Taxpayers Receiving PPP Loans: IRS Provides Important Guidance on Expense Deduction

May 06, 2020

As part of its ongoing efforts to provide guidance on the federal income tax consequences of various Coronavirus Aid, Relief, and Economic Security (CARES) Act provisions, the IRS issued Notice 2020-32 addressing the deductibility of certain expenses incurred in a taxpayer’s trade or business after receiving a loan pursuant to the CARES Act’s Paycheck Protection Program.

Notice 2020-32 relies on provisions in 26 USC (the Code) and explains that in instances where the CARES Act[1] excludes cancellation of indebtedness income that would otherwise be includable in taxable income, the expenses paid with Paycheck Protection Program (PPP) loan proceeds (covered loans) are not deductible.


Congress enacted section 1102 of the CARES Act—the PPP provision—to help small businesses keep their workers employed. At a high level, the PPP offers small businesses two-year loans of up to $10 million with an interest rate of 1% on a first-come, first-served basis.

Under the PPP, a recipient of a covered loan may use the loan proceeds to pay (1) payroll costs, (2) certain employee benefits, (3) interest on mortgage obligations, (4) rent, (5) utilities, (6) interest on any other existing debt obligations, and (7) certain other existing 7(a) loan eligible uses.

The CARES Act also provides that the covered loan recipient can obtain forgiveness of indebtedness on the covered loan in an amount equal to the sum of payments made during the eight-week “covered period” beginning on the covered loan’s origination date for the following expenses: (1) payroll costs, (2) certain employee benefits relating to healthcare, (3) any payment of interest on any covered mortgage obligation, (4) any payment on any covered rent obligation, and (5) any covered utility payment.

Under general federal income tax principles, the forgiveness of debt gives rise to cancellation of indebtedness income that, absent an exception, must be included in the borrower’s taxable income. Section 1106(i) of the CARES Act provides one such exception and excludes from gross income any category of income that may arise from loan forgiveness relating to a covered loan, regardless of whether such income would be

  • properly characterized as income for the discharge of indebtedness under Code section 61(a)(11), or
  • otherwise includable in gross income under Code section 61.

Therefore, the CARES Act (1) provides small businesses with loans to pay employees and survive the coronavirus (COVID-19) pandemic, (2) allows portions of those loans to be forgiven where the borrower spends the loan proceeds in a certain way, and (3) allows the borrower to exclude from taxable income the amounts forgiven that would otherwise be included in the borrower’s taxable income.

Each of these aspects of the CARES Act is intended to be beneficial to small business owners.

Deductibility of Certain Expenses Paid Using PPP Funds

According to the IRS:

Neither section 1106(i) of the CARES Act nor any other provision of the CARES Act addresses whether deductions otherwise allowable under the Code for payments of eligible section 1106 expenses by a recipient of a covered loan are allowed if the covered loan is subsequently forgiven under section 1106(b) of the CARES Act as a result of the payment of those expenses.

Notice 2020-32 seeks to fill the above-mentioned void.

Generally, expenses like those described in section 1106 of the CARES Act (e.g., payroll expenses) are deductible when incurred in a taxpayer’s trade or business.[2] In Notice 2020-32, the IRS acknowledges this general principle but concludes that the taxpayer would receive a “double tax benefit” if allowed to (1) exclude the cancellation of indebtedness income relating to the covered loan and (2) take a deduction for the expenses paid with those borrowed, and ultimately forgiven, covered loan proceeds.

Notice 2020-32 notes that Code section 265(a)(1) provides that a taxpayer is not entitled to a deduction for expenses that are allocable to income that was wholly exempt from tax. Code section 265 effectively seeks to prevent taxpayers from receiving a double tax benefit.

Citing to a number of cases, Notice 2020-32 explains that Code section 265 “also applies where tax-exempt income is earmarked for a specific purpose and deductions are incurred in carrying out that purpose,” and, therefore, “it is proper to conclude that some or all of the deductions are allocable to the tax-exempt income.”

The IRS ultimately relies on Code section 265(a)(1) in disallowing deductions for the amount of any payment of an eligible section 1106 expense to the extent of the resulting covered loan forgiveness (up to the aggregate amount forgiven), concluding that the payment is allocable to tax-exempt income.

Additionally, the IRS explains that its position is consistent with Code section 265(a)’s intended purpose of preventing a double tax benefit, and case law and published rulings denying deductions for otherwise deductible payments for which the taxpayer receives reimbursement.

Is Notice 2020-32 Consistent with Congress’s Legislative Intent?

After Notice 2020-30 was issued, concerns were raised on Capitol Hill that the notice’s position is inconsistent with PPP and CARES Act policy objectives.

In response to the IRS guidance, Senate Finance Committee Chair Chuck Grassley (R-Iowa) expressed disappointment with Notice 2020-32, stating the following:

The intent [of the PPP] was to maximize small businesses’ ability to maintain liquidity, retain their employees and recover from this health crisis as quickly as possible. This notice is contrary to that intent.

On May 4, Senator Grassley said he plans to introduce legislation on the issue.

House Ways & Means Committee Chair Richard Neal (D-Mass) said on May 1 that he intends to ensure that PPP-related expenses are deductible as part of the next COVID-19 relief legislation. A Ways & Means spokesperson also said, “if Treasury doesn’t reverse their position, we will fix it legislatively.”

Despite these concerns, Treasury Secretary Steven Mnuchin has remained insistent that “[i]f the money that’s coming is not taxable, you can’t double-dip.”

Considerations and Comments

  • The PPP and accompanying covered loan forgiveness provided for in the CARES Act were intended to help small businesses survive the COVID-19 pandemic by providing them the means to pay their expenses, including payroll, while their businesses remain closed.
  • The IRS’s ultimate conclusion in Notice 2020-32, although consistent with general tax policy, seems to be at odds with the intended policy objectives of the PPP-related provisions in the CARES Act. Given the prompt responses from congressional members, additional legislation is likely forthcoming.
  • In the absence of further legislation mandating the deductibility of expenses paid using covered loan proceeds, the IRS’s position is consistent with general tax policy against taxpayers receiving double tax benefits, and grounded in federal tax principles.


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If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

Washington DC
Jennifer Breen
Michael D. Kummer
James G. Steele III

Jonathan Zimmerman

Andrew T. Budreika
Daniel F. Carmody
Benjamin W. Stango

New York
Kenneth S. Kail
Richard S. Zarin

Daniel A. Nelson
George P. Mair

Silicon Valley
Barton W.S. Bassett

[1] Pub. L. 116-136, 134 Stat. 281, 286-93 (Mar. 27, 2020).

[2] See 26 USC §§ 161, 162, and 163.