Are In-House Research Expenses Paid from Paycheck Protection Program (PPP) Loan Proceeds (That Qualify For Loan Forgiveness) Eligible for the IRC Section 41 Research Tax Credit

Tax | Edward P. Rigby | Sep 14, 2020

Many clients and colleagues have been asking a key question regarding the PPP loan program enacted as part of the CARES Act signed into law in March, 2020. The key question is, “can I deduct the expenses that are paid with the PPP loan proceeds that my business has borrowed”? The answer, according to IRS Notice 2020-32 is no. A subsequent key question is, “if expenses are non-deductible, do I lose the ability to claim the research tax credit”? The answer is likely yes.

General Background on PPP Loans
The CARES Act clearly states that borrowers that use PPP loan proceeds that meet certain criteria such as use of the loan amount for payroll costs and retaining employment levels and salary amounts, in accordance with Small Business Administration (SBA) guidelines can apply for and be granted loan forgiveness by the SBA participating lender. According to the CARES Act, amounts that are forgiven by the lender will not be treated as taxable loan forgiveness income, i.e., such loan forgiveness is granted tax-free treatment for income tax purposes. Most borrowers and tax practitioners assumed early on in the PPP application process that the expenditures for payroll and certain non-payroll costs allowed under the program such as rents, utilities and interest on certain mortgage obligations would be expenses eligible for a tax deduction when their businesses filed their 2020 income tax returns. The CARES Act and SBA guidance during the initial application process did not specifically address the deductibility of expenses. However, most tax practitioners and clients assumed that it was the Congressional intention to allow businesses to claim tax deductions since the purpose of the PPP loan program was to provide immediate relief to businesses due to the COVID-19 crisis.

IRS Notice 2020-32 On Deductibility of Expenses
On April 30, 2020, the IRS issued guidance on the deductibility of expenses associated with PPP loans qualifying for tax-free loan forgiveness with IRS Notice 2020-32. The IRS notice indicated that in general, based on long-standing IRS ruling positions and applicable case law, the rules under IRC Section 265 would be applied and accordingly, otherwise deductible expenditures that are paid with funds that are treated as tax-free income, would not be allowed as a tax deductible expense. Thus, according to the IRS, if a business borrows funds from the PPP program, and such loan amounts qualify for tax-free loan forgiveness when their forgiveness application is approved by the lender, the payroll and non-payroll costs paid by the funds are not eligible for a tax deduction.

Impact of Notice 2020-32 On Research Tax Credit
Although the IRS did not address the impact of non-deductibility of expenses on federal tax credits, it would appear that if PPP loan proceeds are used to pay wages for in-house research, and the PPP loan is granted forgiveness by the lender, the borrower will not be able to claim the research tax credit for such wages. Expenditures must generally be deductible under IRC Section 174 in order to be credit eligible. Further, funded research expenditures by grant or similar funding program are also not eligible for the tax credit.

The IRS position under Notice 2020-32 on non-deductibility surprised most business owners and tax professionals and has certainly attracted the attention of members of Congress. There are currently proposals introduced by both Houses of Congress to allow business owners to deduct their expenses paid from the PPP loan program. We continue to monitor the prospect of legislative action by Congress to allow for applicable tax deductions and also potential U.S. Treasury action to change the current IRS ruling.

However, borrowers from the PPP loan program who anticipate applying for loan forgiveness and who also have in-house research activities qualifying for the research tax credit should consult with their Prager Metis tax advisor immediately regarding the application of the non-deductibility announcement by the IRS on such tax credits.

If you have specific questions or require further information, please contact the Prager Metis Crisis Management team or Tax Department.