Since the CARES Act was passed, taxpayers and their advisors have wondered if expenses paid for with Paycheck Protection Program (“PPP”) loan funds that were ultimately forgiven will still be deductible for income tax purposes.
The IRS has just released guidance (Internal Revenue Notice 2020-32) which states that no deduction will be allowed for (1) payroll costs, (2) certain employee benefits related to healthcare, (3) interest on mortgage obligations, (4) rent, (5) utilities, and (6) interest on any existing debt obligations to the extent that a taxpayer pays those costs using loans obtained under the PPP pursuant to the CARES Act and which are forgiven pursuant to the CARES Act and SBA rules.
The rationale for this position, which is grounded in both the statutory and federal tax case law, is that a taxpayer is not allowed to deduct otherwise deductible ordinary and necessary business expenses to the extent that such expenses can be linked to tax-exempt income (this is to avoid a double tax benefit). In other words, the portion of expenses paid with the forgiven PPP loan will be non-deductible.
The federal tax treatment is not necessarily the same for state income tax purposes. Some states have decoupled from the federal tax regime which means that forgivable loans and related interest may be taxed by some states as “Cancellation of Debt” (“COD”) income; therefore, in those states, the related expenses should be fully deductible.
Since many state governments are working remotely, we are awaiting further guidance from those states. Moreover, many states will take advantage of the COD income to push taxpayers into higher brackets, especially those states like NJ which are gross income states. Every state is looking for every possible source of revenue.
Notwithstanding the IRS’s position, some members of both the House and the Senate are considering legislation to reinstate the deductibility of these expenses despite the fact that they are paid for with a forgiven loan. Their position is they are trying to “maximize small businesses’ ability to maintain liquidity, retain their employees and recover from this health crisis as quickly as possible.”
So, the IRS position stands, at least until Congress speaks. As always, please contact your Friedman LLP adviser with any questions.