For many entertainment businesses, the recent congressional stimulus has proved to be a smash hit. The IRS, however, is a tough critic and is looking to claw back some of that money by disallowing deductions associated with such stimulus funds. On April 30, 2020, the IRS released Notice 2020-32 (the Notice), which provides some clarity regarding the tax treatment of loans received pursuant to the Paycheck Protection Program (PPP). Specifically, the Notice clarifies that any expenses paid with proceeds from forgiven PPP loans are not deductible for federal tax purposes. In an earlier post, we raised the question of whether such a deduction would be allowed; now the IRS has answered, but it may not get the last word on this issue.
As background, the PPP was enacted to provide loans to small and midsize businesses to help them stay afloat during the COVID-19 pandemic. One of the PPP’s main features is loan forgiveness, through which businesses may be forgiven from repaying up to the full principal and interest amount of a PPP loan if the loan proceeds are used to pay for payroll costs, mortgage interest, rent, or utilities incurred over an eight-week period beginning on the date of receipt of a PPP loan. Significantly, any loans forgiven in this manner are excluded from taxable income. Until now, however, it had been an open question whether any of the above expenses paid with such forgiven loans would be deductible for tax purposes; the IRS has taken the position that they are not.
The primary authority bolstering the IRS’s decision is Internal Revenue Code Section 265 (Section 265). Section 265 generally disallows any deductions for otherwise tax-deductible expenses where such expenses are paid using tax-exempt income. The economic rationale behind Section 265 is that allowing such deductions would effectively let taxpayers “double dip” on tax benefits in that taxpayers would (i) receive tax-free money and (ii) use such tax-free money to generate additional tax savings via a deduction. As applied here, the IRS is concerned that businesses receiving PPP loan forgiveness would be double dipping by receiving tax-free income in the amount of the forgiven loan and, on top of that, receiving a tax deduction for the qualifying expenses listed above that are paid using such tax-free income.
Currently, there is bipartisan support for a legislative override to the Notice. Detractors of the Notice argue that disallowing deductions runs contrary to the PPP’s intent of ensuring that businesses can keep the lights on during these uncertain times. For example, Senate Finance Committee Chair Chuck Grassley (R-Iowa) argued the IRS’s decision is contrary to the PPP’s intent of helping small businesses maintain liquidity. Furthermore, House Ways and Means Committee Chair Richard E. Neal (D-Mass.), through a representative, suggested a legislative fix might be in the works. With the PPP now in full swing and millions of businesses looking for some finality on this issue, we may see a legislative fix soon.
It remains to be seen whether legislators will override the Notice or whether the IRS will have the last word. Venable will continue to monitor and provide updates.
 Normally, debt that is forgiven gives rise to “cancellation of indebtedness” income for tax purposes, because the forgiveness of the debt is considered an economic windfall to the taxpayer.