9-Dec-20
PPP Loan Forgiveness and Inability to Deduct Business Expenses
Take-Away: The IRS just published Revenue Ruling 2020-27 that provides that if an individual or business received a PPP loan under the CARES Act to be used to pay covered business expenses, those expenses cannot be deducted on the loan recipient’s income tax return this year if the forgiveness of that PPP loan is reasonably expected to occur.
Background: The CARES Act established the PPP loan program administered by the SBA. Under the PPP, the SBA is permitted to guarantee the full principal amount of a covered loan. Such a loan may be forgiven based on certain eligible expenses being paid or incurred during the covered period, which initially ran from February 15, 2020 through June 30, 2020, and which was then extended to December 31, 2020. The forgiveness of such a loan is for the following expenses incurred during the covered period: (i) payroll costs; (ii) interest on a covered mortgage obligation; (iii) any covered rent obligation; (iv) and any covered utility payment. The CARES Act specifically provides that the amount of the forgiven loan [debt forgiveness] is not to be included in the loan recipient’s taxable income under IRC 61(a)(11.)
Revenue Notice 2020-32: On May 2, 2020 the IRS issued this Notice which declares that no income tax deduction is allowed for an eligible covered expense that is otherwise deductible if payment of the eligible covered expense results in the forgiveness of the covered PPP loan.
The Problem: The problem is that many individuals and businesses that obtained PPP loans, and used the loan proceeds to pay the covered expenses described above, have the legitimate expectation that the loan will be forgiven, yet the procedure to obtain the loan forgiveness is time consuming and there is a strong likelihood that it will take a long time for the application for the PPP loan’s forgiveness to be accepted by the SBA, long after the borrower’s income tax returns are required to be filed for 2020.
Loan Forgiveness Procedure: Under the CARES Act’s PPP loan forgiveness procedure, the loan recipient calculates the amount of its eligible covered expenses that were paid or accrued during the covered period, and then submits a completed form and supporting documentation to their lender. [Loan Forgiveness Application Form 3508.] Within 60 days of the receipt of that application for the forgiveness of the loan, the lender must issue a decision with regard to the borrower’s application for forgiveness. The SBA then has 90 days after that decision to reimburse the lender, in whole or in part, based on the lender’s decision. However, given the number of PPP loans outstanding, it is highly likely that the actual loan forgiveness procedure will take a lot longer than 150 days as contemplated by the CARES Act.
So long as that loan forgiveness application is outstanding, the loan is not formally forgiven, yet the borrower’s covered business expense will not be deductible because there exists a reasonable expectation of reimbursement.
IRC 265(1): This Tax Code section disallows any amount of eligible expenses otherwise allowable as an income tax deduction (including IRC 161) to the extent the payment of such eligible expenses is allocable to tax-exempt income in the form of the reasonably expected loan forgiveness.
Example: Between February 15, 2020 and December 31, 2020, LastLegs, LLC paid business expenses described in IRC 161, which are also eligible expenses under the CARES Act, including payroll expenses, interest on a mortgage obligation, utility payments, and rent. On November 20, 2020, LastLegs, LLC applied to its lender for forgiveness of the covered PPP loan on the basis of the eligible covered expenses that LastLegs, LLC paid during the covered period. As of the date of its application for loan forgiveness, LastLegs, LLC satisfied all requirements under the CARES Act [Section 1106 of the Act] for forgiveness of the covered PPP loan. LastLegs, LLC’s lender does not inform LastLegs, LLC whether its PPP loan will be forgiven by the end of 2020. When LastLegs, LLC completed its application for a covered PPP loan forgiveness, it knew the amount of its eligible expense that qualified for reimbursement, in the form of covered loan forgiveness, and thus it had a reasonable expectation of reimbursement. Thus, the reimbursement, in the form of the covered loan forgiveness, was foreseeable. Consequently, LastLegs, LLC may not deduct its eligible business expenses for 2020. IRC 265(a)(1) disallows the income tax deduction of LastLegs, LLC’s otherwise eligible and deductible expenses because those expenses are allocable to tax-exempt income in the form of reasonably expected covered loan forgiveness.
Revenue Procedure 2020-51: As a companion to the Revenue Ruling, the IRS also published this Revenue Procedure to address, and provide some relief to those unfortunate PPP borrowers who file an application for the PPP loan forgiveness, who do not deduct those business expenses this year in the belief that their PPP loan will be forgiven in a later year, only to learn that their PPP loan was not ultimately forgiven.
Continuing Debate: Some commentators believe that the Revenue Ruling that denies the income tax deduction for business expenses is contrary to the express language used in the CARES Act (Section 1106(i).) As such, they advocate that business income tax returns be placed on extension until there is a new administration in place in Washington D.C with a more ‘open-minded’ IRS administration to implementthe CARES Act.
Conclusion: A borrower that received a covered loan that is guaranteed under the PPP and paid or incurred otherwise deductible business expenses may not deduct those expenses in the taxable year in which those expenses were paid or incurred if, at the end of the calendar year, the borrower reasonably expects to receive forgiveness of the covered loan on the basis of the expenses that it paid or accrued during the covered period, even if the borrower has not yet submitted an application for forgiveness of the covered loan by the end of the taxable year. The Revenue Ruling thus creates a hardship for those businesses that borrowed funds under the PPP since they will be denied income tax deductions which, in turn, will cause them to pay more in income taxes for 2020 due to fewer income tax deductions claimed, without the assurance that their PPP loan will actually be forgiven. I guess that just about covers how covered expenses incurred during the covered period will be treated under a covered PPP loan.