REVENUE RULING PROVIDES GUIDANCE ON DEDUCTING EXPENSES WHEN PPP LOAN FORGIVEN20 November 2020
Rev Rul 2020-27, 2020-50 IRB
In a Revenue Ruling, the IRS clarifies when a taxpayer that received a Paycheck Protection Program (PPP) loan may deduct otherwise deductible expenses if, at the end of the tax year, the taxpayer reasonably expects to receive forgiveness of the covered loan based on the otherwise deductible expenses.
Background. Section 1102 and 1106 of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act, PL 116-136) established the PPP as a new loan program administered by the Small Business Administration (SBA). The PPP was designed to help small businesses adversely impacted by the COVID-19 emergency to pay payroll costs and other eligible expenses.
Under the PPP, the SBA may guarantee the full principal amount of a covered loan. A covered loan is a PPP loan made during the covered period. (Section 1102(a)(2) of the CARES Act)
The covered period was initially the period beginning on February 15, 2020 and ending on June 30, 2020. (Section 1102(a)(2) of the CARES Act) The covered period was then extended from June 30, 2020 to December 31, 2020. (Paycheck Protection Program Flexibility Act of 2020 (PL 116-142))
An individual or entity with a covered loan (“eligible recipient”) can receive forgiveness of the full principal amount of the covered loan up to an amount equal to the following eligible expenses paid or incurred during the covered period:
1. Payroll costs,
2. Interest on a mortgage obligation,
3. Any rent payment, and
4. Any utility payment. (Section 1106(b) of the CARES Act)
Under the SBA’s procedures, a taxpayer calculates the amount of its covered loan forgiveness (“forgiven amount”) based on the eligible expenses it paid or accrued in the covered period and submits a completed form and supporting documentation to their covered loan lender. (PPP Loan Forgiveness Application Instructions) Within 60 days of receipt of a forgiveness application, the covered loan lenders must issue a decision regarding a forgiveness application. (Section 1106(g) of the CARES Act)
Section 1106(i) of the CARES Act excludes the forgiven amount from the taxpayer’s gross income regardless of whether the income would be
1. Income from the discharge of indebtedness under Code Sec. 61(a)(11), or
2. Otherwise includible in gross income under Code Sec. 61.
In May 2020, the IRS clarified that no deduction is allowed for an eligible expense that is otherwise deductible if the payment of the eligible expense results in forgiveness of a covered loan. (Notice 2020-32, 2020-21 IRB 837)
In Notice 2020-32, the IRS relied on Code Sec. 265(a)(1) and Reg §1.265-1, which provide 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 (other than interest) wholly exempt from income taxes.
In Notice 2020-32, the IRS also relied on authorities holding that deductions for otherwise deductible expenses are disallowed if the taxpayer receives reimbursement for such expenses or if the taxpayer has a reasonable expectation of reimbursement. See Expenses paid with forgiven Paycheck Protection Program loan not deductible (05/04/2020).
Code Sec. 111 provides that a recovery or refund of an amount attributable to an earlier year’s deduction is excluded from income to the extent that the deduction didn’t reduce the amount of tax imposed in the earlier year. This is called the “tax benefit rule.”
When a taxpayer takes a deduction and, in a later tax year, an event occurs that is fundamentally inconsistent with the premises on which the deduction was based, the deducted amount must be taken back into income, except to the extent it’s excludible under the tax benefit rule. An event is fundamentally inconsistent with the premises on which a deduction is based when the event’s occurrence in the same tax year as the deduction would have foreclosed the deduction. (Hillsboro National Bank, (S Ct 1983) 51 AFTR 2d 83-874)
Issue. May a taxpayer that received a covered loan and paid or incurred certain otherwise deductible expenses deduct those expenses in the tax year in which the expenses were paid or incurred if, at the end of such tax year, the taxpayer reasonably expects to receive forgiveness of the covered loan based on the otherwise deductible expenses?
• Situation 1. During the covered period, A paid eligible expenses including interest on a mortgage, utilities and rent. In November 2020, A applied to its lender for forgiveness of its covered loan based on the eligible expenses it paid during the covered period. At that time, and based on A’s payment of the eligible expenses, A satisfied all requirements for forgiveness of the covered loan. The lender did not inform A whether the loan will be forgiven before the end of 2020.
• Situation 2. During the covered period, B paid the same types of eligible expenses that A paid in Situation 1. B, unlike A, did not apply for forgiveness of the covered loan before the end of 2020, although, based on B’s payment of the eligible expenses during the covered period, B satisfied all other requirements for forgiveness of the covered loan. B expects to apply to the lender for forgiveness of the covered loan in 2021.
Holding. No. A taxpayer that received a covered loan guaranteed under the PPP and paid or incurred certain otherwise deductible expenses may not deduct those expenses in the tax year in which the expenses were paid or incurred if, at the end of such tax year, the taxpayer reasonably expects to receive forgiveness of the covered loan based on the expenses it paid or accrued during the covered period, even if the taxpayer has not applied for forgiveness of the covered loan by the end of such tax year.
At the end of 2020, the reimbursement of both A’s and B’s eligible expenses, in the form of covered loan forgiveness, is reasonably expected to occur – rather than being unforeseeable. Accordingly, A’s and B’s eligible expenses are not deductible because there is a reasonable expectation of reimbursement.
In the alternative, Code Sec. 265(a)(1) disallows the deduction of A’s and B’s eligible expenses to the extent the payment of such eligible expenses is allocable to tax-exempt income in the form of the reasonably expected covered loan forgiveness. The fact that the tax-exempt income may not have been accrued or received by the end of the tax year does not change this result; the expenses are disallowed whether or not the taxpayer receives or accrues any tax-exempt income (in the form of covered loan forgiveness) to which the eligible expenses are allocable.