Excluded from Gross Income, but No Deduction of Expenses for forgiven Paycheck Protection Loans
The hallmark of the Paycheck Protection Loan Program (“PPP”) under the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”), is that certain payroll costs (other than salaries, wages and tips in excess of $100,000 in annualized pay per employee, as prorated for the period), interest on mortgage obligations, rent obligations and utility payments incurred and paid with loan proceeds during the eight week period beginning on the date of the disbursement of the PPP loan are subject to forgiveness (provided no more than 25% of the forgiven amount was used for non-payroll costs, and there are no reductions based on average number of full time equivalent employees or relating to salary and wages not otherwise eliminated by June 30, 2020). Moreover, Section 1106(i) of the CARES Act specifically provides that the amount forgiven shall be excluded from gross income (i.e., no cancellation of debt income).
Nevertheless, while the IRS has confirmed there is no cancellation of debt income for forgiven PPP loan amounts, the IRS is nonetheless of the position that PPP related expenses, such as for wages, rent and interest, paid using those forgiven loan amounts are not deductible expenses for federal income tax purposes. In particular, on April 30, 2020, the IRS released Notice 2020-32, as guidance that pursuant to IRS Code § 265(a)(1) and Treas. Reg. §1.265-1, trade or business expenses or interest paid with forgiven PPP loan proceeds are not deductible under IRS Code §§ 162 and 163, given that such forgiven amounts are tax-exempt income and to do otherwise would confer a double tax benefit. Arguably, this is not consistent with the intent of Congress in enacting the CARES Act, as argued by certain members of the House and Senate, even though the CARES Act did not specifically address deductibility of expenses for taxation purposes. However, to reverse this guidance would require amended legislation or judicial review of agency action (notably, this guidance not issued through “notice and comment” would not be subject to judicial deference). In the meantime, unless rolled-back or challenged, the lack of a deduction on a dollar for dollar basis would effectively result in a tax cost equal to the amount of PPP forgiven debt multiplied by the federal tax rate of 21% (for corporations) or up to 37% (for pass-through entities, where taxation is at the individual level). Unfortunately, this is not what many eligible recipients had expected when applying for the loan based on available guidance from the Treasury Department and the Small Business Administration (the “SBA”).
Moreover despite this and other identified issues with the hastily drafted CARES Act publicly communicated upon enactment, legislators have chosen so far to not override interim final rules (effective without advance notice and public comment) and guidance of agencies charged with interpreting, implementing, and enforcing the CARES Act, instead concentrating efforts on uncontroversial increased funding. Significantly, although recently presented with the opportunity to apply a legislative pen to rectify certain ambiguities/ rules arguably exceeding regulatory authority, the only substantive changes to the PPP under the Paycheck Protection Program and Health Care Enhancement Act, which was enacted on April 24 to provide additional PPP funding, was to set aside $60 million to be lent through community lenders, credit unions and smaller to mid-sized bank. Accordingly, it may be up to companies with standing to challenge administrative action in Court, unless governmental agencies do chose to revise rules and guidance based on comments receive after publication of their rules and guidance.
Government will Audit any PPP Loan Over $2 million; Criminal Penalties if Loan is Not Necessary
After multiple public companies were criticized for obtaining PPP loans, Treasury Secretary Steven Mnuchin announced that all loans over $2 million will receive a full review of that loan prior to receiving any loan forgiveness to determine whether the loan was necessary.
Indeed, prior to submitting a PPP loan application the applicant was required to certify in good faith that the loan request was “necessary”. If the loan is not found to be “necessary” recipients could be faced with fines of up to $1 million and up to 30 years in prison. While the CARES Act suspended the normal requirement that a borrower be unable to obtain credit elsewhere, it does require that borrowers certify in good faith that “[c]urrent economic uncertainty makes th[e] loan request necessary to support the ongoing operations of the applicant.”
In making this certification, the initial FAQ put out by the SBA and Department of the Treasury indicates that borrowers must take into account their current business activity and their ability to access other sources of liquidity sufficient to support their ongoing operations that is not significantly detrimental to their business.
Unfortunately, whether the loan is “necessary” is a vague and undefined term that leaves many companies that are somewhere in the middle unsure as to whether they will face penalties. For questions, companies should carefully review their particular situation with legal counsel.
Fortunately, the SBA announced a “safe harbor” from criminal consequences for companies who did not “need” the loan if the monies are returned by May 7, 2020.
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This alert should not be construed as legal advice or a legal opinion on any specific facts or circumstances. This alert is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The contents are intended for general informational purposes only, and you are urged to consult your attorney concerning any particular situation and any specific legal question you may have. We are working diligently to remain well informed and up to date on information and advisements as they become available. As such, please reach out to us if you need help addressing any of the issues discussed in this alert, or any other issues or concerns you may have relating to your business. We are ready to help guide you through these challenging times.