Last Wednesday, November 18, 2020, the IRS issued Revenue Ruling 2020-27 and Revenue Procedure 2020-51, which formalize the guidance in Notice 2020-32, issued in late April of 2020 – see our May 6, 2020 blog post on the subject.
The PPP program was supposed to make the lives of business owners easier during the pandemic, but after 11 pages of FAQs and 26 Interim Final Rules, it has just added to their burden.
The IRS holds that businesses which paid eligible expenses with the proceeds of Paycheck Protection Program (PPP) loans – may not deduct such expenses on their income tax returns, contrary to Section 1106 of the CARES Act. In other words, you get the benefit of the money, but you can’t deduct payments for expenses such as payroll, rent, interest on covered mortgage obligations and any covered utility payments. That effectively increases your net business income.
By way of illustration, the IRS presents two scenarios in which a business owner received a PPP Loan during 2020:
Business Owner A paid expenses listed in IRS Code Section 161, and are noted in the CARES Act as “eligible expenses,” which include qualified payroll costs, as well as qualified mortgage interest, utility, and rent payments.
In November of 2020, Business Owner A applied to its lender bank for forgiveness of the PPP loan, supporting its application with documentation of its eligible expenses. Based upon the expenses paid, Business Owner A had satisfied all requirements under the CARES Act (section 1106) for the loan to be forgiven.
However, the lending bank does not say whether the loan will be forgiven before the end of 2020.
Nonetheless, Business Owner A knew that its eligible expenses qualified for full forgiveness of the PPP loan, and had a reasonable expectation of such forgiveness, which is in effect a foreseeable reimbursement of those expenses via tax-exempt income. Therefore, Business Owner A may not deduct these eligible expenses from the 2020 tax returns. Alternatively, IRS Code Section 265(a)(1) “disallows a deduction of A’s otherwise deductible eligible expenses because the expenses are allocable to tax-exempt income in the form of reasonably expected covered loan forgiveness.”
Business Owner B paid the same types of eligible expenses during 2020 as Business Owner A, but did not apply for forgiveness of the PPP Loan before year-end. However, based upon the eligible expenses paid, Business Owner B had every reasonable expectation that an application for forgiveness of the PPP loan would be granted.
Since the reasonable expectation of forgiveness exists, applied for or not, and thereby the foreseeable reimbursement via tax-exempt income of the eligible expenses, Business Owner B may not deduct these expenses from the 2020 tax return. Alternatively, IRS Code Section 265(a)(1) applies in this scenario as well as the first.
Note that, should the application for PPP loan forgiveness be denied in whole or in part for either Business Owner A or Business Owner B, to the extent that eligible expenses are not reimbursed, they will revert to tax-deductible status. See Revenue Procedure 2020-51, linked above.
U.S. Treasury Secretary Steven T. Mnuchin encourages PPP borrowers to apply for loan forgiveness as quickly as possible. It will be interesting to see what position Janet Yellen, if confirmed as the new Treasury Secretary, will take regarding deductibility of PPP eligible expenses with respect to forgiven PPP loans.
It is still possible that the IRS’ rule will be nullified by Congressional action; a number of Senators and Representatives have affirmed that disallowing the tax-deductibility of eligible expenses was not their intent in writing the CARES Act.
Stay tuned – we will have more on PPP loans – that much, at least, is certain. And next week we will address the tax changes the Biden Administration is proposing for businesses.
If you would like guidance on whether or not you should apply for forgiveness of your PPP loan in 2020, please click here to email me directly.
Until next Wednesday – Happy Thanksgiving!