The Internal Revenue Service (IRS) recently released Revenue Ruling 2020-27, further stating its position that expenses paid for with the proceeds of the Paycheck Protection Program (PPP) loan will not be considered deductible for income tax purposes. This finding holds true even if the taxpayer does not apply for or receive forgiveness of the loan during the tax year.
The PPP allowed businesses to receive a loan if they were impacted by the COVID-19 pandemic. If the proceeds of these loans were used for “covered expenses,” then the loan could be forgiven. These covered expenses include the following:
- Payroll costs
- Interest on a covered mortgage obligation
- Any covered utility payment
- Any covered rent payment
If the loan was forgiven, the Coronavirus Aid, Relief, and Economic Security (CARES) Act stated that any amount that would be typically included in gross income of the eligible recipient by reason of forgiveness shall be excluded from gross income.
The expenses listed above are typically deductible by businesses; however, in May 2020 the IRS issued Notice 2020-32 clarifying that no deduction is allowed for an otherwise deductible expense if the expense is paid with a covered loan which is forgiven. This position is based upon Internal Revenue Code (IRC) Section 265(a)(1), which says that no deduction is allowed for any amount otherwise allowable as a deduction to the extent the amount is allocable to one or more classes of income wholly exempt from income taxes. This position taken by the IRS results in the same outcome as if the forgiveness had been taxable.
In Revenue Ruling 2020-27, the IRS further expanded on their position from Notice 2020-32. While the IRS’s position was clear that if the deductions were funded with indebtedness excluded from income then no deduction would be allowed, many practitioners have questioned the connection between the timing of forgiveness and deductions. What would happen if the forgiveness of the debt and the payment of the expenses occurred in different years? As the loan forgiveness is not excluded from gross income until the application is approved by the lender, the taxpayer may not know if the expenses are going to be funded with exempt income. Could a taxpayer deduct expenses in 2020 if the loan had not actually been forgiven yet?
Revenue Ruling 2020-27 states that if at the end of a tax year, a taxpayer reasonably expects that the loan will be forgiven, then any deduction for the covered expenses used for forgiveness of the loan will be disallowed in the year paid or incurred, not the year of forgiveness. The IRS’s position is the same even if the application for forgiveness has not been filed by the end of the tax year, but the taxpayer intends to file for forgiveness in the subsequent year and reasonably expects the loan to be forgiven.
This deduction disallowance could result in a unique issue. If a loan recipient’s forgiveness application is denied or the taxpayer decides not to apply for forgiveness in the subsequent tax year, then the expenses should have been deducted as they are not allocable to a class of income excluded from income tax. This could result in a taxpayer needing to potentially amend a prior year’s return where such deduction was disallowed under Revenue Ruling 2020-27.
To combat this issue, the IRS issued Revenue Procedure 2020-51. If a taxpayer who has expenses disallowed in a tax year due to following Revenue Ruling 2020-27, then the taxpayer may deduct the disallowed amounts either on the 2020 original tax return (including extensions) or file an amended 2020 tax return or an administrative adjustment request (AAR) under section 6227 of the IRC for 2020, or on the 2021 originally filed tax return. Taxpayers relying on this safe harbor of Revenue Procedure 2020-51 are required to attach a statement to the tax return as required by Section 4.04 of the Revenue Procedure.
Businesses that received a PPP loan and have either already applied for or are considering applying for loan forgiveness should contact their tax advisor to weigh the impact of this new guidance. For more information, reach out to us at firstname.lastname@example.org.