The CARES Act’s marquee stimulus provision for small businesses—forgivable loans under the paycheck protection program (“PPP”)—was supposed to come without a tax bill. Or at least that was what Congress seemed to say when it provided that loan forgiveness would be excluded from gross income for tax purposes.
Yesterday, the IRS disagreed. Applying longstanding tax principles that deny tax deductions for expenses associated with tax-exempt income, the IRS announced that if a borrower receives forgiveness of a PPP loan, it will lose any tax deduction (up to the amount forgiven) for the payroll costs, mortgage interest, rent, and utility expenses that are included in the forgiveness calculation.
How PPP Loan Forgiveness Works
Under Section 1102 of the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”), eligible borrowers may apply for a PPP loan in a maximum amount that is based on the borrower’s average “payroll costs” during a lookback period. The lookback period is either the twelve full months preceding the loan application date, the calendar year 2019, or certain other periods for seasonal employers. “Payroll costs” consist of salaries up to $100,000 per employee, plus certain other compensation, benefits, and taxes paid during the lookback period (“Base Payroll Costs”). The maximum loan is the greater of $10,000,000 or two-and-one-half times the borrower’s average monthly Base Payroll Costs.
A borrower may then apply for forgiveness under Section 1106 of the CARES Act for a portion of the loan generally equal to the payroll costs, plus certain eligible payments for mortgage interest, rent, and utilities, that are made during the eight weeks following funding of the loan (“Forgiveness Eligible Expenses”). The amount forgiven may not exceed the principal amount of the loan, and may also be reduced in the event the borrower decreases its full-time equivalent headcount or individual employee salaries before the end of the eight-week period; in the event either or both of those limitations applies, the forgiveness amount will be less than the Forgiveness Eligible Expenses. An application for forgiveness requires that the borrower provide documentation to, and receive approval from, the PPP lender.
Tax Treatment of Loan Forgiveness
Under general tax law principles, forgiveness of a business loan would result in income for the borrower unless a specific exception applied, such as if the borrower were insolvent. Congress chose to displace that general rule, however, for PPP loans that are forgiven. Section 1106(i) of the CARES Act states that, for purposes of the Internal Revenue Code of 1986, any amount that would otherwise “be includible in gross income of the eligible recipient by reason of forgiveness … shall be excluded from gross income.” Congress seems to have intended that one dollar of loan forgiveness under the PPP result in one dollar of after-tax stimulus to the borrower, rather than 79 cents, for instance, for a corporation with a 21% effective tax rate.
The IRS, however, has decided to treat Forgiveness Eligible Expenses in a manner that defeats that apparent legislative intent. In Notice 2020-32, the IRS announced that it will deny tax deductions for Forgiveness Eligible Expenses to the extent they result in actual forgiveness of the PPP loan. (It appears, although the notice is not explicit on this point, that in the event the amount forgiven is limited to an amount less than the Forgiveness Eligible Expenses, the deduction for each such expense is proportionately reduced until the total reduction is equal to the amount forgiven.)
If the IRS position prevails, the taxable income of a borrower will be increased (or its loss reduced) by the full dollar amount of loan forgiveness under the PPP. The IRS position would also have state income tax consequences in states that conform to the income and deductions available under the current federal tax code. As a result, the stimulus effect of PPP forgiveness would be reduced by each borrower’s effective tax rate.
Congressional leaders have already begun to weigh in, with Senate Finance Committee Chair Chuck Grassley quoted as saying that the notice is “contrary to [Congressional] intent” regarding the tax treatment of PPP loan forgiveness, and the office of House Ways & Means Committee Chair Richard Neal expressing plans for legislation to override the notice.
As noted above, Notice 2020-32 does not provide details on how a borrower must reduce its deductions if the amount forgiven is less than its Forgiveness Eligible Expenses (which may occur because those expenses exceed the loan amount or because of a decrease in headcount or salaries that reduces the amount forgiven). The notice says that a deduction for each expense will be disallowed “to the extent of” the resulting forgiveness (and that the total amount disallowed will not exceed the aggregate amount forgiven), but does not specify whether a taxpayer may allocate the disallowed amount to particular expenses or must treat a proportionate amount of each expense as disallowed. The methodology could make a difference if the deductibility of any of a borrower’s Forgiveness Eligible Expenses were limited by other tax rules.
The notice also does not address other tax benefits that could result from payments of Forgiveness Eligible Expenses. For instance, certain payroll costs are eligible for the work opportunity tax credit or the credit for paid family leave under Section 45S of the Internal Revenue Code. The position taken in the notice might suggest that those credits should be unavailable for payroll costs that give rise to PPP loan forgiveness
Our tax team continues to monitor developments with respect to the treatment of PPP loan forgiveness. If you have questions, please reach out to the authors or any of your contacts at WilmerHale.