Expense Deduction Disallowed for 2020 if PPP Loan Forgiveness Anticipated in 2021
The IRS released a revenue ruling (Revenue Ruling 2020-27) on November 18, 2020 that addresses the timing of eligible expense deductions for taxpayers that have received a loan under the Paycheck Protection Program (PPP) and that expect to receive loan forgiveness. Revenue Ruling 2020-27 confirms that such taxpayers may not deduct otherwise deductible expenses in the year the expenses are incurred if the taxpayer reasonably expects to receive forgiveness of the loan in 2021 (even if the taxpayer has not submitted a loan forgiveness application by the end of 2020). The position outlined in Revenue Ruling 2020-27 augments the IRS’ position outlined in Notice 2020-32, which was released on April 30, 2020.
In conjunction with the release of Revenue Ruling 2020-27, the IRS announced a safe harbor procedure (Revenue Procedure 2020-51) for eligible taxpayers that have paid or incurred otherwise eligible PPP expenses during 2020, but loan forgiveness is denied or the taxpayer decides not to request loan forgiveness.
The PPP, one of the stimulus measures created by Section 1102 of the CARES Act, provides for the granting of loans to small businesses, nonprofit organizations, veterans’ organizations, and tribal businesses in an effort to address the financial crisis and keep workers employed during the COVID-19 pandemic. A PPP loan recipient may use the funds to pay payroll costs, certain employee healthcare costs, interest on mortgage obligations, rent, and utilities. Subject to specified limits, a borrower can apply to the lender for all or a portion of the PPP loan to be forgiven.
Section 1106(i) of the CARES Act provides that any amount of PPP loan forgiveness that would (but for that subsection) be includible in gross income instead will be excluded from gross income. However, the CARES Act is silent on whether eligible business expenses that result in PPP loan forgiveness are deductible for tax purposes. Notice 2020-32 and newly released Revenue Ruling 2020-27 address this issue.
Based on the notice and the revenue ruling, a borrower will not be allowed to deduct expenses paid or incurred that result in the forgiveness of a covered PPP loan, and the income associated with the forgiveness is excluded from gross income. The IRS treats the forgiven amount as a class of “wholly” tax-exempt income as described in Section 265(a) or as expenses to be reimbursed and, therefore, expenses that are “allocable” to the tax-exempt income or subject to reimbursement are nondeductible. Similarly, in the case of expenditures that are required to be capitalized to the cost of inventory, such costs would not be capitalized and would not be taken into account in determining the taxpayer’s cost of goods sold.
Questions have been raised as to whether Notice 2020-32 and Revenue Ruling 2020-27 are a correct application of the law, and many borrowers face uncertainty regarding the deductibility of PPP loan-eligible expenses for calendar year 2020, given that many of these loans may not be forgiven in 2020. In addition, the Small Business Administration (SBA) has stated publicly that it will audit all PPP loans of $2 million or more to determine borrower eligibility to receive the PPP loan based on the loan application requirements. Borrowers with PPP loans of $2 million or more also likely will be required to complete detailed SBA questionnaires (Forms 3509 and 3510) and provide extensive documentation substantiating their overall eligibility for the loan funds.
PPP Loan Forgiveness Process
A PPP loan recipient can request forgiveness of the loan by submitting an application to the lender, together with required documentation. The lender will respond in one of four ways:
- Approve the application in the full amount requested by the borrower;
- Approve the application in part in an amount less than the amount requested by the borrower;
- Deny the application in full; or
- Deny the application without prejudice, a response that will be given when the SBA notifies the lender that a loan review is pending at the time the borrower submits the application.
If the borrower’s application is denied in whole or in part, the borrower may appeal the decision to the SBA.
For various reasons, certain taxpayers that borrowed funds under the PPP may not have their loan forgiveness approved by December 31, 2020, and in some cases, borrowers may decide to wait until 2021 to submit a loan forgiveness application.
The two examples presented in Revenue Ruling 2020-27 and the IRS conclusions therein (see below) indicate that any delay in SBA approval does not appear to create sufficient uncertainty at year end to avoid the disallowance of a deduction of eligible expenses in the 2020 taxable year. It appears that there must be other more persuasive and compelling reasons that a taxpayer has a sufficient level of uncertainty by year-end, i.e., the taxpayer does not otherwise expect to meet the necessary qualifications for loan approval or the taxpayer intends to repay the loan for other non-tax reasons.
IRS Position in Notice and Revenue Ruling
Notice 2020-32 clarifies that no deduction is allowed for an expense that is otherwise deductible if the payment of the expense results in forgiveness of a PPP loan when the income associated with the forgiveness is excluded from gross income. Under the principal argument outlined in the notice, the IRS applies Section 265(a)(1) of the Internal Revenue Code (IRC) and §1.265-1 of the corresponding regulations, which disallow expenses for any amount otherwise allowable as a deduction that is allocable to one or more classes of income other than interest wholly exempt from the taxes imposed by subtitle A of the IRC. Disallowing a deduction for expenses paid with tax-exempt funds prevents a double tax benefit from arising. The notice also raises an alternative argument by listing several examples of authorities determining that deductions for otherwise deductible expenses are disallowed if the taxpayer receives reimbursement for such expenses.
Revenue Ruling 2020-27 amplifies the conclusion outlined in Notice 2020-32 by addressing the taxable period for which the expense deduction should be disallowed. In particular, the ruling discusses two specific fact patterns:
- Situation 1: Taxpayer A pays qualifying PPP expenses during its covered period beginning February 15, 2020 and ending on December 31, 2020. In November 2020, A applies to the lender for forgiveness of the covered loan on the basis of the eligible expenses it paid during the period. Based on A’s payment of the eligible expenses, A meets all requirements for forgiveness of the covered loan, although the lender does not notify A whether the loan will be forgiven before the end of 2020.
- Situation 2: Taxpayer B pays qualifying PPP expenses during its covered period, similar to Taxpayer A in Situation 1. However, B does not apply for forgiveness of the loan by the end of 2020. Taking into account B’s payment of the eligible expense during the covered period, B meets all other requirements for forgiveness of the covered loan and expects to apply for forgiveness in 2021.
Revenue Ruling 2020-27 states that both A’s and B’s PPP-eligible expenses are not deductible in the year paid or incurred. In arriving at this position, the Revenue Ruling reiterates the arguments outlined in Notice 2020-37 and concludes that in both situations, A and B each have a reasonable expectation of reimbursement at year-end. Notably, the analysis in the revenue ruling describes the existing loan forgiveness procedures in the CARES Act and additional procedures published by the SBA as “clear and readily accessible guidance” available to loan recipients like Taxpayers A and B. Accordingly, by virtue of incurring PPP-eligible expenses and having a reasonable expectation of loan forgiveness by year-end, A’s and B’s expenses are not deductible in the year paid or incurred.
Safe Harbor Procedure
Rev. Proc. 2020-51 addresses the situation where a borrower’s application for loan forgiveness is ultimately denied or the borrower decides not to apply for forgiveness. The safe harbor procedure allows these taxpayers to deduct expenses using any one of the following filing methods:
- A timely filed (including extensions) original federal tax return or information return (e.g., Form 1065) for the 2020 taxable year;
- An amended 2020 tax return or administrative adjustment request; or
- A timely filed (including extensions) original federal income tax return or information return for the 2021 taxable year.
To use one of these approaches, the taxpayer must attach a statement to its tax return in accordance with the requirements outlined in the revenue procedure.
Revenue Ruling 2020-27 does not distinguish between PPP loans that are above or below $2 million. Accordingly, a broad reading of the ruling would suggest that the IRS intended for the disallowance of expenses in the year paid or incurred to apply generally to taxpayers with PPP loans of any amount, provided that such taxpayers (1) paid or incurred eligible expenses within the covered period, and (2) submitted an application for loan forgiveness by year-end, or intend to do so after year-end. As such, absent any legislation that would effectively overturn Notice 2020-32 and Revenue Ruling 2020-27, it is likely that taxpayers seeking to deduct PPP-eligible expenses on their 2020 return will face challenges from the IRS upon examination of their tax returns.
Further, since the revenue ruling only addresses the federal income tax implications of two relatively simple fact patterns, there is uncertainty as to whether Situation 1 and Situation 2 are sufficiently broad to apply to all taxpayers with PPP loans of any size that incur PPP-eligible expenses and intend to apply for loan forgiveness. As mentioned above, the analysis in the revenue ruling states that the loan forgiveness procedures are clear and readily accessible to taxpayers, implying that the IRS currently considers the SBA review process to be ministerial in nature.
Taxpayers with PPP loans exceeding $2 million may disagree with the premise that loan forgiveness is reasonably expected given the substantive and rigorous nature of the SBA questionnaires and information requests they have received thus far during the loan forgiveness process.
It is possible that Congress may effectively overturn the holding in the notice and revenue ruling through subsequent legislation. Immediately after the release of Revenue Ruling 2020-27, Senate Finance Committee Chairman Chuck Grassley (R-Iowa) and Ranking Member Ron Wyden (D-Ore.) released a joint statement urging Treasury to reconsider its position on the deductibility and timing of PPP expenses. Although Congress has introduced several bills since May 2020 to allow taxpayers to claim a deduction without regard to whether any amount is excluded from gross income under Section 1106(i) of the CARES Act, no legislation has been enacted.
We will continue to monitor developments and will provide further updates as needed.