is worth noting that the Paycheck Protection Program Flexibility Act of 2020, which was signed into law on June 5, did not address the issue of deductibility of expenses paid with PPP funds.
For taxpayers in California, please note that the state has not conformed to the provision in the CARES Act excluding any amount of the PPP loan that is forgiven from gross income; however, there may still be an opportunity to exclude this PPP loan forgiveness from income under other statutory exceptions.
Taxpayers should watch for further legislation and consult your tax adviser to determine how these laws impact your specific situation.