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Are business expenses paid with PPP loans tax deductible?

On March 27, the President signed the Coronavirus Aid, Relief, and Economic Security Act, or CARES Act, into law.  The CARES Act added the Paycheck Protection Plan to the Small Business Act at Section 7.  15 U.S.C. 636(a)(36)(A)(viii).  

The PPP allowed qualifying businesses to take out a forgivable loan to use for payment of payroll costs, certain employee health benefits, mortgage interest, rent, utilities and interest on other debt.  The question then arose on whether the expenses paid for with the PPP loan were deductible for federal income tax, Pennsylvania Personal Income Tax (“PIT”) and Pennsylvania Corporate Net Income Tax (“CNIT”) purposes.

The federal tax situation

The Internal Revenue Service answered the question with Notice 2020-32, released May 2.  The notice first pointed out that § 1106(i) of the CARES Act excludes from gross income of a loan recipient forgiveness of the loan, which would normally be included in income because of Internal Revenue Code (“IRC”) § 61(a)(11).  Nothing in the CARES Act addressed the deductibility of expenses paid with the loan proceeds, however.

Normally, those expense payments are deductible under IRC §§ 161, 162, and 163 unless subject to an exception.  An applicable exception is found in IRC § 265(a)(1) and Treas. Reg 1.265-1 which applies if the payment is itself exempt from income tax.  IRC § 265 is usually applied when the expenses are paid to earning tax exempt income.  See Banks v. Commissioner, 17 T.C. 1386 (1952); Heffelfinger v. Commissioner, 5 T.C. 985 (1945); Rev. Rul. 74-140.  

IRC § 265 has, however, been applied to deny expenses paid for with money exempt from federal income tax.  In Manocchio v. Commissioner, 78 T.C. 989 (1982), the taxpayer tried to deduct expenses paid for a course with a tax-exempt grant for educational assistance from the Veterans’ Administration.  The Court held that the expenses paid for by the grant were not deductible because of IRC § 265(a)(1). 

Notice 2020-32 specifically relies on Rev. Rul. 83-3 which held that IRC § 265(a) provides that where tax-exempt income is used for a specific purpose and expenses are incurred for that purpose, no deduction from adjusted gross income is allowed.  The Notice concludes specifically that eligible § 1106 expenses that result in loan forgiveness under § 1106(b) of the CARES Act are not deductible to the extent of the forgiveness because of IRC § 265(a).  Notice 2020-32 additionally concludes that IRC § 1106(b) expense payments are also not deductible because, under case law, the taxpayer, in effect, receives reimbursement for the expenses.   See Rev. Rul. 80-348 and Rev. Rul. 80-173 and the cases cited therein.

The following is an accountant’s example of the application of Notice 2020-32:

Actual Results  Forgiven PPP Loan  Taxable Income
 Income  250.000  0  250,000
Wages (150,000) 75,000 (75,000)
Expense (50,000) 0 (50,000)
Net Income  50,000 75,000 125,000

 

The PIT situation differs from the federal tax situation in that PPP loans, as business loans are taxable on forgiveness and expenses paid with the loans are deductible.  For now, the latest word on the matter is Personal Income Tax Bulletin 2009-04 which is entitled “Cancellation of Business Indebtedness.”  When a person paying PIT is an end taxpayer of a pass-through entity, there is an added dimension discussed in Personal Income Tax Bulletin 2009-04.  Taxability and deductibility are the same in that situation, however.

The PA PIT situation

Although the calculation of taxable income is different under the PIT, the result is essentially the same under both the PIT and the federal income tax as calculated pursuant to Notice 2020-32.  

The following is an accountant’s example of the application of Personal Income Tax Bulletin 2009-04:

 

Actual Results  Forgiven PPP Loan  Taxable Income
 Income  250.000 75,000  325,000
Wages (150,000) 0 (150,000)
Expense (50,000) 0 (50,000)
Net Income  50,000 75,000 125,000

 

Such treatment is to be distinguished from the PIT treatment of federal government stimulus checks otherwise known as economic impact payments.  Those payments are considered rebates not taxable for Pennsylvania tax purposes according to the COVID-19 Information part of the Pennsylvania Department of Revenue website.  An employer should be aware that other COVID-19 grants, such as grants to employees for hazardous duty, may have a different tax result entirely. 

PA CNIT situation

The CNIT is levied on the federal taxable income of a corporation without certain deductions and modified by certain additions and subtractions not here applicable.  Therefore, the treatment of PPP loans under the CNIT is the same as that directed by Notice 2020-32 for federal income tax purposes.

Commentary

Both the federal and Pennsylvania approach avoid the “double dip.”  In that way, those approaches are fairer than attempts to allow deductibility of expenses suggested by some for the new stimulus bill now being debated in Congress.  The traditional approach allowed tax deductions of expenses paid with a business loan during the term of the loan.  If the loan was forgiven, then taxability of the forgiveness could remedy any mistake made in allowing the deduction of payment of the expenses with the forgiven loan.  When the CARES Act excluded the forgiveness of PPP loans from gross income, it changed the traditional view that such an occurrence was a taxable one.       

The CARES Act approach put borrowers of PPP loans in a potentially different position regarding deductible expenses from other borrowers of business loans.  According to the IRS this was not the intention of the Congress, but apparently, it continues to be the interpretation of the Pennsylvania Department of Revenue that PPP loans and their forgiveness should be treated, for tax purposes, like any other business loans.  

Spencer G. Nauman Jr., is the senior partner of the Harrisburg law firm Nauman, Smith, Shissler and Hall, LLP.  Mr. Nauman has been with the firm more than 40 years and his primary practice areas are corporate, probate/estate planning, taxation and insurance.  He represents several community foundations and the state community foundation organization. 

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