Many businesses are asking whether they can deduct expenses paid in 2020 even though those expenses were paid with Paycheck Protection Program (“PPP”) loan proceeds that they hope will be forgiven.
Section 1102 and 1106 of the CARES Act established the PPP as a new loan program administered by the Small Business Administration (“SBA”) to assist small businesses nationwide adversely impacted by COVID-19 to pay payroll costs and other covered expenses. The taxpayer can receive forgiveness of the full principal amount of the PPP loan up to an amount equal to the following eligible expense that are paid or incurred during the covered period: (1) payroll costs, (2) interest on a covered mortgage obligation, (3) any covered rent obligation payments, and (4) any covered utility payment. The “covered period” is the 24 week (or 8 weeks if elected) period immediately following disbursement of the loan or a period ending December 31, 2020, whichever is shorter. Under section 1106(i) of the CARES Act, the forgivable portion of the PPP loan is not includible in gross income.
On May 2, 2020, the Department of the Treasury and the IRS released Notice 2020-32, which clarified the IRS’s position that no deduction is allowed for an eligible expense if the payment of the eligible expense results in forgiveness of the PPP loan. While disappointing, this makes sense under general tax principles. Many question whether this was the intent behind the law, though, and there is a pending Senate Bill that would amend the CARES Act to make clear that the deductions are allowed even though the forgiven loan is excluded from gross income.
But what about companies who have not yet confirmed that their PPP loan will indeed be forgiven by December 31, 2020? Should they take the deduction for the expenses since they are legally still responsible for paying the loan? Or should they forego the deduction, in light of IRS guidance, and then file an amended return if the loan is not forgiven?
On November 18, 2020, the IRS released Revenue Ruling 2020-27 which clarified the tax treatment of expenses paid for with PPP funds, specifically in situations where the loan wasn’t forgiven by the end of the year it was received (December 31, 2020). Not surprisingly, the IRS concluded that if a taxpayer computing taxable income on the basis of a calendar year reasonably expects to receive forgiveness of the PPP loan on the basis of the expenses it paid or accrued during the covered period, then the taxpayer may not deduct those expenses, even if the taxpayer has not yet submitted an application for forgiveness.
The same day the IRS issued Revenue Procedure 2020-51 which provides a safe harbor for taxpayers who have (in 2020) a reasonable expectation to receive forgiveness of the PPP loan, but in a subsequent year, the lender notifies the taxpayer that forgiveness of all or part of the PPP loan is denied or the taxpayer irrevocably decides not to seek forgiveness for some or all of the PPP loan (for example, a taxpayer that determines that it will not qualify for loan forgiveness and withdraws the application submitted to the lender). These taxpayers may use the below safe harbor procedures.
- Safe harbor for deductions to be claimed in tax year 2020: The taxpayer may claim the deductions on their timely filed, including extensions, original income tax return or information return, as applicable, for the 2020 tax year, or amended return or AAR under Internal Revenue Code section 6227 for tax year 2020, as applicable. For example, ABC Corp. has a reasonable expectation to receive forgiveness of the PPP loan. ABC Corp. submits the application for forgiveness in December 2020 but forgiveness is denied in February 2021. Under the safe harbor, ABC Corp. can deduct the eligible expenses on its income tax return for tax year 2020, even though ABC Corp. had a reasonable expectation on December 31, 2020 that the loan would be forgiven. Alternatively, if ABC Corp. ultimately decided not to submit an application for forgiveness in tax year 2021, ABC Corp. can deduct the eligible expenses on its income tax return for tax year 2020.
- Safe harbor for deductions to be claimed in subsequent tax year: The taxpayer may claim the deductions the subsequent tax year (2021), because those taxpayers may deduct the eligible expenses in the year that the loan forgiveness is denied under general tax principles, assuming that the taxpayer does not elect to the safe harbor stated above in paragraph (1). For example, Kelly Smith, an independent contractor, submits her application for forgiveness in March 2021. She filed her income tax return for tax year 2020 on April 15, 2021, and does not claim a deduction for the eligible expenses since she still has a reasonable expectation the loan will be forgiven. On April 16, 2021, her application for forgiveness is denied. Under this safe harbor, she can claim the deductions on her 2021 return. (She should consider amending her 2020 return, though, to receive a refund and benefit from the time value of money.)
Taxpayers applying one of these safe harbors must attach the statement described in Revenue Procedure 2020-51 to the return on which the taxpayer deducts the eligible expenses. The statement must be titled, “Revenue Procedure 2020-51 Statement,” and must include the 7 items listed therein.