Non-deductibility of Expenses Paid with Forgiven Paycheck Protection Program Loans

According to new guidance issued by the IRS in Notice 2020-32, no deduction is allowed for otherwise deductible expenses if they are paid with PPP loan funds that are forgiven and the income associated with the forgiveness is excluded from the taxpayer’s income. The basis for the IRS’ disallowance of the tax deduction for such expenses is Internal Revenue Code (IRC) Section 265(a).

IRC Section 265(a) provides that a deduction is not allowed for any amount otherwise deductible that is allocated to one more classes of income which are wholly exempt from income taxes. The IRS ruled that the CARES Act’s exclusion from income of forgiven PPP loan amounts results in a “class of exempt income” under Section 1.265-1(b)(1) of the Treasury Regulation. Therefore, the payment of such expenses is non-deductible from income because such payment is allocable to tax exempt income.

The effect of the IRS’ holding regarding the non-deductibility of expenses forgiven under the CARES Act is to negate the benefit that was thought to be provided by the Paycheck Protection Program’s loan forgiveness.  Whether Congress will respond to the IRS’s interpretation set forth in IRS Notice 2020-32 is yet to be seen.

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Posted by Attorney Marcia S. Orgill. Orgill concentrates her practice in the area of business and personal taxation—especially complex domestic and international tax strategies.