The CARES Act Giveth, the IRS Taketh Away…

May 5, 2020

On May 1, the IRS issued guidance clarifying, and, arguably, drastically affecting, the impact of the income exclusion for amounts of loans forgiven under the Paycheck Protection Program (“PPP”) that was part of the Coronavirus Aid, Relief, and Economic Security Act (PL 116-136, the “CARES Act”). In Notice 2020-32, 2020-21 IRB, the IRS ruled that no deduction will be allowed for expenses to the extent that they are funded with any portion of a PPP loan that is forgiven. Because PPP loans will only be forgiven to the extent that they are used for certain payroll costs, rent, utilities and interest on other indebtedness, this ruling means that the benefit provided by an exclusion from income will largely be offset by the loss of these deductions.

Assume a taxpayer has $500 of other net income, and uses $100 of PPP loan proceeds to pay rent and salaries that would otherwise be deductible. If the loan is forgiven, and is not excluded from income, the deductions would offset that income, leaving the taxpayer with net income of $500. If the loan forgiveness is excluded but the deductions are lost, the taxpayer is left with the same $500 of net income. In fact, it is possible that a taxpayer that is otherwise insolvent would prefer to have cancelation of indebtedness income, which might be excludable from income under pre-existing rules governing such income, and still be able to claim the deductions for its expenses.

The Internal Revenue Code does contain a general rule that precludes deductions for otherwise deductible expenses that are allocable to exempt income (see Section 265(a)(1) of the Code). So it may be understandable that the IRS would view the availability of the deductions in this case as an unwarranted benefit. However, it is difficult to harmonize this announcement with the statutory intent. The CARES Act can easily be read as intended to confer just this benefit – the forgiveness of the PPP loans without a corresponding reduction of deductions – because its express language failed to include a denial of these deductions. Given the fact that the forgiveness is inextricably tied to the use of the funds for expenses that are, on their face, deductible, such a failure clearly implies an intent not to vitiate the benefit afforded by the tax-free forgiveness.

We are available to discuss the impact of these rules on you and your particular situation, and to assist with other tax matters in these challenging times.

Louis Tuchman at +1 212 592 1490 or [email protected]

© 2020 Herrick, Feinstein LLP. This information is provided to keep clients and interested parties informed of legal developments that may affect or interest them. The information is not intended as legal advice or legal opinion and should not be construed as such.