PPP Loan Forgiveness and The Denial of Deductions for Covered Expenses – What’s Wrong with the IRS’s Position?
May 04, 2020
The Paycheck Protection Program[i] has been welcomed by many as the cornerstone of the CARES Act.[ii] It was passed by Congress and signed into law by the President shortly after the government-ordered shutdown of businesses and other organizations[iii] throughout the country as part of the effort to contain the spread of the coronavirus, and in the wake of the economic downturn that followed this countermeasure.
The Program offers many small businesses[iv] – both those that are shuttered and those that remain open – the cash liquidity they need to retain much of their workforce at salaries that approach pre-shutdown levels.[v] It also provides these businesses the wherewithal to pay their rent and utilities, as well as certain other pre-existing indebtedness.
The Federal government, working through private lenders,[vi] is making the above-referenced funds[vii] available to an eligible business through a nonrecourse, unsecured, 100 percent government-guaranteed loan.
The first PPP loans were made on April 3 – only one week after enactment of the Program – and will continue to be offered, provided funds are available, until June 30, 2020.[viii]
PPP Loan Forgiveness
A key feature of the Program provides that a business will not be required to repay the principal amount of its PPP loan[ix] if the business uses the loan proceeds for certain statutorily prescribed purposes[x] – specifically, payroll costs, rent, utilities, and certain pre-existing indebtedness – over the eight-week period that begins with its receipt of the proceeds.[xi]
In order to fully enjoy this benefit, the business must be able to adequately substantiate its use of the proceeds.[xii] Moreover, the business must not have reduced its employee workforce or the total salary of any of its employees[xiii] during the eight-week period.[xiv]
These requirements – that the loan be used to retain workers and maintain payroll, to make lease and utility payments[xv] – are basically the same purposes that a business represents on its PPP loan application as its reasons for seeking the loan.[xvi]
Once the loan is forgiven, the SBA will remit to the lender (no later than 90 days after the date on which the amount of the forgiveness is determined) funds equal to the amount forgiven, plus any interest accrued thereon;[xvii] thus, the government will indemnify the lender for its “loss.”
Through this mechanism, a business that fully satisfies its obligations under the Program may effectively be treated as having received a grant of money from the government.[xviii]
Forgiveness: Tax Treatment
According to the legislation, for Federal tax purposes, the amount of any PPP loan which is forgiven, as described above, will be excluded from the gross income of the borrower-business,[xix] notwithstanding that it would otherwise have been includible as income from the discharge of indebtedness.[xx]
In terms that a child would appreciate – yes, I’m a big kid – if forgiveness of the PPP loan was the whipped cream on a sundae, the exclusion of such loan forgiveness from income was the cherry on top.[xxi]
The CARES Act is otherwise silent as to the tax treatment of the cash flows under the Program. It does not address (i) the receipt of the loan proceeds by the business, (ii) the receipt of the salary by the employees of the business, or the receipt of the rent by the business’s landlord, and (iii) the payment of the foregoing expenses by the business.
Moreover, neither the Senate nor the House has contemporaneous legislative history regarding the CARES Act, such as a committee report or technical explanation, which sheds light on these tax issues; and although the Joint Committee on Taxation has prepared a helpful summary of the legislation’s tax provisions, it does nothing more than repeat the language of the forgiveness provision.[xxii]
Borrowed Funds, Generally
If we accept the PPP loan as bona fide indebtedness – i.e., its forgiveness is not a foregone conclusion[xxiii] – then the business’s receipt of the loan proceeds should not be includible in the gross income of the business for purposes of determining its income tax liability. On these facts, as in the case of any other loan, the business has not realized an accretion in value; the loan has to be repaid.
In general, the business’s use of borrowed proceeds does not affect the tax treatment of the expenditures made by the business using such proceeds. Thus, a business that uses loan proceeds to satisfy its ordinary and necessary operating expenses, including, for example, reasonable salaries and rent, may nevertheless deduct the expenses in determining its taxable income.[xxiv] Similarly, if the borrowed sums are used to acquire depreciable property for use in the business, the business may claim depreciation deductions[xxv] in respect of such property.[xxvi] If the loan is used to acquire inventory, the amount so expended is added to cost of goods sold.[xxvii]
The flipside of this favorable tax treatment? The business may not deduct its repayment of the loan principal.[xxviii]
Much the same way that the use of borrowed funds by a business generally does not affect its tax treatment of the business expenditures made using such funds, the tax treatment of the recipient of those payments does not depend upon their origin as loan proceeds. Thus, the employee to whom salary is paid using these proceeds, or the landlord to whom rent is paid using borrowed funds, must include the amount received in its gross income for purposes of determining its tax liability.[xxix]
Application for Forgiveness
Unlike most loans, the Program allows a business to apply for forgiveness of its PPP loan. Such an application may be filed after the end of the eight-week period during which the loan proceeds are supposed to have been used for their legislatively mandated purposes, and must include documentary evidence that demonstrates the business’s use of the loan proceeds and supports its request for forgiveness of the loan.
The lender has 60 days after receipt of the borrower’s application to issue a decision thereon.[xxx] Until the PPP loan is forgiven, it remains a debt of the business.[xxxi]
In light of the foregoing, and given the overall emphasis of the CARES Act’s tax provisions on assisting businesses with generating liquidity,[xxxii] – presumably for the period following the forgiveness of the PPP loan, during which businesses will likely not be operating at pre-lockdown levels – many businesses that have applied for PPP loans, and many that have already received them, and have been making payments using the proceeds from such loans, have done so under the assumption that such payments will be deductible for tax purposes.
The IRS Finally Speaks
On April 30, 2020, however, the IRS issued Notice 2020-32 (the “Notice”) – more than one month after the enactment of the Program, and almost four weeks after the submission of the first PPP loan applications.
According to the Notice, it “clarifies” that no deduction will be allowed under the Code for an expense that would otherwise be deductible by a business if the payment of the expense – i.e., the use of the loan proceeds by the business for payroll costs, rent and utilities, in accordance with the terms of the Program – results in forgiveness of a PPP loan pursuant to the CARES Act, and the income associated with such forgiveness is excluded from gross income for tax purposes.[xxxiii]
The CARES Act, the Notice states, provides that, for purposes of the Code, any amount which would otherwise be includible in the gross income of the borrower-business, by reason of the forgiveness of the PPP loan under the Program, “shall be excluded from [the] gross income” of the business. The Notice explains that this includes “any category of income that may arise from loan forgiveness under the Program, regardless of whether such income would be (1) properly characterized as income from the discharge of indebtedness under section 61(a)(11) of the Code, or (2) otherwise includible in gross income under section 61 of the Code.”
Before continuing with our summary of the Notice, query to what other category of income the IRS is referring therein that may arise from loan forgiveness? It is obvious that the relationship between the creditor and the debtor may result in the forgiveness being treated as something other than cancellation of indebtedness income; thus, for example, the forgiveness of a loan may be treated as a gift, a contribution to capital, an adjustment or credit to purchase price, compensation for services or for the use of property, or a distribution. However, with the exception of a “contribution to capital,”[xxxiv] none of these alternative treatments makes any sense in the context of a PPP loan.
The Notice concedes that the CARES Act does not address whether deductions otherwise allowable under the Code for payments of “eligible expenses” by the borrower-business will still be allowed if the PPP loan is subsequently forgiven “as a result of the payment of those expenses.”
As stated earlier, the Code generally provides for a deduction for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. The rent obligations, utility payments, and payroll costs paid comprise typical trade or business expenses for which a deduction under the Code is usually appropriate.
The Notice points out, however, that no deduction is allowed to a taxpayer under the Code for any amount, otherwise allowable as a deduction, that is allocable to one or more classes of income that are wholly exempt from the income tax.[xxxv] The purpose of this rule is to prevent a double tax benefit: the deduction of the payment made with the loan proceeds and the subsequent exclusion of such loan proceeds from gross income notwithstanding the forgiveness of the loan.
This disallowance provision, the Notice explains, 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.[xxxvi]
The Notice explains that, to the extent the CARES Act operates to exclude from gross income the amount of a forgiven PPP loan, it results in a “class of exempt income.” Therefore, the Notice concludes, the Code disallows any otherwise allowable deduction for the amount of any payment of an eligible PPP expense to the extent of the resulting loan forgiveness because such payment is allocable to tax-exempt income. “This treatment,” the Notice observes, “prevents a double tax benefit.”
According to the Notice, this conclusion is consistent with prior guidance of the IRS which provides that, where tax-exempt income is earmarked for a specific purpose, and expenses are incurred in carrying out that purpose, the Code denies the deduction of such expenses because they are allocable to the tax-exempt income. The Notices states that the direct link between (1) the amount of tax-exempt loan forgiveness that a PPP loan recipient receives pursuant to the CARES Act, and (2) an equivalent amount of the otherwise deductible payments made by the recipient for expenses, constitutes a sufficient connection for the Code to disallow deductions for such payments under any provision of the Code, to the extent of the income excluded under the CARES Act.[xxxvii]
How “Strong” is the Notice?
The IRS’s reasoning for denying a deduction to a business that uses its PPP loan proceeds in accordance with the legislative mandate of the CARES Act to retain its employees and to maintain their salaries is somewhat misguided; it also presents a “chicken and egg” problem.
The Notice relies upon the tax treatment of costs (i) that are incurred for the generation of income that is intrinsically tax-exempt, without regard to the actions of the taxpayer, or (ii) that are paid with funds that are intrinsically tax-exempt, without regard to the actions of the taxpayer.
It then tries to equate these situations with the exclusion from gross income for any debt forgiveness that may be granted to a business which uses its PPP loan proceeds to pay the salaries of its employees (among other things); thus, on the one hand, it treats the loan as if it were not a loan but, rather, a tax-exempt grant, and on the other, it treats the forgiveness (and the attendant exclusion from income) as the tax-exempt income to be generated by the expenditure of the funds for the directed purpose.
Fortunately, there is a better alternative, one that is both more in line with the economic goal of the CARES Act, and more defensible from a tax perspective. This alternative is premised on respecting the PPP loan as such.
The cancellation of a taxpayer’s indebtedness is generally treated as ordinary income.[xxxviii] There are circumstances, however, in which the taxpayer is not required to recognize such income.[xxxix] For example, the Code has long provided that the income realized by a taxpayer by reason of the discharge of the taxpayer’s indebtedness will not be included in the taxpayer’s gross income if the discharge occurs in a bankruptcy proceeding[xl] or when the taxpayer is insolvent, to the extent of such insolvency.[xli] Over the years, additional non-recognition situations have been added to the Code for which Congress has determined that recognition of discharge of indebtedness income, and the resulting tax liability, would not serve society well.[xlii]
That is not to say that Congress decided to give taxpayers a free ride under the cancellation of indebtedness rules, having allowed them to spend the borrowed funds, claim deductions therefor, and still avoid the recognition of income upon the discharge of such indebtedness.
Rather, Congress has recognized that such immediate recognition would not be appropriate under the circumstances, when the debtor business was likely in need of liquidity.[xliii] However, in recognition of the accretion in value realized by the debtor, and in order to recapture the tax benefit bestowed upon the debtor by reason of the exclusion of the discharged indebtedness from the gross income of the business, Congress required the business to reduce certain tax attributes[xliv] which, over time, would otherwise have reduced the tax liability of the business. In this way, the business repays the tax benefit over time.[xlv]
Why wouldn’t this approach apply under the current circumstances? It would provide the borrower-business with badly needed liquidity for the post-PPP loan period, while also ensuring that the business, assuming it survives, does not enjoy a double tax benefit.
We are still in the early stages of the Program. The IRS should reverse the position set forth in the Notice. If it unwilling to do so, Congress has time to act before the appropriate tax returns have to be filed.
[i] The “PPP” or the “Program”. See Sections 1101-1107 of the CARES Act.
[ii] The Coronavirus Aid, Relief and Economic Security Act. Pub. L. 116-136.
[iii] Other than those deemed “essential.” The President declared a national state of emergency on March 13, 2020, and the legislation was enacted on March 27, 2020.
As I write this, some states are already taking steps to reopen their economies. I’m certain they mean well, but like Theoden when he led his people to Helm’s Deep, I fear they too are underestimating the threat facing them.
[iv] See Section 1102(a)(2)(D) of the CARES Act. The definition of “small business” has been the subject of much discussion over the last couple of weeks. If I were feeling magnanimous, I’d say that Congress was sloppy. The problem with that, though, is that Congress was pretty specific in the language chosen to describe what it meant by “small.” Because I’m not in a generous mood, I’m inclined to say that Congress got caught. That’s a subject for another day.
[v] Notwithstanding that many of these employees were in no position to work because the employer-businesses were still closed by government order. Indeed, many employees requested to be fired by their employers in order to qualify for state unemployment benefits which, when supplemented by the $600 per week stipend payable by the Federal government under the CARES Act, put them in a better position economically than if they had remained employed. Go figure. I seem to recall some Senators predicting that would happen. Again, that’s another subject for another day.
[vi] Many of whom seem to have forgotten a certain bailout not that long ago.
[vii] The CARES Act appropriated $349 billion for this purpose. On April 16, the Program announced it had run out of money. The following week, Congress passed the “Paycheck Protection Program and Health Care Enhancement Act” (“CARES Act 3.5”), which authorized an additional $321 billion for the Program.
[viii] Section 1102(a)(2) of the CARES Act.
[ix] Section 1106(b) of the CARES Act.
[x] Which were subsequently modified somewhat by the Small Business Administration and the Department of the Treasury. For example, the statute does not specify what portion of the loan proceeds must be applied toward the payment of payroll costs – the SBA, however, has indicated that at least 75 percent of the proceeds must be so used. See Q&A 2.o. in Part III of the interim final rule, Business Loan Program Temporary Changes; Paycheck Protection Program, Docket No. SBA-2020-0015, 85 Fed. Reg. 20811, 20813-20814 (April 15, 2020).
In some cases, this is simply impossible. Take for example, the case of a business, like a restaurant, that typically has relatively low payroll costs and high rent.
[xi] In the case of a loan made on June 30, for example, the eight-week period will end on August 24, 2020.
[xii] Section 1106(e) and (f) of the CARES Act.
[xiii] This applies only to an employee with an annualized salary of not more than $100,000. What’s more, such an employee’s salary may be reduced by up to 25 percent without adverse consequences to the employer. Section 1106(d)(3) of the ARES Act.
[xiv] Section 1106(d) of the CARES Act. However, the statute also affords the business the opportunity to cure these failures no later than June 30, 2020. Section 1106(d)(5).
[xv] See the definitions in Section 1106(a) of the CARES Act.
[xvi] To the extent the business fails to satisfy the above requirements, at least a portion of the loan will remain outstanding; according to the statute, the loan will bear interest at an annual rate not to exceed 4 percent, and will be payable over a term not to exceed ten years.
The SBA has set the interest rate at 1 percent and the term of the loan at 2 years; what’s more, the repayment schedule includes a six-month deferral.
[xvii] Section 1106(c)(3) of the CARES Act.
[xviii] Think of it as a quasi-“substance over form” analysis.
[xix] Section 1106(i) of the CARES Act.
[xx] IRC Sec. 61(a)(11); Reg. Sec. 1.61-12; IRC Sec. 108.
[xxi] The open question, until last week, was whether that sundae also came with sprinkles or peanuts?
What? Were you expecting a reference to celery dipped in hummus, with flax seeds drizzled over it? C’mon.
[xxii] Joint Committee on Taxation, Description of the Tax Provisions of Public Law 116-136, the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act (JCX-12R-20). See page 104.
April 23, 2020.
[xxiii] In light of the uncertainty expressed by many loan recipients over how and when they are to spend the proceeds, the SBA may end up with more debtors than they bargained for.
[xxiv] IRC Sec. 162.
[xxv] Including bonus depreciation.
[xxvi] IRC Sec. 167.
[xxvii] IRC Sec. 263A.
[xxviii] As distinguished from the interest paid by the borrower to the lender in exchange for the use of the lender’s funds. The tax treatment of such interest payments may depend upon the uses to which the funds are put. IRC Sec. 163.
[xxix] IRC Sec. 61.
[xxx] In the case of a PPP loan made on June 30, the eight-week period ends on August 24; if the business applies to the lender for forgiveness on August 25, the lender has 60 days – until October 24, 2020 – to decide whether the business qualifies for forgiveness. Section 1106(g) of the CARES Act.
[xxxi] Albeit one that, by statute, is unsecured, nonrecourse, and guaranteed by the Federal government.
[xxxii] For example, the relaxation of the NOL, excess business loss, and interest deduction rules, and the delay of payment of the employer share of payroll taxes. See Section 2301 through 2308 of the CARES Act. https://www.taxlawforchb.com/2020/04/tax-considerations-as-businesses-prepare-to-emerge-from-the-covid-19-shutdown/
[xxxiii] Section 1106(i) of the CARES Act.
[xxxiv] In the sense of IRC Sec. 118. See the changes made thereto by the Tax Cuts and Jobs Act.
[xxxv] The Notice cites IRC Sec. 265(a)(1) and Reg. Sec. 1.265-1.
The term “class of exempt income” means any class of income that is either wholly excluded from gross income under the Code or wholly exempt from taxes under the provisions of any other law. Reg. Sec. 1.265-1(b)(1).
[xxxvi] In which case, the deductions are treated as allocable to the tax-exempt income.
[xxxvii] Inexplicably, the Notice finishes its discussion by stating that the deductibility of payments is also subject to disallowance where the taxpayer is reimbursed for such payments. This is a corollary to the tax benefit rule under which the gross income for a tax year includes the recovery in that year of an expense deducted in another.
Although the concepts underpinning the rule may be extended to other scenarios, the debt forgiveness in question is not one of them.
[xxxviii] IRC Sec. 61(a)(11).
[xxxix] IRC Sec. 108(a).
[xl] IRC Sec. 108(a)(1)(A).
[xli] IRC Sec. 108(a)(1)(B) and 108(a)(3).
[xlii] For example, IRC Sec. 108(a)(1)(D), which was added in 1993, in response to the housing bust of the early 1990s, when, by reason of a significant and sudden drop in the real estate market, owners found themselves with property that was underwater.
[xliii] There is an exception. Under IRC Sec. 108(e)(2), if an accrual basis taxpayer claimed a deduction for an expense that was later forgiven, the taxpayer would have to recognize the discharged liability as income.
[xliv] In an amount determined by reference to the amount of debt discharged that was excluded from income. IRC Sec. 108(b)(3).
[xlv] IRC Sec. 108(b). Among these tax attributes are NOLs, capital loss carryovers, the basis of property, and various credits.
For a somewhat analogous situation, see also IRC Sec. 118 and Sec. 362. According to Sec. 118 of the Code, prior to its amendment in 2017, gross income did not include any contribution to the capital of a corporation made by persons who are not shareholders of the corporation. This included a contribution from a governmental entity, provided the funds were used for certain capital expenditures and not for operating expenses. Assuming the funds were properly used and capitalized, the taxpayer was required to reduce their basis for the property acquired, thus ensuring the subsequent recognition of the “exempted” contribution.