As we approach the end of 2020, many taxpayers and tax practitioners have been pondering whether or not expenses that were incurred in 2020 and paid with Payroll Protection Program (PPP) proceeds would be deductible in the current year if the PPP loan wasn’t forgiven until next year. On November 18, the IRS released much-awaited guidance in the form of Revenue Procedure 2020-51 and Revenue Ruling 2020-27 and clarified their position.
Let’s refresh our memories on why this is so important.
Earlier this year, in an effort to help taxpayers combat the effects of the COVID-19 pandemic, the Small Business Act authorized loans which were guaranteed under the PPP and had the potential to be forgiven if the proceeds were used for certain qualifying expenses detailed in the CARES Act. If taxpayers obtained a PPP loan and used the proceeds for these qualified expenses during their covered period, they could apply for loan forgiveness. Further, if the loan was forgiven, the proceeds wouldn’t be considered taxable income to the taxpayer.
In the subsequent months, however, the Treasury Department released Notice 2020-32, which stated that IRC Sec. 265 disallows the deduction of any expenses incurred in connection with the recognition of tax-exempt income, regardless of whether the tax-exempt income is received or accrued in 2020. In other words, even though the loan forgiveness technically is not taxable income, by disallowing the deduction of the expenses paid that give rise to the loan forgiveness, Treasury has essentially made the loan forgiveness taxable.
Since the deduction for these expenses would be disallowed only if the PPP loan was forgiven, many taxpayers have been left wondering what would happen if they had not yet received notification that their loans would be forgiven by the end of 2020. Would the expenses be disallowed in 2020, since that’s when they were incurred? Or since the loan forgiveness didn’t actually happen until 2021, would the expenses be disallowed in 2021?
With this recent guidance, the picture is beginning to come into focus.
Revenue Ruling 2020-27 considers two scenarios.
In situation one, a taxpayer incurs expenses in 2020 and applies for PPP loan forgiveness in 2020, but their lender (through the SBA) does not inform them whether or not their loan will be forgiven by 12/31/2020.
In situation two, a taxpayer incurs expenses in 2020 but does not apply for loan forgiveness until 2021. In both cases, the taxpayers meet the criteria for forgiveness under the CARES Act.
In both situations, since the taxpayer used the loan proceeds for qualifying expenses and either has submitted or intends to submit a forgiveness application, they have a reasonable expectation of reimbursement of the expenses, i.e. loan forgiveness. Because the expectation of forgiveness is reasonable, rather than being unforeseeable, a deduction for the expenses is considered inappropriate on the 2020 income tax return. Revenue Ruling 2020-27 holds that:
A taxpayer that received a covered loan guaranteed under the PPP and paid or incurred certain otherwise deductible expenses listed in section 1106(b) of the CARES Act may not deduct those expenses in the taxable year in which the expenses were paid or incurred if, at the end of such taxable year, the taxpayer reasonably expects to receive forgiveness of the covered loan on the basis of the expenses it paid or accrued during the covered period, even if the taxpayer has not submitted an application for forgiveness of the covered loan by the end of such taxable year.
What happens if a taxpayer has a reasonable expectation of loan forgiveness in 2020 only to find out in 2021 that their loan wasn’t actually forgiven? That’s where Revenue Procedure 2020-51 comes into play.
Revenue Procedure 2020-51 sets forth a safe harbor which allows deduction of qualified expenses on the taxpayer’s 2020 or 2021 income tax return in the event that a taxpayer had a reasonable expectation of PPP loan forgiveness as of 12/31/2020 but subsequently discovers that their request for loan forgiveness is denied.
In order to be eligible for the safe harbor, the taxpayer:
a) Must have paid or incurred eligible expenses in the 2020 taxable year for which no deduction is permitted because, at the end of the 2020 taxable year, the taxpayer reasonably expects to receive forgiveness of the PPP loan (see Revenue Ruling 2020-27).
b) Submitted before the end of the 2020 taxable year, or as of the end of the 2020 taxable year intends to submit in 2021, an application for PPP loan forgiveness; and
c) Is notified by their lender in 2021 that forgiveness of all or part of their PPP loan is denied.
A taxpayer is also eligible for the safe harbor if they meet criteria a) and b) above and voluntarily decide in 2021 to not seek forgiveness of the PPP loan or withdraw their application for forgiveness.
Under the safe harbor procedures, a taxpayer meeting the criteria above can deduct the qualified expenses either on a timely filed 2020 income tax return, on an amended 2020 income tax return or Administrative Adjustment Request under IRC Sec. 6227, or on a timely filed income tax return for the 2021 tax year.
On the return in which the deduction is taken, the taxpayer must attach a statement titled “Revenue Procedure 2020-51 Statement” and must include certain information such as which safe harbor they are utilizing, the amount and date of the PPP loan, the amount of denied loan forgiveness and the amount of eligible expenses the taxpayer is deducting.
Reading these two pieces of guidance together, it’s apparent the IRS believes that any expenses incurred by a taxpayer in connection with potential loan forgiveness should be disallowed on the taxpayer’s 2020 income tax return. While this wasn’t the answer that many were hoping for, it does provide us with the position that we can expect the IRS to take on this matter.