December 15, 2020

The Unforgiving Nature of PPP Forgiveness and the IRS’ New Guidance

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• The IRS issued guidance clarifying that a taxpayer (even one that has not applied for PPP loan forgiveness by the end of tax year 2020) is prohibited from deducting expenses paid for with a PPP loan if the taxpayer reasonably expects that the PPP loan will ultimately be forgiven.

• The IRS concurrently provided a safe harbor which permits a tax year 2020 deduction for otherwise deductible eligible expenses if a taxpayer received a PPP loan and: (1) the eligible expenses are paid or incurred during the 2020 tax year; (2) the taxpayer received a PPP loan and, at the end of the 2020 tax year, taxpayer expects to be forgiven in a tax year after the 2020 tax year; and (3) post-2020, the forgiveness request is denied (in whole or in part), or the taxpayer never actually requests forgiveness of the PPP loan.

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The Internal Revenue Service (IRS) released Notice 2020-32 earlier this year clarifying that borrowers would not be able to deduct expenses as laid out in Internal Revenue Code (IRC) §265 on their federal income tax return to the extent those expenses result in forgiveness of Paycheck Protection Program (PPP) loans.¹ Understandably, this guidance caused concern and confusion. A new year is just around the corner and the majority of borrowers still haven’t even applied for forgiveness—leaving many wondering what that means considering the Notice’s express language that a borrower gets no deduction “if the payment of the expense results [emphasis added] in forgiveness of a covered loan.” As such, many borrowers were left uncertain as to how to properly comply with the law and guidance set out by the IRS when filing their 2020 tax returns. And this issue spans not only this tax year but other years to come—increasing already anxious taxpayers’ confusion and concerns.

In response to the confusion, the IRS recently released Rev. Rul. 2020-27, amplifying Notice 2020-32 and clarifying that a taxpayer that received PPP loans may not deduct expenses in the taxable year in which the expenses were paid or incurred if, at the end of that 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.” Thus, even if forgiveness has not yet occurred, a taxpayer is prohibited from deducting expenses paid for with a PPP loan if the taxpayer reasonably believes the PPP loan will ultimately be forgiven.

Rev. Rul. 2020-27 Examples

The IRS provided the following two clarifying examples in the Rev. Rul., paraphrased below:

  • Situation 1. During the 2020 covered period, A used PPP loan funds to pay for eligible expenses, including payroll costs, interest on a mortgage, utility payments, and rent. In November 2020, A applied for PPP loan forgiveness on the basis of those eligible expenses. At that time, and based on A’s payment of the eligible expenses, A satisfied all CARES Act requirements for forgiveness of the covered loan. The lender does not inform A whether the loan will be forgiven before the end of 2020.
  • A may not deduct A’s eligible expenses. When A completed the PPP loan forgiveness application, A knew the amount of eligible expenses that qualified for reimbursement and had a reasonable expectation of reimbursement. The reimbursement, in the form of covered loan forgiveness, was foreseeable. In the alternative, IRC §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.
  • Situation 2. The facts are the same as in Situation 1, except that B did not apply for forgiveness of the covered loan before the end of 2020. However, taking into account B’s payment of the eligible expenses during the covered period, B satisfied all other CARES Act requirements for forgiveness of the covered loan. B expects to apply to the lender for forgiveness of the covered loan in 2021.
  • Result and Analysis: B may not deduct B’s eligible expenses. Although B did not complete an application for PPP loan forgiveness in 2020, by the end of 2020, B satisfied all other requirements for forgiveness and at the end of 2020 expected to apply to the lender for forgiveness in 2021. More specifically, at the end of 2020, B knew the amount of its eligible expenses that qualified for reimbursement and had a reasonable expectation of reimbursement. The reimbursement in the form of covered loan forgiveness was foreseeable. In the alternative, IRC §265(a)(1) disallows a deduction of B’s otherwise deductible eligible expenses, because the expenses are allocable to tax-exempt income in the form of reasonably expected covered loan forgiveness.

Rev. Proc. 2020-51’s Safe Harbor

But what happens if a taxpayer has eligible expenses which aren’t deducted on a 2020 tax return and, subsequently, forgiveness is reduced or completely withheld?  Well, along with Rev. Rul. 2020-27, the IRS released Rev. Proc. 2020-51, which created a safe harbor that allows taxpayers to claim a deduction on the timely filed original income tax return or information return for the 2020 tax year; the amended return or an administrative adjustment request (AAR) for the 2020 tax year; or a timely filed original income tax return for a subsequent tax year if:

  • The eligible expenses are paid or incurred during the 2020 tax year;
  • The taxpayer received a PPP loan that, at the end of the 2020 tax year, he expects to be forgiven in a tax year after the 2020 tax year; and
  • Subsequently, either the whole or part of the forgiveness request is denied, or the taxpayer does not actually request forgiveness of the PPP loan.

Conclusion

Understandably, many businesses had hoped that they would be able to deduct PPP loan funds that were used for eligible expenses in the 2020 taxable year. Specifically, these businesses envisioned: (1) deducting as business expenses the eligible expenses that were paid with PPP funds in 2020, and (2) including as gross income the forgiven amounts as a discharge of indebtedness in taxable year 2021. Had that played out, it would net to zero after the 2021 taxable year—and those struggling businesses would benefit from the favorable 2020 tax treatment.

Instead, under Rev. Rul. 2020-27those struggling small businesses will have higher taxable income for 2020. Obviously, affected businesses now have additional immediate year-end tax planning concerns in light of this ruling.

We will continue to monitor the situation, especially considering that senior members of Congress have indicated their concern that the IRS’s current position imposes an unfair burden on struggling businesses. Already, the Senate has proposed changes in its bipartisan Small Business Expense Protection Act of 2020. Congressional relief would be welcome to millions of taxpayers who confront the choice of a higher taxes or foregoing PPP loan forgiveness.

If you have any questions about PPP loan forgiveness, don’t hesitate to contact our legal team at 410-862-2673 or fill out our online form.

Footnotes

  1. 2020-21 I.R.B. 837 (May 18, 2020). You can read more about this topic in our earlier post, “PPP Loan Forgiveness is Not Allowed to Result in Double-Dipping” which you can find at: https://askfrost.com/ppp-loan-forgiveness-double-dipping/.”
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