By Scott Lewis, CPA, MSA
Late on April 30, 2020, the IRS published additional tax guidance under Notice 2020-32, specifically addressing the deductibility of expenses when loans under the Paycheck Protection Program (PPP) are forgiven. The PPP was part of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) passed on March 27th, 2020, to protect the American people from the public health and economic impacts of COVID-19.
In summary, Notice 2020-32 states that the amount of the PPP loans forgiven will be considered tax-exempt income for federal tax purposes. However, to not incur a double tax benefit, covered allowable deductions paid by the PPP are not tax deductible, to the extent of loan forgiveness. For example, if the PPP loan amount is $150,000, and $150,000 of allowable/deductible payroll and rent expenses were paid with this loan, but only $100,000 was considered forgiven (due to a variety of factors), only $50,000 of these expenses can be tax deducted. The $100,000 of ”forgiven income” offsets the otherwise deductible expenses.
The authority cited by the IRS on this Notice comes from Internal Revenue Code §265 (a)(1). This disallows any otherwise allowable deductions under any provision of the Code, including section 162 (Trade or Business expenses), and section 163 (Interest), for any payment of an eligible section 1106 expense (the section of the CARES Act that defines the forgiveness of the PPP loans, which includes payroll and rent). The disallowance is up to the extent of the resulting loan forgiveness as this is allocable to the tax-exempt income. Otherwise it would cause a double tax benefit, tax-exempt debt forgiveness income and allowable payroll and other covered expense deductions.
We understand that there is still a lot of uncertainty with addressing the calculation of the loan forgiveness of the PPP loans. Detailed record keeping must be kept and should track every dollar expended by the loans for their covered uses. This includes no more than 25% for non-payroll costs such as rent, utilities, and mortgage interest. The American Institute of Certified Public Accountants (AICPA), as well as many business industry groups have petitioned the SBA to provide guidance on what specific factors and timeframes should be included in calculating this loan forgiveness, but nothing final has been issued at this time. It is our understanding that most of the forgiveness calculations will revolve around the number of full-time equivalent employees and payroll costs during the forgiveness period.
There is also uncertainty on how the above will intersect with other tax provisions and other accounting factors. Some examples include: Will this tax-exempt income be subject to Alternative Minimum Tax (AMT)? Many states consider loan forgiveness as taxable income; will there will be conformity provisions to add back the disallowed payroll and other expenses. Will disallowed interest expense affect the business interest limitation calculations? Will these reclassifications of expenses affect any tax basis loan covenants such as EBITDA (earnings before interest, taxes, depreciation, and amortization) that may exist?
Again, we strongly recommend keeping detailed records on all expenditures paid using the PPP proceeds. These will be needed for proof that the loans were only used for covered expenses such as payroll costs and rent, interest and utilities, for loan forgiveness, which must be specifically requested with the loan lender. The lender must decide on the forgiveness within 60 days of submission.
Congress could override the IRS guidance on their reliance of Code §265 by passing a law that will explicitly allow the tax deductibility of these covered expenses. We will update as we know more.
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