The IRS clarifies the deductibility of PPP-funded expenses

The IRS has issued new guidance addressing a question that has lingered since the launch of the Paycheck Protection Program (PPP): Are expenses paid with proceeds from PPP loans deductible for federal tax purposes?

The answer, according to Revenue Ruling 2021-02, is yes — if certain conditions are met. This guidance reverses the IRS's previous position and brings welcome clarity to manufacturers who received PPP funds.

Background on the PPP

The Paycheck Protection Program was established by the Coronavirus Aid, Relief, and Economic Security (CARES) Act to provide forgivable loans to eligible small businesses facing economic hardship due to the COVID-19 pandemic. The program was designed to help businesses keep their workforce employed during the crisis.

While the CARES Act specified that forgiven PPP loans would not be included in taxable income, it did not address whether expenses paid with those loan proceeds would be deductible.

The IRS's Initial Position

In Notice 2020-32, issued in April 2020, the IRS took the position that expenses paid with forgiven PPP loan proceeds would not be deductible. The agency cited a provision of the tax code that generally disallows deductions for expenses related to tax-exempt income.

This interpretation was met with significant criticism from the business community and tax professionals, who argued it contradicted congressional intent and effectively created a tax on businesses at a time when they were already struggling.

Congressional Clarification

In response to the controversy, Congress included language in the Consolidated Appropriations Act, 2021 (CAA), which was signed into law on December 27, 2020, explicitly stating that deductions would be allowed for otherwise deductible expenses paid with forgiven PPP loan proceeds, and that the tax basis and other attributes of the borrower's assets would not be reduced as a result of loan forgiveness.

The New Guidance

Revenue Ruling 2021-02, issued on January 6, 2021, officially revokes the IRS's prior guidance and confirms that:

• Eligible expenses paid with PPP loan proceeds are deductible, even if the loan is forgiven or the borrower reasonably expects to receive forgiveness
• This applies to both original PPP loans and "second draw" PPP loans
• The timing of deductions follows normal tax accounting principles (generally, the year in which the expense was paid or incurred)

Implications for Manufacturers

For manufacturing businesses that received PPP loans, this guidance provides several important benefits:

1. Increased tax savings: Manufacturers can now deduct eligible payroll costs, rent, utilities, and other covered expenses paid with PPP funds, potentially resulting in significant tax savings for 2020 and 2021.
2. Simplified tax planning: The clarification eliminates the need for complex strategies that some businesses were considering to maximize deductions while complying with the previous IRS position.
3. Cash flow preservation: The ability to deduct these expenses means more cash remains available for operations, investment, and recovery.

Action Steps for Manufacturers

In light of this guidance, manufacturing businesses should:

• Review their 2020 tax planning with their accountant to ensure they're taking full advantage of available deductions
• Maintain thorough documentation of how PPP funds were used, as this remains critical for loan forgiveness
• Consider how this tax treatment affects their overall financial position and cash flow projections for 2021
• Stay informed about any additional guidance related to second-draw PPP loans and other COVID-19 relief programs

Conclusion

The IRS's reversal on the deductibility of PPP-funded expenses represents a significant win for manufacturing businesses that utilized the program. By allowing these deductions, the government has ensured that PPP loans provide the full measure of relief intended by Congress, without unexpected tax consequences.

As always, we recommend consulting with your tax advisor to understand how this guidance applies to your specific situation and to ensure you're maximizing available tax benefits while maintaining compliance.