The Paycheck Protection Program (PPP), created as part of the Coronavirus, Aid, Relief, and Economic Security Act (CARES Act), has provided over 4.8 million loans to businesses impacted by the Covid-19 pandemic. If businesses use their PPP loans for business expenses such as rent, utilities, certain payroll costs, and mortgage interest then those expenses may be forgiven, subject to wage and full-time equivalent tests. This forgiveness is a critical feature of the program, incentivizing businesses to allocate funds toward supporting their employees and by extension their communities.
In fact, it is so important that Congress expressly excludes this forgiveness from gross income under Section 1106(i) of the CARES Act. Forgiven disbursements are considered, “canceled indebtedness” and Section 1106(i) of the CARES Act excludes this canceled indebtedness from gross income, providing, “any amount which (but for this subsection) would be includible in gross income of the eligible recipient by reason of forgiveness described in [1106(b)] shall be excluded from gross income.”
While the CARES Act allows businesses to exclude from gross income expenses that are forgiven as part of their PPP loan, the IRS, in Notice 2020-32, signaled its intention to deny corresponding deductions for such expenses. In general, businesses are able to deduct ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. Rent, utility payments, and payroll costs comprise typical trade or business expenses for which a deduction under tax code Section 162 generally is generally appropriate. Mortgage interest payments are similarly deductible under Section 163. If these costs were also excluded from gross income because they were eligible expenses as part of a PPP loan, then businesses may receive a potential double tax benefit, by both excluding the forgiven disbursement from income while also deducting the same expense. The double tax benefit provided for in the PPP is not a problem, but rather is the mechanism by which businesses are incentivized to allocate funds towards favored uses.
Notice 2020-32 clarifies the IRS position that the double tax benefit will not be permitted, providing, “no deduction is allowed under the Internal Revenue Code for an expense that is otherwise deductible if the payment of the expense results in forgiveness of a covered loan pursuant to Section 1106(b) of the…CARES Act…and the income associated with the forgiveness is excluded from gross income for purposes of the Code pursuant to Section 1106(i) of the CARES Act.” The notice cites tax code Section 265(a)(1), which provides that no deduction is allowed for any amount otherwise allowable as a deduction [that 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 subtitle A of the tax code.
Under the IRS position, businesses would be able to exclude forgiven disbursements from gross income, but would not be allowed to deduct such expenses, offsetting the double tax benefit. As described below, there may be a supportable position to deduct business expenses that were forgiven as part of a PPP loan, especially when considering (1) the plain and unambiguous meaning of Section 1106(i); (2) Congressional intent, and (3) the relatively low weight of authority afforded to an IRS notice.
Plain Reading of the Statute; IRS’s Prior Positions on COD Income
A plain reading of the tax code does not support the IRS’s position. Tax code Section 265(a)(1) provides in part that “No deduction shall be allowed for…any amount otherwise allowable as a deduction which is allocable to one or more classes of income other than interest…wholly exempt from the taxes imposed by this subtitle,...” Treasury Regulation 1.265-1(b) provides that “a class of income which is considered as wholly exempt from the taxes imposed by subtitle A includes any class of income which is:
(i) wholly excluded from gross income under any provision of Subtitle A, or
(ii) wholly exempt from the taxes imposed by subtitle A under the provisions of any other law.”
Section 1106(i) of the CARES Act provides that “For purposes of the Internal Revenue Code of 1986, any amount which (but for this subsection) would be includible in gross income of the eligible recipient by reason of forgiveness described in subsection (b) shall be excluded from gross income.”
As an initial matter, Section 1106(i) “excludes” canceled indebtedness due to loan forgiveness from gross income; it does not “exempt” such amounts. Accordingly, Section 1106(i) of the CARES Act does not fit under a plain reading of Section 265(a) or the second subsection of Treas. Reg. 1.265-1(b). Similarly, because the amounts forgiven are excluded from gross income under Section 1106(i) of the CARES Act, rather than any provision of Subtitle A of the Internal Revenue Code (the CARES Act clarifies how the forgiven disbursements are treated for tax purposes, but does not amend any language of the Internal Revenue Code), they do not fit under a plain reading of the Section subsection of Treas. Reg. 1.265-1(b).
Furthermore, tax code Section 108 provides a conundrum for the IRS. Under Section 108, gross income does not include income from discharge of indebtedness under several scenarios, including if the taxpayer is insolvent. The IRS has previously taken the position that income from discharge of indebtedness is not a class of tax-exempt income but rather tax-deferred income. See Pugh v. Commissioner (“[T]he Commissioner argued that section 108 income was not tax-exempt but only tax-deferred, because it would eventually be offset against tax attributes.”).
In addition, presuming this is no longer the IRS’s position, would certain businesses that were insolvent, bankrupt (of which Covid has undoubtedly resulted in many businesses becoming insolvent or filing for bankruptcy) or otherwise described under Section 108 be precluded from deducting eligible expenses paid from PPP funds? After all, Section 1106(i) of the CARES Act only applies to amounts that, but for Section 1106(i), would be includible in gross income (thus Section 1106(i) would technically not apply to businesses that qualify for income exclusion under Section 108). Surely that was not Congress’s intent. Congress intended to provide for immediate liquidity, and all the benefits that come from that additional liquidity, for all businesses, not just businesses that were not insolvent or were not in bankruptcy. To avoid such disparate (and confusing) treatment, the IRS should defer to Congressional intent, which as described below clearly provides that all businesses should be eligible to deduct PPP loan amounts forgiven.
Congress’s response to Notice 2020-32 was immediate and uniform. The intent of the CARES Act, in relevant part, was to provide emergency assistance for businesses affected by the Covid-19 pandemic by ensuring they had the liquidity to survive the crisis. Liquidity requires cash and the double tax benefit facilitates that goal (otherwise businesses may have to budget for increased quarterly estimated tax payments). Numerous members of Congress issued statements echoing this sentiment and condemning the IRS Notice. For example, Senate Finance Committee Chairman Chuck Grassley said, “[u]nfortunately, Treasury and the IRS interpreted the law in a way that’s preventing businesses from deducting expenses associated with PPP loans. That’s just the opposite of what we intended and should be fixed.”
Within a week of the release of Notice 2020-32, a bipartisan group of Senators including Chuck Grassley (R-Iowa), John Cornyn (R-Texas), Ron Wyden (D-Ore.), Marco Rubio (R-Fla.), and Tom Carper (D-Del.) introduced the Small Business Expense Protection Act of 2020 (Protection Act). The Protection Act confirms the intended treatment of business expenses forgiven under Section 1106(i) of the CARES Act by amending that Section to include, “…no deduction shall be denied or reduced, no tax attribute shall be reduced, and no basis increase shall be denied, by reason of the exclusion from gross income…” Senator Cornyn stated in support that, “this legislation would erase any confusion by clarifying that expenses paid with a forgiven PPP loan can still be deducted from small businesses’ taxes.” The Protection Act was referred to the Committee on Finance and no further action has been taken at this time.
Congress’s response shows that it intended for both forgiven disbursements to be excludable from gross income and for the expenses themselves to be deductible from gross income in order to facilitate liquidity to help businesses survive. Comments made by members of Congress, as well as the introduction of the Protection Act confirms that the IRS position in Notice 2020-32 does not reflect Congressional intent.
As persuasive authority, Notice 2020-32 is entitled to less deference than other types of guidance. Regulations carry the highest weight of authority of any administrative guidance, go through an extensive review process and are generally subject to public comment and the Administrative Procedure Act. Revenue rulings and revenue procedures are published in the Internal Revenue Bulletin and generally constitute controlling precedent for the taxpayer and the IRS, but are not binding on courts. Revenue rulings and revenue procedures are considered more authoritative than other IRS pronouncements such as private letter rulings, instructions, and the Internal Revenue Manual.
Similar to revenue rulings and revenue procedures, notices are published in the Internal Revenue Bulletin, but are not binding on courts. However, notices differ from the more authoritative persuasive authority in that they do not provide for the opportunity for notice-and-comment periods as found in the Administrative Procedure Act. This opportunity to comment cannot be overstated because persons who are subjected to the guidance have the most at stake and may want to comment. By issuing Notice 2020-32 without allowing for interested parties to provide valuable insights, the IRS failed to identify how its position differed with Congressional intent and how it would impact businesses struggling under the Covid-19 pandemic. Furthermore, guidance surrounding the PPP has been constantly changing and new legislation has been enacted (for example, see the Paycheck Protection Program Flexibility Act of 2020) and proposed (i.e., the previously discussed Protection Act). In considering the level of deference that should be afforded to Notice 2020-32, these factors may lead a court to give it little or no deference.
The PPP has helped millions of businesses and their employees and communities to try to withstand the response to the Covid-19 pandemic. The IRS has done an incredible job in providing and facilitating other pandemic relief, including locating and issuing impacted persons and issuing critically necessary stimulus checks to millions and providing relief from certain IRS collection enforcement, all while managing its over 70,000 employee workforce over 50 states with varying state and local public health emergency orders.
Unfortunately, the IRS position in Notice 2020-32 undermines Congress’ intent to help struggling businesses with liquidity by potentially preventing businesses from taking ordinary business expense deductions on expenses that were forgiven as part of a PPP loan. In light of Notice 2020-32, Congress should pass the Protection Act or similar legislation to reaffirm its original intent and to forestall further confusion on this issue. Absent much-needed Congressional action or the IRS rescinding Notice 2020-32, businesses should carefully consider whether the (1) plain and unambiguous meaning of Section 1106(i); (2) Congressional intent; and (3) the relatively low weight of authority afforded to an IRS notice provide support for them to take the deductions, a position contrary to Notice 2020-32.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Juan Vasquez, Jr. is a shareholder and co-chair of the tax controversy section in the Houston and San Antonio offices of Chamberlain Hrdlicka. He can be reached at firstname.lastname@example.org.
Jaime Vasquez is a shareholder in the San Antonio office of Chamberlain Hrdlicka. He can be reached at email@example.com.
Victor Viser is an associate in the San Antonio office of Chamberlain Hrdlicka. He can be reached at firstname.lastname@example.org.