Are Expenditures from PPP Loans Tax-Deductible?
Recent guidance from the IRS has created some confusion over the tax-deductibility of expenses paid by a Paycheck Protection Program (“PPP”) loan recipient using PPP funds under the recently-established CARES Act. Although lack of clarity and miscommunication has accompanied much of the rules originating from Washington in response to the COVID-19 pandemic, this issue appears to involve a difference of opinion between Congress and the Treasury Department, with high stakes for taxpayers.
This article assumes its readers are familiar with PPP loans in general, and those who are not can quickly get up to speed by reading a March 30 BNN article. This article is limited to discussing federal income tax treatment of the PPP loans; state income tax treatment may vary. Also, note that GAAP accounting treatment is discussed in an April 30 BNN article.
Every dollar of PPP loan funds will take one of three paths:
- Received by the applicant, but returned by May 18, if determined that the need was not truly established to support making a “good faith certification” (the subject of another April 30 article),
- Received and then spent on costs ineligible for loan forgiveness, or
- Received and spent on costs that do qualify for loan forgiveness.
These three paths each involve an influx of cash and an expenditure of it, providing at least six possible “movements” of cash, for which a tax treatment must be assigned.
- Option #1 above is simple: The loan is returned in a balance sheet-only transaction. No income or deductions result.
- Option #2 is also relatively straightforward: The receipt of the loan principal (and its repayment) are balance sheet-only activities, while the expenditures will be treated consistently with the use of those funds.
- Option #3 is where things become tricky, as discussed below.
Note that one loan can involve all three paths, although not for the same dollars. An applicant could, for instance, borrow $100,000 and return $30,000 by May 18 as unneeded; spend $60,000 on qualifying costs and enjoy the resulting forgiveness; and spend $10,000 on costs that do not qualify for forgiveness, thereby incurring the need to pay back the $10,000 loan principal (plus interest).
Let’s look separately at the two movements of cash involving a PPP loan that qualifies for forgiveness:
Loan received (the influx)
A number of exceptions exist, but generally a forgiven loan constitutes taxable income – just as if revenue was received with which to repay the loan. However, Sec. 1106(i) of the CARES Act specifically states that the normal rules do not apply, and that forgiven loans “shall be excluded from gross income” for federal income tax purposes.
Qualifying expenses (the outlay)
The tax treatment of the expenses that qualify a loan for forgiveness is the source of confusion and dispute.
In the CARES Act, Congress does not explicitly say whether or not the outlays are deductible. Practitioners quickly noticed this, but also saw a logical path to deductibility when viewed in context of related laws, and noted that nothing in the CARES Act specifically suggested that expenses were not deductible, either. Interested parties were hopeful guidance would be forthcoming. That guidance arrived in the form of Notice 2020-32, in which the Treasury Department stated that expenditures would not be deductible up to the amount of loan forgiveness excluded from income. On its face, there may be logic to that interpretation, because the relevant pieces (the two “movements” described above) foot to taxable income of zero, just like they do in a non-PPP scenario in which revenue is earned from operations and is in turn spent on a deductible outlay.
Example 1: Taxpayer collects sales revenue of $10,000 and spends the same amount on payroll. The revenue is taxable and the payroll is deductible. Its net income is zero ($10,000 – $10,000 = $0).
Likewise, in the case of PPP loan forgiveness, Section 265 of the Code reinforces this concept in an attempt to get the Taxpayer back into the same economic position as stated in Example 1, as typically no deduction is allowed for expenses incurred in connection with the production of tax-exempt income.
Example 2: Borrower collects $10,000 in PPP loans and spends it on payroll. The loan is forgiven and its influx of cash is nontaxable pursuant to Sec. 1106(i) of the CARES Act. The outlay (under Treasury’s interpretation) is nondeductible. Borrower’s net income is zero ($0 – $0 = $0).
But here is the issue: What if Congress intended for the forgiven PPP loans to be even more potent for the borrower than could be accomplished by merely giving the funds to the borrower and asking it to serve as a conduit for those funds ending up in the hands of employees (or other recipients whose eventual receipt qualify the borrower for the forgiveness)? What if that added potency consists of the borrower’s ability to enjoy a tax deduction, even though those outlays were funded by someone else? That added potency is exactly what some high-ranking members of Congress say they intended for the law to accomplish when they helped to write it.
Example 3: Borrower collects $10,000 in PPP loans and spends it on payroll and other eligible expenses. The loan is forgiven and its influx of cash is nontaxable pursuant to Sec. 1106(i) of the CARES Act. The outlay (under this interpretation) is fully deductible. Borrower’s net loss is $10,000 ($0 – $10,000 = $-10,000). If the applicable federal tax rate is 37%, this allows a $10,000 PPP loan to have a favorable impact of $13,700. (Note that in some cases, beyond the scope of this article, a loss can be deferred via a basis increase.)
In defending his department’s stance in Notice 2020-32, Treasury Secretary Mnuchin argued that allowing a deduction for outlays when the related “revenue” is tax-free amounts to double-dipping, and the IRS position preventing that outcome is “basically Tax 101”. However, the next day, he received a letter from Sen. Chuck Grassley, Sen. Ron Wyden, and Rep. Richard Neal, showing Congressional support for an alternative interpretation.
In their letter, this small bipartisan group of congressmen (all members or chairs of committees responsible for crafting the nation’s tax laws) wrote to Sec. Mnuchin informing him that Notice 2020-32:
- Was an overreach by Treasury,
- Misinterpreted the law in arriving at its “non-deductibility” conclusion, and
- Was contrary to congressional intent.
The letter pointed out that Congress meant not only to fund the actual amount of the forgiven loan, but also allow the borrower to indirectly enjoy an added source of capital, consisting of the reduced taxes achieved by the expenditures’ deductions. It encouraged Sec. Mnuchin to “reconsider (his) determination”.
The letter also pointed out that while Notice 2020-32 referred to a number of cases that Treasury believed supported its own position that the expenditures are not deductible, those cases heavily turned on Congressional intent (a common and widely accepted concept of law), and Congressional intent in this case is for the outlays to be deducted.
Digging slightly below the surface and supported by the correspondence sent to Sec. Mnuchin by Congressmen Grassley, Neal, and Wyden, we reveal that expenditures made with forgivable PPP loan proceeds were intended to be tax-deductible by the PPP recipient, assuming they otherwise qualify. Unfortunately, another source of authority, IRS Notice 2020-32, uses much more clear language to deny that same deduction – although the notice’s legacy is now in question. In these financially troubled times, many companies undoubtedly have budgeted cash flows that contemplate the more favorable interpretation of these positions, and Notice 2020-32 is a legitimate concern if left unchecked. Hopefully in the days and weeks to come, this conflict in guidance will be resolved by Treasury modifying its position.
For more information or a discussion on how this may impact you, please contact Matthew Landon or your BNN advisor at 800.244.7444.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.