Expenses Paid With Forgiven PPP Loan Proceeds Not Deductible

Medical Practice Tax News - COVID-19

The Paycheck Protection Program (PPP) included in the CARES Act allows businesses with 500 or fewer employees to receive loans to pay payroll costs, rent and certain other expenses. PPP loans can later be forgiven if the employer retains its employees and satisfies other requirements.

Loan Forgiveness

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 (each, an eligible section 1106 expense):

(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.

See section 1106(a) (defining the terms “covered period”, “covered mortgage obligation,” “covered rent obligation,” “covered utility payment,” and “payroll costs”), (b) (regarding eligibility for covered loan forgiveness), and (g) (regarding covered loan forgiveness decisions).

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.

Deductibility of Eligible Section 1106 Expenses

The CARES Act provides that the amount of any PPP loan that is later forgiven does not give rise to taxable income. Without this provision, the forgiveness of the loan would constitute taxable income in the form of cancellation of indebtedness income.

One question that I repeatedly get asked is whether businesses that used PPP loan proceeds to pay deductible expenses (such as payroll or rent) are able to deduct these expenses if the PPP loan is later forgiven. Unsurprisingly, the IRS has answered that question with a resounding no.

In Notice 2020-32, the IRS states that because the amount of the forgiven loan is excluded from income, the forgiven loan is a class of exempt income under Section 265 of the Internal Revenue Code. As a result, Section 265(a)(1) applies, which disallows a deduction otherwise allowable under the Internal Revenue Code if allocable to one or more classes of exempt income (other than interest income).

Further, the IRS determined that any otherwise deductible expenses funded by PPP loan proceeds that are subsequently forgiven are not deductible. This position is not surprising, as otherwise businesses would have gotten a double tax benefit from the PPP loan forgiveness program.