The IRS last Thursday at Notice 2020-32 severely frayed financial lifelines for struggling businesses under the SBA’s paycheck protection program (“PPP“). In Notice 2020-32, the IRS said a taxpayer cannot claim a tax deduction for payroll, rent, utilities, and other business expenses funded by a PPP loan that is canceled. The IRS ‘position reduces the attractiveness and usefulness of PPP loans for businesses struggling with the COVID-19 pandemic and complicates tax reporting for businesses that take advantage of the program. Congress will likely have to pass new legislation confirming that businesses can deduct these expenses because the Coronavirus Aid, Relief and Economic Security Act (“CARES”), who created the PPP, did not address this issue (hence the need for an IRS interpretation).
What Notice 2020-32 says
Like our electronic alerts from April 3, 2020 and 23 april 2020 discuss, PPP loans are available from April 3, 2020 to June 30, 2020 for eligible businesses to cover the cost of payroll, insurance premiums and group health care benefits, rent and utilities, and interest on most trade debts. Under article 1106 of the CARES law, a PPP borrower may request forgiveness of the loan to the extent of the amounts spent during the period of 8 weeks after the original date of the loan for the above “eligible“Expenses. The amount that can be surrendered is reduced if the company has laid off employees or decreased employee compensation by more than a certain amount during that 8 week period, but this reduction penalty does not apply in the as the company re-establishes its number of employees and its remuneration. before June 30, 2020.
Usually, a canceled loan results in a taxable forgiveness of debt income (“CODI“) under the Internal Revenue Code (“Coded”) article 61 (a) (11), subject to modifications and exclusions under the Code article 108. (Article 108, among other provisions, excludes CODI to the extent that the taxpayer is insolvent; if the release of the debt occurs in bankruptcy proceedings; for certain debts incurred in a farming enterprise; or for certain debts incurred in a real estate business if the taxpayer special election.) However, article 1106 (i) of the CARES law provides that CODI otherwise resulting from the forgiveness of a PPP loan under Section 1106 “will be excluded from gross income”.
As the IRS noted in Notice 2020-32, Congress in the CARES Act did not similarly consider whether qualifying expenses funded by a canceled PPP loan were deductible under the Code. article 162. Therefore, the IRS said, the Code’s regular deduction rules applied, including the Code. article 265, who denies a deduction for “[a]any amount… which is attributable to one or more categories of income… totally exempt from taxes. The purpose of Article 265 is to avoid a double tax advantage – that is to say., tax-exempt income, and a deduction for expenses incurred to generate such income or financed by such income. The IRS cited regulations, case law, and rulings that Section 265 of the Code applied not only to otherwise deductible expenses incurred for the purpose of earning or producing tax-exempt income, but also where the tax-exempt income was earmarked for a specific purpose. and deductions have been made to achieve this goal. Here, the IRS said, the express intention of the PPP loan was to allow the taxpayer to pay the qualifying expenses listed in the CARES Act, and the loan cancellation was conditional on the amount of qualifying expenses incurred during the period. 8 weeks following the creation date of the loan. This link between the eligible expenses and the CODI exemption for the forgiveness of the underlying PPP loan brought these expenses within the scope of Article 265, thus denying a deduction. The IRS also cited case law outside of the context of section 265 to the effect that you cannot claim a deduction for an expense that is reimbursed.
What to do?
The consensus among tax scholars and commentators is that the IRS was still in a bad position (had it concluded that the expenses were deductible, the IRS could have been accused of overstepping its authority by legislating to fill a void. statutory left by Congress) and that there are valid arguments both for and against its conclusion in Opinion 2020-32. (The IRS’s position can also lead to unfair results. For example, a borrower who “violates” the conditions of the CARES Act to obtain a PPP loan forgiveness, but obtains a debt forgiveness otherwise and excludes the CODI under Article 108 of the code or simply not repaying the PPP loan while delaying the “forgiveness” event that would trigger the CODI, might be in a better tax position than the taxpayer who “plays by the rules” and gets the loan canceled under article 1106 of the CARES law. Oversights and ambiguities like this issue are common and not surprising given the pressure under which Congress negotiated the CARES Act to deal with the burgeoning COVID-19 pandemic. Democrats and Republicans in Congress said Friday and over the weekend that the IRS position does not reflect their intention, but Congress will likely need to enact tax corrections legislation to overturn the IRS position .
Pending further action from Congress – which, given the politically charged atmosphere in Washington, could take some time – taxpayers are at a stalemate on how to deal with qualifying expenses funded by a PPP loan. . Their position is particularly complicated because it is possible – especially for a taxpayer whose fiscal year ends shortly after the date of obtaining a PPP loan – that a taxpayer can take out a PPP loan and pay the eligible expenses in one. year but have the PPP Loan canceled one year later.
Taxpayers are not bound by the IRS position in Notice 2020-32. They may wish to claim deductions for qualifying expenditure funded by a PPP loan, rather than waive such deductions, and then be forced to file an amended return later if the tax landscape changes to support the deductions (through Congressional action, the IRS overturning its favorable ruling (s) of the United States Tax Court or other judicial bodies). However, a return stance contrary to published IRS guidelines should only be taken after carefully checking with tax advisors for the legal support of that position and the risks of an IRS review. To avoid penalties (typically 20% of tax arrears), for example, a taxpayer cannot simply ignore the IRS’s position: to disclose its position to the IRS in a return footnote or an attached statement. Note that the above caveats apply to penalties only: The taxpayer would still need to repay taxes and interest during an IRS review, and would do well to set aside reserves for those amounts if possible. A taxpayer can also put their tax return on the extension and expect the issue to be resolved favorably before the extended due date (but should still pay estimated taxes on the original due date, taking into account the notice. 2020-32).
Another issue for taxpayers receiving PPP loans is to what extent their respective states have complied or can comply with the provisions of the CARES Act or subsequent legislation of Congress. The California legislature, for example, has yet to determine the extent to which the state can or will comply with the provisions of the CARES Act; and the California Franchise Tax Board confirmed in its May 2020 tax news that California does not currently comply with the CODI exclusion of the CARES Act and certain other tax changes. For now, a California taxpayer appears to be in the Kafkaesque position where, for state tax purposes, canceling a PPP loan can generate a CODI, but the expenses funded with the loan may still be deductible (that is to say, mirror image of federal treatment).
Stay tuned for updates on these issues, including the status of Congressional fixes and California compliance.