Editor: Kevin D. Anderson, CPA, J.D.
Paycheck Protection Program (PPP) loans are eligible for forgiveness if the business uses the funds to pay for eligible items such as payroll, certain employee health care costs, interest on mortgage obligations, rent, and utility expenditures. Provided the applicable requirements are met, a borrower of a PPP loan can apply to the lender for all or a portion of the loan to be forgiven. One important issue is whether expenses paid for with PPP loans can be deducted as business expenses. This item traces the history of IRS guidance and, ultimately, congressional legislation on that topic.
IRS position on deductibility
When the PPP was created by the Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136, it appeared Congress's intent was that any amount of a PPP loan that was forgiven would not be considered cancellation-of-debt (COD) income to the borrower (see CARES Act Section 1106(b)). However, because this section of the CARES Act is an "off-Code" provision, Sec. 61(a)(11) (which provides for the inclusion of discharged debt in gross income) and Sec. 108(a)(1)(B) (which provides for the exclusion of discharged debt from gross income when the taxpayer is insolvent) are not applicable as they relate to taxation of the forgiveness. As a result, the IRS took the position that otherwise deductible expenses that were paid with loan proceeds that were ultimately forgiven should be nondeductible, despite Congress's apparent intent.
The IRS communicated its position in Notice 2020-32, released on April 30, 2020. The IRS explained that the CARES Act did not address whether otherwise allowable expenses are still deductible if they are paid for with a PPP loan. The Service then reasoned that the forgiven amount is treated as a class of tax-exempt income, rather than as COD income under Sec. 61(a)(11). Therefore, the related expenditures under Secs. 162 and 163 should be governed by Sec. 265(a)(1) (which disallows the deductibility of expenses paid with tax-exempt income) to the extent that the covered loan is forgiven (up to the aggregate amount forgiven). Consistent with the purpose of Sec. 265, this treatment prevents a double tax benefit.
Many tax professionals and the AICPA believed that Notice 2020-32 was an incorrect interpretation of the law. Nonetheless, as a result of the IRS's position, some taxpayers were faced with substantial cash flow challenges related to expense deductibility, especially for tax years that ended before the tax year in which the loan was officially forgiven by the lender and, ultimately, by the U.S. Small Business Administration (SBA).
Notice 2020-32 also generated some confusion because it did not specify in which tax period the deduction for expenses should be reduced. Accordingly, questions arose as to whether the disallowance of deductions should be in the tax year the expense is paid/incurred or in the tax year in which the borrower is notified of the amount forgiven by the lender and/or the SBA. The IRS doubled down on its initial position under Notice 2020-32 by releasing Rev. Rul. 2020-27 on Nov. 18, 2020. The ruling confirmed that 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 did not submit a loan forgiveness application by the end of 2020.
Rev. Rul. 2020-27 addressed the timing issue while elaborating upon the IRS's position as outlined in Notice 2020-32. The two examples in Rev. Rul. 2020-27 indicated that any delay in SBA approval does not generate sufficient uncertainty at year end to avoid the expense deduction disallowance in the 2020 tax year. The IRS indicated that, to be able to deduct expenses paid with PPP loan funds, there must be persuasive evidence that a taxpayer has an adequate level of uncertainty by year end, such as that the taxpayer reasonably expected that it would not meet the qualifications for loan forgiveness or that the taxpayer simply did not intend to apply for forgiveness and ultimately would repay the PPP loan for other nontax reasons.
Simultaneously with the release of Rev. Rul. 2020-27, the IRS issued Rev. Proc. 2020-51, which provided a safe-harbor procedure for eligible taxpayers that had paid or incurred otherwise eligible PPP expenses during 2020, but who were denied loan forgiveness or who decided not to request loan forgiveness. The guidance under Rev. Rul. 2020-27 and Rev. Proc. 2020-51 caused many taxpayers to prepare for the worst and remit increased estimated tax payments as required under Secs. 6654 and 6655.
In late December 2020, Congress stepped in. The COVID-Related Tax Relief Act of 2020, enacted as part of the Consolidated Appropriations Act, 2021, P.L. 116-260, confirms that otherwise deductible business expenses paid out of PPP loans may be deducted for federal income tax purposes. In addition, the legislation makes clear that the borrower's tax basis and other attributes of the borrower's assets will not be reduced as a result of the loan forgiveness (since this is an off-Code provision unaffected by Sec. 108(b)). This legislation thus reversed the IRS's position on the deductibility of expenses paid using forgiven PPP loans.
In response to the legislation, the IRS released Rev. Rul. 2021-2 on Jan. 6, 2021, which withdraws its initial positions outlined under Notice 2020-32 and Rev. Rul. 2020-27. More specifically, Rev. Rul. 2021-2 confirms that no deduction will be disallowed, no tax attribute will be reduced, and no basis increase will be denied by reason of the exclusion from gross income of PPP loan amounts that are forgiven. Accordingly, taxpayers that incurred or paid PPP-eligible expenses may deduct the amounts in the year paid or incurred, depending on their overall method of accounting, and may consider the full amount of such expenses in computing any related tax attributes. Such attributes include but are not limited to the research-and-development tax credit, the work opportunity tax credit, and other employment-related credits.
The COVID-Related Tax Relief Act of 2020 applies to tax years ending after the date of the enactment of the CARES Act. Thus, taxpayers that had filed their tax returns without claiming a deduction for expenses allocable to PPP loan forgiveness should consider amending those returns to claim a deduction for expenses paid using forgiven PPP loan proceeds.
Kevin D. Anderson, CPA, J.D., is a managing director, National Tax Office, with BDO USA LLP in Washington, D.C.
For additional information about these items, contact Mr. Anderson at 202-644-5413 or firstname.lastname@example.org.
Contributors are members of or associated with BDO USA LLP.