May 04, 2020
To prevent taxpayers from claiming what the Internal Revenue Service (the IRS) believes to be an unintended double tax benefit under the Paycheck Protection Program (PPP), the IRS issued Notice 2020-32, 2020-21 I.R.B. 1 (the “Notice”) to deny deductions for the payment of expenses resulting in the complete or partial forgiveness of a covered PPP loan. This includes otherwise deductible expenses for certain payroll, mortgage interest, rent and utilities for which Congress provided PPP loans under Section 1106(b) of the Coronavirus, Aid, and Economic Security Act (the “CARES Act”). Accordingly, Congress may now need to act with a legislative fix if it believes that the position of the IRS reflected in the Notice is inconsistent with its legislative intent.
Under the Paycheck Protection Program, the recipient of a covered loan can obtain forgiveness of such loan by an amount equal to the sum of the following expenses paid by the recipient during the eight-week period beginning on the date that the covered loan was originated: (i) payroll expenses, (ii) the payment of rent on leases in force before February 15, 2020, (iii) the payment of interest of mortgage incurred before February 15, 2020, and (iv) utility expenses for which service began before February 15, 2020; provided, that no more than 25% of the forgiven amount can be attributable to non-payroll expenses. However, the amount that can be forgiven is reduced if, during the eight-week period beginning on the date of the origination of the loan, either (i) the average number of full-time employees employed by the recipient is reduced (as compared to the number of full-time employees of the recipient between either (A) February 15, 2019, and June 30, 2019, or (B) January 1, 2020, and February 29, 2020) or (ii) the salary or wages of certain employees are reduced by more than 25% as compared to full quarter immediately preceding the eight-week covered period.
Section 1106(i) of the CARES Act specifically states that any amount that would otherwise be included in the gross income of a taxpayer arising from the forgiveness of a loan received under the Paycheck Protection Program as a result of the payment of amounts described in the immediately preceding paragraph shall be excluded from the gross income of the recipient for U.S. federal income tax purposes.  Although the CARES Act contains express language disallowing payroll deductions by the amount of the employee retention credits received by an employer under Section 2301 of the CARES Act and the Families First Coronavirus Response Act contains language providing that tax credits received as a result of the payment of sick or family leave are included in the gross income of the recipient, the CARES Act does not specifically address the deductibility of payments that give rise to the forgiveness of a loan received under the Paycheck Protection Program.
The Notice states that Section 265(a)(1) of the Code applies to disallow an otherwise allowable deduction under Section 162 or Section 163 of the Code to the extent that the payment of the expense giving rise to such otherwise allowable deduction resulted in a covered loan received under the Paycheck Protection Program being forgiven pursuant to Section 1106(b) of the CARES Act. The Notice states that this treatment prevents a double tax benefit in a manner consistent with the purpose of Section 265 of the Code and is also consistent with prior IRS guidance addressing the application of Section 265(a) of the Code to otherwise deductible payments.
Although it is unclear whether Congress intended that taxpayers lose a deduction for otherwise allowable deductions to the extent that the payments giving rise to such deductions resulted in the forgiveness of a loan under Section 1106(b) of the CARES Act, Congress may now need to provide a legislative fix to allow such deduction notwithstanding Section 265(a) of the Code if the IRS’s position set forth in the Notice is inconsistent with its legislative intent.
Accordingly, taxpayers receiving loans under the Paycheck Protection Program will need to account for the non-deductibility of covered expenses that result in the forgiveness of a covered loan pursuant to Section 1106(b) of the CARES Act when modeling their post-tax cash flows, particularly if a taxpayer intended to carryback a net operating loss generated or increased by such expenses to a prior year under the five-year net operating loss carryback provided by amendments set forth in the CARES Act.
 The Paycheck Protection Program was established by Section 1102 of the CARES Act. For more on the Paycheck Protection Program, please refer to our client note, “Coronavirus Aid, Relief, and Economic Security Act (CARES Act): Paycheck Protection Program Summary.”
 Ordinarily, income fr
om the cancellation of indebtedness is included in the gross income of a taxpayer pursuant to Section 61(a)(11) of the Internal Revenue Code of 1986, as amended (the “Code”). Section 2301(e) of the CARES Act provides that rules similar to those contained in Section 280C(a) of the Code shall apply to the employee retention credit.
 Families First Coronavirus Response Act, Section 7001(e)(1).
 Section 265(a)(1) of the Code provides that “[a]ny amount otherwise allowable as a deduction which is allocable to one or more classes of income other than interest (whether or not any amount of income of that class or classes is received or accrued) wholly exempt from the taxes imposed by this subtitle, or any amount otherwise allowable under section 212 [of the Code] (relating to expenses for production of income) which is allocable to interest (whether or not any amount of such interest is received or accrued) wholly exempt from the taxes imposed by this subtitle.”
The Notice provides that “the direct link between (1) the amount of tax exempt covered loan forgiveness that a recipient receives pursuant to section 1106 of the CARES Act, and (2) an equivalent amount of the otherwise deductible payments made by a recipient for eligible section 1106 expenses, constitutes a sufficient connection for section 265(a) [of the Code] to apply to disallow deductions for such payments under any provision of the Code, including sections 162 and 163 [of the Code], to the extent of the income excluded under section 1106(i) of the CARES Act.”
 The fact that (a) Congress took the time to add specific language into the CARES Act providing that the forgiveness of loans received under the Paycheck Protection Program would be excluded from the gross income of a taxpayer without subjecting the forgiven amount to attribute reduction under Section 108(b) of the Code and (b) Congress added language into both the Families First Coronavirus Response Act and the CARES Act providing that the receipt of payroll tax credits would either increase a taxpayer’s gross income or decrease the amount of deductions allowable to the taxpayer each support a conclusion that Congress intended that taxpayers receive a double benefit as a subsidy to taxpayers impacted by COVID-19. Furthermore, statements by Senate Finance Committee Chair, Chuck Grassley, and Ways and Means Committee Chair, Richard E. Neal, have expressed disappointment with the Notice’s guidance, with Neal stating that Congress is planning to “fix this in the next response legislation.”
 Taxpayers deciding whether to receive a loan under the Paycheck Protection Program or receive the employee retention credit in lieu of such loan should also consider the impact of the Notice, as taxpayers are now precluded from obtaining double benefits under both programs. In particular, (i) taxpayers receiving loans under the Paycheck Protection Program may not deduct otherwise deductible payments that give rise to the forgiveness of a loan received under the Paycheck Protection Program and (ii) taxpayers claiming the employee retention credit in lieu of a loan under the Paycheck Protection Program are now required to reduce their compensation expenses by amount of employee retention credits received in a particular year.