IRS Guidance Says No Deduction Is Allowed for Business Expenses Paid with Forgiven PPP Loans (IN11378, Version 10, Updated November 24, 2020)

Summary

Version 10 of CRS Insight IN11378 (November 24, 2020) adds two IRS issuances of November 18, 2020. Rev. Rul. 2020-27 states that a taxpayer cannot deduct expenses paid in 2020 if they "reasonably expect" those expenses to be forgiven at a later date, and Rev. Proc. 2020-51 provides a safe harbor for PPP borrowers whose forgiveness was denied in part or in full and who wish to file an amended return to claim business deductions. It also adds that the chairs of the House Ways and Means and Senate Finance Committees say the IRS interpretation is contrary to congressional intent, while the ranking member of Ways and Means says there was no clear congressional intent to allow a deduction. The section on tax practitioners' concerns is dropped.

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                                                                                              INSIGHTi



IRS Guidance Says No Deduction Is Allowed
for Business Expenses Paid with Forgiven PPP
Loans

Updated November 24, 2020
The Coronavirus Aid, Relief, and Economic Security Act (CARES Act; P.L. 116-136) created Small
Business Administration (SBA) Paycheck Protection Program (PPP) loans to cover payroll expenses and
certain operating costs; the loans can be forgiven if the borrower meets certain criteria.
On April 30, 2020, the Internal Revenue Service (IRS) issued Notice 2020-32, stating that PPP recipients
cannot claim a deduction for expenses funded from the forgiven PPP loans. Subsequent IRS guidance
provides further details.


PPP Forgiveness
Borrowers can apply for forgiveness on the principal and accrued interest, if the borrower maintains
employment and limits wage decreases.
In general, forgiven debt—“cancellation of indebtedness income” or CODI—is subject to income
taxation, unless specifically excluded. Section 1002 of the CARES Act excludes forgiven PPP loan
amounts.

Tax Deductibility of Business Expenses
The CARES Act has no language on the deductibility of PPP expenses. Under Internal Revenue Code
(IRC) Sections 162 and 163, taxpayers can deduct ordinary or necessary business expenses, which would
include PPP-eligible expenses. However, IRC Section 265(a)(1) states that an expense cannot be deducted
if it is allocable to income exempt from taxation.

Double Benefit
A “double benefit” arises when a taxpayer receives tax-free income (like a forgiven loan) and is also able
to claim a tax benefit (like a deduction or a credit) using that income. For example, assume a taxpayer
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                                                                                                  IN11378

CRS INSIGHT
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faces a top marginal income tax rate of 37% and takes out a PPP loan for $100,000 that is forgiven by the
lender and not subject to tax. The first benefit is a tax-free grant of $100,000. If the taxpayer can also
deduct the loan amount as business expenses, a second benefit is $37,000 in tax savings ($100,000 *
37%).
If Congress meant to disallow this “double benefit,” a question can be raised as to why the exclusion of
the loan forgiveness was explicitly provided in the legislation. To illustrate, Table 1 assumes a $100,000
forgiven loan, $100,000 of deductible expenses, and a 37% tax rate. The normal treatment in the tax code
(the forgiven loan is taxable, and the associated business expenses paid from that loan are deductible)
would generate a $37,000 tax liability from that taxation of the CODI (scenario 1). But that amount would
be entirely offset by a $37,000 tax savings from deducting the business expenses. Excluding the forgiven
loan results in no tax on the income, but allowing deductions provides a tax saving of $37,000 (scenario
2). If, however, the forgiven loan is not taxed and deductions are disallowed, there is no tax on the income
or benefit from the deduction. Including the loan in income and allowing deductions (scenario 1) leads to
the same outcome as excluding the loan and disallowing deductions (scenario 3). Hence, one could argue
that this exclusion was included in the law because it was Congress’s intent to provide this additional
benefit.

                            Table 1. Hypothetical Example of Tax Effect
                  of Disallowing Deductions for Business Expenses on PPP Loans
                                                                       Tax Savings from the
              Tax Scenario                     Tax On Income                Deduction                  Net Tax Effect

 1. Normal Tax Treatment                                  $37,000                       -$37,000                           0
 2. Treatment w/ Exclusion on Forgiven
                                                                 0                      -$37,000                 -$37,000
 Debt
 3. Treatment w/ Exclusion on Forgiven
                                                                 0                             0                           0
 Debt and No Deduction

    Source: CRS calculations, assuming a $100,000 forgiven loan, $100,000 in deductible business expenses, and a 37% tax
    rate.


IRS Guidance
IRS Notice 2020-32 (April 30, 2020) disallows deductions for expenses paid for by forgiven PPP loans.
Tax filers may need to amend quarterly filings or might challenge this decision in court, although the
outcome is not clear. IRS Rev. Rul. 2020-27 (November 18, 2020) states that a taxpayer cannot deduct
expenses paid in 2020 if they “reasonably expect” those expenses to be forgiven at a later date. IRS Rev.
Proc. 2020-51 (November 18, 2020) provides a safe harbor for PPP borrowers whose loan forgiveness has
been denied in part or full, and who wish to file an amended return to claim business deductions.
Some policymakers have expressed concerns with IRS’s position, including the chairs of the House Ways
and Means and Senate Finance Committees, who have stated that IRS’s interpretation is contrary to
congressional intent. The ranking member on the Ways and Means Committee, however, has stated that
there was not a clear congressional intent to allow a deduction.

Treatment in Revenue Estimates
According to media reports, the Joint Committee on Taxation—in a July 27, 2020, letter to Senator John
Cornyn—indicated that the revenue estimate for the CARES Act was consistent with its interpretation of
the intent of allowing deductibility of expenses, and that legislation affirming the deductibility of
expenses would have no revenue effect.
Congressional Research Service                                                                                    3




Economic Benefit of PPP Loans
IRS’s position would reduce the economic benefit of PPP loans to taxpayers. Businesses could lay off
employees and not apply for PPP loan forgiveness. With that said, businesses could still find PPP loans
are the most preferable option for short-term economic relief compared to alternative COVID-19
assistance measures.

Options for Congress
If Congress decides that Section 265(a)(1) should be waived for business expenses funded by forgiven
PPP loans, it could enact legislation. Congress has enacted exemptions, such as IRC Section 265(a)(6)
(mortgage interest and property taxes deductible on a home receiving a tax-free military housing
allowance or a parsonage allowance for religious clergy). The Safeguarding Small Business Act (S. 3596),
the Heroes Act (H.R. 6800), the Small Business Expense Protection Act (H.R. 6821; S. 3612), and the
Safeguarding Small Business Act (S. 3596) would amend the CARES Act to allow taxpayers to receive
PPP loan forgiveness without affecting their ability to claim expense deductions . An updated version of
the Heroes Act (H.R. 925), which allows deductibility, passed the House on October 1.


Author Information

Sean Lowry                                                Jane G. Gravelle
Analyst in Public Finance                                 Senior Specialist in Economic Policy




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