On April 30, 2020, the Internal Revenue Service (IRS) issued Notice 2020-32 (the “Notice”) to address the deductibility of loan amounts received under the Paycheck Protection Program ( PPP) of Coronavirus Aid, Relief, and Economic Security. Law (the “CARES Law”). In summary, the IRS has stated that no tax deductions will be allowed for expenses paid with the proceeds of the PPP loan as long as these amounts are waived under the terms of the CARES Act. This alert describes the PPP loan cancellation provision of the CARES Act, the terms of the notice, the impact the notice will have on PPP loans in the future, and the need to provide additional advice on the effects. loan cancellation tax.
PPP loan forgiveness under the CARES law
The CARES Act provides that beneficiaries of PPP loans are eligible for a discount to the extent that the loan funds are used for certain costs related to the payroll (“covered expenses”). Under Section 1106 (i) of the CARES Act, any amount remitted is excluded from gross income. The amount of the loan forgiveness may be reduced if a beneficiary does not meet conditions such as retaining their full-time employees or the salaries of such employees.
Although the CARES Act expressly states that remitted amounts are excluded from gross income, it does not address the interaction between Section 1106 (i) of the CARES Act and sections of the Internal Revenue Code (the “Code” ) relating to the tax consequences of the forgiveness loan. In an effort to clarify, the IRS has now issued guidelines describing the effect of loan forgiveness on the deductibility of covered expenses.
IRS Notice 2020-32
In the notice, the IRS determined that loan amounts canceled under Section 1106 (i) of the CARES Act are income exempt from tax under Section 265 of the Code and Regulations. accompanying cash. Under section 265 (a) (1) of the Code, a taxpayer is not permitted to deduct amounts attributable to fully tax-exempt income. As a result, any PPP loan amount used for covered expenses will not be deductible as long as these loan amounts are waived. The tax consequences for a loan recipient will be the same as if the PPP loan amounts received were included in gross income and subject to tax. This direction is unexpected given that Congress expressly excluded PPP loan amounts from gross income; if amounts were not excluded from gross income, the tax result would be the same.
Tax consequences of the notice
Denying a deduction for covered expenses reduces the tax benefit available to PPP loan recipients. In some cases, a potential loan recipient may be in a better financial position if they do not get a PPP loan. The following examples illustrate the various tax consequences of the Notice:
- Example 1 – Net benefit. Take the example of a company receiving a loan that will pay $ 1 million in personnel costs, whether or not it receives a PPP loan. The recipient obtains a PPP loan of $ 1 million and uses the loan to pay $ 1 million of salary costs qualified as covered expenses. The loan is completely canceled. Prior to the Notice, the beneficiary had no additional taxable income on the loan proceeds and had a net benefit of $ 1 million. After the Notice, the beneficiary in effect has additional taxable income of $ 1 million, producing a federal tax bill of $ 210,000. For this employer, the PPP loan still produces a net profit after the Notice in the amount of $ 790,000.
- Example 2 – Break even. Consider the same facts as in Example 1, except that the loan recipient will not pay employee salary costs unless they receive a PPP loan. For this employer, there will be no financial benefit to obtaining a PPP loan. If the employer does not receive a PPP loan, they will lay off or lay off employees and avoid salary costs, which will have no tax impact. Under the Notice, the receipt of a PPP loan of $ 1 million will also have no tax impact on the employer. PPP loan is excluded from gross income and covered expenses cannot be deducted. Prior to the Notice, the employer received a net benefit equal to the amount of its deduction, namely $ 1 million. This employer will want to weigh the additional costs of obtaining a PPP loan (for example, time spent on applying, attorney fees, and audit risk) against the benefits of retaining employees.
- Example 3 – Loss. Consider the same facts as in Example 2, except that the loan recipient uses more than 25% of the loan proceeds for uncovered expenses. In this case, the employer will be disbursed for the expenses not covered. The amounts used for covered expenses will not be deductible and will have no tax impact for the employer. The employer will then have to reimburse the part used for uncovered expenses. In this scenario, the employer is better off if he does not get a PPP loan. Prior to the notice, the employer would have the additional tax benefit of the deduction for covered expenses to help offset the costs of repaying the loan.
- Example 4 – Intermediate entities. Intermediate entities face significant tax consequences after the Notice. Take the example of an S company that receives a PPP loan of $ 1 million. The S-corporation has 10 shareholders, each receiving a salary of $ 100,000. Each shareholder is subject to a 40 percent income tax rate (both federal and state). After the Notice, the S-corporation does not receive any deduction for salary expenses at the entity level. Since an S corporation is a flow-through entity, denial of deductions results in an additional 40% tax on the million dollars. Based on the 40 percent income tax rate and the 40 percent effective tax due to the denial of deductions, S Corporation will only have a net benefit of $ 200,000.
After the Notice, a partnership that obtains a PPP loan can now be denied deductions for guaranteed payments and K-1 distributions from partners. For a partner who receives a guaranteed payment and distribution, this will mean being subject to income tax, self-employment, and denial of a deduction.
Additional advice needed
Indeed, the Notice produces a tax result which seems contrary to the purpose of the CARES Law and adds to the unpredictability surrounding the PPP. Due to this unusual outcome, we are still awaiting further clarification from Congress on its intent behind the loan forgiveness provisions of the CARES Act. In addition to the deductibility of payroll expenses, questions remain as to whether the PPP loan forgiveness requires a reduction in net operating losses under Article 108 of the Code or has an impact on the base. of a partner in a partnership under article 752 of the Code. For these reasons, companies should carefully assess the risks involved with PPP loan cancellation before applying for and obtaining a loan.
The opinions and conclusions in this article are solely those of the author, unless otherwise stated. The information contained in this blog is of a general nature and is not offered and can not be considered as legal advice for any particular situation. The author has provided the links mentioned above for informational purposes only and, in doing so, does not adopt or integrate the content. Any federal tax advice provided in this communication is not intended or written by the author for use, and may not be used by the recipient, for the purpose of avoiding penalties that may be imposed on the recipient by the recipient. IRS. Please contact the author if you would like to receive written advice in a format that complies with IRS rules and can be relied on to avoid penalties.