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Deductibility of Expenses Paid by a Paycheck Protection Program Loan

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Deductibility of Expenses Paid by a Paycheck Protection Program Loan

The Coronavirus Aid, Relief and Economic Security Act[1] (the “CARES Act”) was signed into law on March 27, 2020.  The CARES Act was intended to provide relief for individuals and businesses that have been negatively impacted by the coronavirus pandemic.  One of the most significant aspects of the CARES Act was the creation of the Paycheck Protection Program (the “PPP”), under which certain eligible businesses and individuals received forgivable Small Business Administration (“SBA”) loans during the covered period (originally beginning on February 15, 2020 and ending on June 30, 2020, but extended under the Consolidate Appropriations Act, 2021).  The CARES Act authorized up to $349 billion in forgivable loans to small businesses for job retention and certain other expenses through the PPP.  In April 2020, Congress authorized additional PPP funding.  Further funding was authorized at the end of December with the passage of the Consolidated Appropriations Act, 2021(the “CAA 2021”).

Qualifying for a PPP Loan

Any small business, small business concern, non-profit organization or tribal business concern which employed five hundred (500) or less employees during the period beginning February 15, 2020 and ending June 30, 2020 (the “Covered Period”) (such businesses must have been in operation as of February 15, 2020 and have paid salaries to employees or made payments to independent contractors) were originally eligible for the first round of PPP loans.  “Employees” include individuals who work full-time, part-time or on some other basis.  Further, individuals who during the period beginning February 15, 2020 and ending June 30, 2020 operated as a sole proprietorship or independent contractor and eligible self-employed individuals were also eligible.  Businesses with more than five hundred (500) employees were eligible in certain industries.  The PPP allowed eligible businesses and individuals to receive loans with an interest rate of one percent (1%) to generally cover certain business expenses originally for eight (8) weeks (later extended to up to twenty-four (24) weeks).  These eligible businesses and individuals applied for a PPP loan at any lending institution approved to participate in the PPP through the existing SBA 7(a) lending program or at any additional lender approved by the SBA and Department of Treasury.

The CAA 2021 allows eligible entities to obtain PPP second draw (“PPP2”) loans. PPP2 loans are available to eligible entities that employ not more than three hundred (300) employees (500 for accommodation and food service employers) and had a decline in gross receipts during the first, second, third, or fourth quarter of 2020 by twenty-five percent (25%) or more when compared to the same quarter in 2019.  Entities that received original PPP loans are eligible to apply for PPP2 loans if they meet the above criteria and have used the full amount of the original loan prior to disbursement of the second loan.

What is Covered?

PPP loan proceeds must be used by the business on certain eligible expenses.  Allowable uses of the PPP loan include the following:

  • Payroll costs (including cash tip or equivalent, vacation pay, dismissal or separation pay, any retirement benefit, State or local tax assessed on the compensation of employees and payments to a sole proprietor or independent contractor that is a wage, commission, income, or similar compensation and that is in an amount that is not more than $100,000 in one (1) year, as prorated for the Covered Period);
  • Costs related to the continuation of group health care benefits during periods of paid sick, medical, or family leave, and insurance premiums;
  • Employee salaries, commissions, or similar compensation (employee compensation is not allowable in excess of an annual salary of $100,000 prorated over the Covered Period);
  • Rent payments for leases that began before February 15, 2020;
  • Utilities payments; and
  • Interest (not principal or prepayment) payments on covered mortgage obligations for mortgages in place before February 15, 2020).

Generally, at least sixty percent (60%) of the PPP loan must have been used for payroll.  The SBA and Department of Treasury provided further guidance regarding the exclusion of compensation in excess of $100,000 annually stating that such exclusion applies only to cash compensation and not to non-cash benefits, including: (a) employer contributions to defined-benefit or defined-contribution retirement plans; (b) payment for the provision of employee benefits consisting of group health care coverage, including insurance premiums; and (c) payment of state and local taxes assessed on compensation of employees.

An eligible business or individual’s maximum PPP loan amount was the lesser of: (a) The sum of: two and a half (2.5) times the average total monthly payments for payroll costs incurred during the last twelve (12) months (or from calendar year 2019) and the outstanding amount of an SBA economic injury disaster loan that was made during the period beginning on January 31, 2020 and ending on the date covered loans were made available (such loans may be refinanced as part of a covered loan); or (b) Ten Millions Dollars ($10,000,000).

For purposes of calculating the maximum loan amount, payroll costs include the sum of payments of any compensation with respect to employees that is: (a) salary, wage, commission, or similar compensation; (b) payment of cash tip or equivalent; (c) payment for vacation, parental, family, medical, or sick leave; (d) allowance for dismissal or separation; (e) payment required for the provisions of group health care benefits, including insurance premiums; (f) payment of any retirement benefits; or (g) payment of State of local tax assessed on the compensation of employees.  Payroll costs are calculated on a gross basis without regard to (i.e., not including subtractions or additions based on) federal taxes imposed or withheld, such as the employee’s and employer’s share of FICA and income taxes required to be withheld from employees.  As a result, payroll costs are not reduced by taxes imposed on an employee and required to be withheld by the employer.  However, payroll costs do not include the employer’s share of payroll tax.  For example, an employee who earned $4,000 per month in gross wages, from which $500 in federal taxes was withheld, would count as $4,000 in payroll costs. The employee would receive $3,500 and $500 would be paid to the federal government. However, the employer-side federal payroll taxes imposed on the $4,000 in wages are excluded from payroll costs.

Further guidance from the SBA and Department of Treasury also provided that payments to independent contractors and sole proprietors are not included in the calculation of payroll costs because they are not employees and they have the ability to apply for a PPP loan on their own.

In calculating the maximum loan amount, payroll costs do not include: (a) compensation of an individual employee in excess of an annual salary of $100,000, as prorated for the Covered Period; (b) payroll taxes, railroad retirement taxes, and income taxes during the Covered Period; (c) any compensation of an employee whose principal place of residence is outside of the United States; and (d) qualified sick leave wages and qualified family leave wages for which a credit is allowed under the new Families First Coronavirus Response Act.

PPP Loan Forgiveness

If the business or individual spends the PPP loan proceeds on the above listed eligible expense items within a designated period of time (originally eight (8) weeks and now up to twenty-four (24) weeks) and uses sixty percent (60%) of the PPP loan proceeds on payroll expenses, then under the CARES Act, the interest and principal on the PPP loan should be entirely forgiven upon the submission of an application to the lender servicing the PPP loan.  The business or individual must verify that the PPP loan amount for which forgiveness is requested was used for the eligible expenses – to retain employees, make interest payments on a covered mortgage, make payments on a covered lease or make eligible utility payments.  The CARES Act indicates the SBA will pay to the lender the amount of loan forgiveness, plus any interest accrued through the date of payment.  The CARES Act does not condition the SBA’s payment of interest on any amount or percentage of loan forgiveness.

The amount of PPP loan forgiveness may be reduced in the event a borrower reduces: (a) the total number of employees (on a full-time equivalent (“FTE”) basis); or (b) the wages of an employee.  The amount of PPP loan forgiveness is reduced by the percentage by which the average monthly number of FTE employees during the Covered Period is less than the average monthly number of FTE employees during either: (a) the period from February 15, 2019 to June 30, 2019; or (b) the period from January 1, 2020 to February 29, 2020.  The borrower is allowed to choose which comparison period to apply.  For seasonal employers, the applicable comparison period is prescribed to be from February 15, 2019 to June 30, 2019.  The amount of PPP loan forgiveness is also reduced by the amount of any decrease in total salary or wages paid to an “eligible employee” during the Covered Period.  An eligible employee is an employee who did not receive in any single pay period in 2019 wages or salary at an annualized rate of pay of more than $100,000.  The reduction is computed by comparing twenty-five percent (25%) of the eligible employee’s salary/wages in the most recent full quarter to the salary/wage decrease during the Covered Period.

The SBA has provided guidance for employers that attempt to rehire an employee if the employee declines the offer of employment.  Specifically, the borrower’s PPP loan forgiveness amount will not be reduced if the borrower laid off an employee, offered to rehire the same employee, but the employee declined the offer.  To qualify for this exception, the borrower must have made a good faith, written offer of rehire, and the employee’s rejection of that offer must be documented by the borrower.  

Portions of PPP loans not forgiven are payable over a maximum of ten (10) years from the date on which the borrower applies for loan forgiveness, will bear interest at a maximum rate of four percent (4%), and will continue to be guaranteed by the SBA.  PPP loan payments will be deferred for at least six (6) months and up to one year starting on the origination date of the loan (including payment of principal, interest, and fees).

PPP Loan Tax Consequences

Generally, a debt that is forgiven results in taxable cancellation of debt (“COD”) income to the debtor.  Nevertheless, under Section 1106(i) of the CARES Act, the forgiveness of PPP loan debt is excluded from the debtor’s gross income for purposes of the Internal Revenue Code (the “Code”).  The aim of the PPP loan is to provide businesses with funds to maintain operations and continue paying employees, not to create a tax burden for businesses receiving the funds.  Further, the debtor’s tax attributes such as net operating losses, credits, capital and passive activity loss carryovers, and basis should not be reduced on account of this exclusion.

Expenses Paid with PPP Loan Proceeds

The CARES Act fails to address whether deductions otherwise allowable under the Code for payments of eligible expenses by a recipient of a PPP loan are allowed if such PPP loan which paid for those eligible expenses is subsequently forgiven.  However, in a Notice discussed below, the IRS stated that expenses paid with PPP loan proceeds cannot be deducted because the PPP loans are forgiven without the debtor having taxable COD income.  Expenses allocable to the PPP loan were therefore nondeductible, because deducting the expenses would result in a double tax benefit.

The IRS issued Notice 2020-32[2] to provide guidance regarding the nondeductible of otherwise deductible expenses paid by a PPP loan when such PPP loan was forgiven and therefore excluded from gross income.  Generally, I.R.C. Section 161 provides that in computing taxable income under I.R.C. Section 63, the taxpayer is allowed deductions for certain items (for example, I.R.C. Sections 162 and 163).  I.R.C. Section 162 allows a taxpayer a deduction for all ordinary and necessary expenses paid or incurred during the table year in carrying on any trade or business.  Generally, payroll costs, rent obligations, utility payments and employee benefits are deductible under I.R.C. Section 162 in carrying on the taxpayer’s business.  I.R.C. Section 163 provides a deduction for certain interest paid or accrued during the taxable year on indebtedness such as a mortgage obligation of a trade or business.  However, I.R.C. Section 161 further provides that these deductions are subject to certain exceptions, including I.R.C. Section 265.  Taxpayers, under I.R.C. Section 265, are not allowed deductions for any amount otherwise allowable as a deduction if such income is exempt from tax.  I.R.C. Section 265 also applies where tax exempt income is earmarked for a specific purpose and deductions are incurred in carrying out that purpose.[3]  Further, deductions for otherwise deductible expenses are disallowed if the taxpayer receives reimbursement for such expenses. The purpose of I.R.C. Section 265 is to prevent a double tax benefit for the taxpayer.

Since Section 1106(i) of the CARES Act operates to exclude from gross income the amount of a PPP loan forgiven under Section 1106(b) of the CARES Act, the application of Section 1106(i) results in a “class of exempt income” under I.R.C. Section 256.  Accordingly, the IRS held in Notice 2020-32[4] that I.R.C. Section 265 disallows any otherwise allowable deduction under any provision of the Code, including I.R.C. Sections 162 and 163, for the amount of any payment of an eligible Section 1106 expense to the extent of the resulting PPP loan forgiveness because such payment is allocable to tax-exempt income.  This treatment was to prevent a double tax benefit which the IRS asserted was consistent with the IRS’s prior guidance regarding the application of I.R.C. Section 265 to otherwise deductible payments.

The IRS further established its position in Notice 2020-32[5] with Rev. Rul. 2020-27[6] in which it held that a taxpayer may not deduct expenses paid or incurred related to a PPP loan if, at the end of such taxable year, the taxpayer reasonably expects to receive forgiveness of the PPP loan.   In each of the situations discussed in Rev. Rul. 2020-27,[7] the taxpayer computed taxable income on the basis of the calendar year for federal income tax purposes and received a PPP loan from a private lender in 2020.  In the first situation, the taxpayer applied for forgiveness before the end of 2020.  In the second situation, the taxpayer expected to apply for forgiveness in 2021 but satisfied all of the requirements for forgiveness during 2020.  The IRS held the taxpayer has a reasonable expectation of reimbursement in the form of PPP loan forgiveness in both situations regardless of whether or not the PPP loan application has been submitted.  As such, deducting the expenses was considered inappropriate under I.R.C. Section 265.

On Sunday, December 27, 2020, the CAA 2021 was signed into law and changed the IRS’s position regarding whether PPP loan related expenses were deductible.  The COVID-related Tax Relief Act of 2020 (“COVIDTRA”) and the Taxpayer Certainty and Disaster Tax Relief Act of 2020 (“TCDTR”), are both included in the CAA.  The CAA 2021 modifies the CARES Act and overrides the IRS and Treasury Department determination by providing that businesses are able to deduct expenses funded with PPP loan proceeds. COVIDTRA clarifies taxpayers whose PPP loans are forgiven are allowed deductions for otherwise deductible expenses paid with the proceeds of a PPP loan, and that the tax basis and other attributes of the borrower’s assets will not be reduced as a result of the loan forgiveness.  Specifically, COVIDTRA provides that “no deduction shall be denied, no tax attribute shall be reduced, and no basis increase shall be denied” due to a PPP loan being excluded from the taxpayer’s gross income.   COVIDTRA further provides that if the taxpayer receiving PPP loan forgiveness is a partnership or a S corporation, then the amount of the PPP loan excluded from income due to forgiveness shall be treated as tax exempt income for purposes of I.R.C. Sections 705 and 1366.  Additionally, any increase in the adjusted basis of a partner’s interest in a partnership under I.R.C. Section 705 shall equal the partner’s distributable share of expense deductions resulting from the PPP loan forgiveness.

For example, consider a business that obtained a $500,000 PPP loan and used those funds to cover payroll costs during the covered period. The $500,000 of debt forgiveness would not be included in taxable income, and the $500,000 of payroll expenses would still be deductible. If the business’s effective tax rate was thirty percent (30%), it would generate a $150,000 tax savings from the PPP loan and the related expenditures on top of the $500,000 of cashflow from the loan. For pass-through entity owners, their basis would be reduced by the $500,000 of deductible expenses, but due to the CAA 2021 would also be increased by the $500,000 of tax-exempt cancellation of debt income, resulting in no net impact to basis (although there may still be a timing mismatch between those two basis adjustments).  This means that pass-through entity owners will not be indirectly harmed by having to reduce their basis in the pass-through entity as a result of the PPP loan forgiveness. This treatment applies to original PPP loans as well as PPP2 loans.

The changes under the CAA 2021 are effective as of the enactment date of the CARES Act.

[1]               P.L. 116-136, 134 Stat. 281, 286-93 (March 27, 2020).

[2]               2020-21 IRB 837 (May 18, 2020).

[3]               See Rev. Rul. 83-3, 1983-1 C.B. 72 (where tax exempt income is earmarked for a specific purpose, and deductions are incurred in carrying out that purpose, I.R.C. Section 265(a) applies because such deductions are allocable to the tax-exempt income); see also Christian v. United States,  201 F. Supp. 155 [9 AFTR 2d 1069] (E.D. La. 1962) (school teacher was denied deductions for expenses incurred for a literary research trip to England because the expenses were allocable to a tax-exempt gift and fellowship grant); Banks v. Commissioner, 17 T.C. 1386 (1952) (certain educational expenses paid by the Veterans’ Administration that were exempt from income tax, were not deductible); Heffelfinger v. Commissioner, 5 T.C. 985 (1945), (Canadian income taxes on income exempt from U.S. tax are not deductible in computing U.S. taxable income); and Rev. Rul. 74-140, 1974-1 C.B. 50, (the portion of a state income tax paid by a taxpayer that is allocable to the cost-of-living allowance, a class of income wholly exempt under I.R.C. Section 912, is nondeductible under I.R.C. Section 265).

[4]               2020-21 IRB 837 (May 18, 2020).

[5]               2020-21 IRB 837 (May 18, 2020).

[6]               2020-50 IRB (Nov. 19, 2020).

[7]               Id.

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