Typically, when a business obtains a loan, the loan proceeds are not includable in the gross income of the borrower for tax purposes at the time of the loan. Generally, the loan proceeds can then be spent for any business purpose (subject to loan covenants). Throughout the life of the loan, expenses funded with loan proceeds would be deductible, so long as the expense on its face is a deductible expense. But, if at any point the loan is forgiven, the amount of the forgiveness is then included in the gross income of the borrower as cancellation of debt income, unless the borrower qualifies for an exception.
The Paycheck Protection Program (“PPP”) loan proceeds are also not includable in the gross income of the borrower for tax purposes at the time of the loan; however, these proceeds may only be spent on qualifying expenses, which include payroll, rent, utilities, and interest. In addition, the CARES Act provides for forgiveness of this loan, so long as the funds are used for such eligible expense during the forgiveness period. The CARES Act expressly states that the forgiveness of the loan will not be treated as a taxable event to the borrower; thus, when forgiveness of the PPP loan occurs, the borrower does not need to include the proceeds in gross income for tax purposes.
The CARES Act is silent with respect to the deductibility of expenses paid with PPP loan proceeds, and therefore the Internal Revenue Service (“IRS”) has issued guidance to fill this gap. In Notice 2020-32, the IRS clarified that expenses paid from PPP loan proceeds will not be deductible to the extent the loan amount used to pay such expenses is forgiven. Under this guidance, any otherwise allowable deduction, for example a deduction for wages paid, is disallowed up to the aggregate amount of the PPP loan that is forgiven. The IRS based its guidance on the reasoning that a deduction for an expense funded with proceeds that were borrowed and not repaid, would provide a double benefit. In the event the PPP loan proceeds are not forgiven, however expenses otherwise allowable will remain deductible regardless of whether PPP loan proceeds were used to pay such expenses, because the borrower will be expected to repay the loan.