Yes, the title of this article might sound similar to the most widely known phrase from William Shakespeare’s play Hamlet. And it is rightly so, because this is one of the most discussed question since quite some time. The Internal Revenue Service (IRS) has taken a viewpoint which denies deduction of expenses related to the loan forgiven under the Paycheck Protection Program (PPP). The American Institute of Certified Public Accountants (AICPA) has been continually advocating for a legislation for more clarity on the intent of the Congress stating that the receipt and forgiveness of PPP loan should not affect the deductibility of ordinary business expenses.
Background – PPP Loan Forgiveness
The CARES Act, enacted in March 2020, had established the PPP as a new loan program designed to assist small businesses nationwide who were adversely impacted by the COVID-19 pandemic. An individual or entity that is eligible to receive the PPP loan can receive forgiveness of the full principal amount of the loan up to an amount equal to the payroll costs and certain other eligible expenses incurred during the covered period.
The moot point is that can the recipient of the PPP loan claim a deduction for these expenses on their tax return if their PPP loan has been forgiven in full or part? If yes, when? If no, why? Do we have (yet) any simple, straightforward and complete answers for all our questions? You guessed it right…..no we don’t, which is surely not a surprise! So what answers do we have at this stage? Let us go through what the IRS and AICPA have to say.
IRS Interpretation of the Law
According to Notice 2020-32, the IRS is of the viewpoint that a taxpayer who receives a PPP loan is not allowed to deduct such expenses to the extent the payment of those expenses results in loan forgiveness. In addition to this notice, the IRS recently issued Revenue Ruling 2020-27 and Revenue Procedure 2020-51 which further magnifies the position taken by the IRS regarding non-deductibility of such expenses. The IRS’ interpretation relies on some judicial precedents and on a particular Income Tax Regulation which states 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) which is tax-exempt.
In simple words, if any expenses incurred by the taxpayer are related to the income which is non-taxable, then such expenses are non-deductible on the tax return. And, per CARES Act, since the PPP loan forgiveness amount is not to be included within gross income, the IRS says that the expenses which are incurred (e.g. payroll and other eligible costs) to get a forgiveness of the PPP loan are non-deductible.
AICPA Interpretation of the Law
The AICPA is of the viewpoint that the interpretation by the IRS is contrary to the intent of the Congress. As such, the AICPA has taken an opposing viewpoint to that of the IRS and has been constantly advocating for the Congress to include a legislation to clarify this issue in more detail in any year-end must-pass bill.
Current Status of this Issue
As on the date of writing this article (December 2nd, 2020), the taxpayers will have to follow the IRS guidance published in Revenue Ruling 2020-27 and Revenue Procedure 2020-51. Though there is a bleak hope of the Congress clarifying this issue in more detail in any forthcoming year-end bill, until that happens, the taxpayers would have no choice but to follow what the IRS has interpreted.
Revenue Ruling 2020-27 provides guidance on whether a PPP loan participant that paid or incurred certain otherwise deductible expenses can deduct those expenses in the taxable year in which the expenses were paid or incurred if, at the end of such taxable year, the taxpayer “reasonably expects” to receive forgiveness of the PPP loan. The revenue ruling also provides guidance for situations in which the PPP loan participant has not applied for forgiveness by the end of 2020 taxable year, but intends to apply in the next taxable year. The IRS says that if a taxpayer has received a PPP loan and “reasonably expects” it to be eventually forgiven since the loan funds were appropriately utilized for eligible expenses, it does not matter when the loan forgiveness application is filed, whether in 2020 or 2021, such expenses cannot be deducted on the 2020 tax return on the premise that the loan has not yet been forgiven as at the end of taxable year 2020. What is defined as a “reasonable expectation”? The revenue ruling does not provide an answer to that. (Like we had already guessed earlier….no simple and straightforward answers…at least not yet!)
Revenue Procedure 2020-51 provides a ‘safe harbor’ for deductibility of expenses incurred to get a forgiveness of PPP loan when the said PPP loan is “reasonably expected” by the PPP borrower to be forgiven, but when eventually such forgiveness is denied in full or part in subsequent tax year (i.e. 2021), or for those taxpayers who decide not to seek forgiveness. It also clarifies the taxable year in which such expenses can be deducted. Let us look into some salient points of this Revenue Procedure.
Taxpayers Eligible for Safe Harbor under Revenue Procedure 2020-51
Taxpayers who meet all of the below stated requirements are eligible for this safe harbor.
Who, in a subsequent taxable year (i.e. 2021), irrevocably decides not to seek forgiveness for some or all of the PPP loan. For example, a taxpayer eventually determines that it will not qualify for PPP loan forgiveness and withdraws the application already submitted in subsequent taxable year (i.e. 2021).
Safe Harbor Procedures
Eligible taxpayers as described in the above point may use the safe harbor procedures as stated below. It enables a PPP borrower to recover a disallowed deduction when its loan forgiveness is denied in whole or part, or if the borrower does not seek a loan forgiveness. To clarify, if the PPP borrower “reasonably expects” the PPP loan to be forgiven either in 2020 or 2021, then such expenses are non-deductible on the 2020 tax return. But if that “reasonable expectation” turns out to be wrong and eventually only a part or no amount of PPP loan is granted forgiveness, then this safe harbor kicks in. (Yes, you are right, the two magical words “reasonable expectation” are getting more interesting!)
Eligible taxpayers (as defined in a separate point in this article) may deduct eligible expenses on the taxpayer’s timely filed (including extensions) original income tax return (or information return, as applicable) for the 2020 taxable year, or amended return or Administrative Adjustment Request (AAR) for 2020 taxable year, as applicable.
Eligible taxpayers (as defined in a separate point in this article) may deduct eligible expenses on the taxpayer’s timely filed (including extensions) original income tax return (or information return, as applicable) for the subsequent taxable year (i.e. 2021). Eligible taxpayers may, but do not need to, use this safe harbor to deduct eligible expenses in a subsequent taxable year (i.e. 2021) because those taxpayers may deduct the eligible expenses in the year in which the loan forgiveness is denied (i.e. 2021) under general tax principles, assuming that the taxpayer does not elect to the use the safe harbor to claim such deduction for 2020 taxable year.
Baffled by points (1) and (2) above? Initially I was too, so you are not alone! I know this is confusing, so let me explain points (1) and (2) jointly with an example:
A taxpayer considers $500 of “eligible PPP expenses” as non-deductible on its 2020 tax return by “reasonably expecting” a PPP loan forgiveness of $500, but eventually during 2021 only $400 is granted as loan forgiveness. In such a scenario, the taxpayer has a choice of either using the safe harbor to take the balancing unforgiven amount of $100 as a deduction on their 2020 tax return (if not yet filed), or amend the 2020 tax return (if already filed) and take this deduction of $100 (along with the ‘safe harbor’ statement), or just take the $100 deduction on their 2021 tax return without needing to resort to any safe harbor provision.
A taxpayer may not be able to deduct an amount of eligible expenses in excess of the principal amount of the taxpayer’s PPP loan for which forgiveness was denied or will no longer be sought.
A taxpayer applying for this safe harbor needs to attach a statement to the 2020 tax return on which the taxpayer deducts such eligible expenses. The statement must be titled “Revenue Procedure 2020-51 Statement” and must include extensive details as enlisted in the text of the Revenue Procedure 2020-51.
Sources of information for this article:
This article has been compiled based on the IRS Revenue Procedure 2020-51 and IRS Revenue Ruling 2020-27.
How can Initor Global help the CPA Firms?
We can help you in determining the amount of expenses that can be deducted on your client’s tax return based on their PPP loan forgiveness amount, and the tax year during which such deduction can be claimed on their tax return. We can also work out whether your clients’ expectation for loan forgiveness is a “reasonable expectation” based on their specific information of loan amount and related expenses. We can provide guidance on the documentation which is necessary to be maintained, and also for assisting in maintaining proper accounting records. And most importantly, we shall constantly stay in touch with all the latest happenings on this issue plus any further guidance from the IRS, and would regularly provide you with up-to-date services to enable your clients to take full benefit of the available deductible expenses on their tax return.
Since the tax return filing due date for 2020 taxable year is still a few months away, and those taxpayers requesting an extension having even more time to file their tax returns, we can still hope that the Congress might enact a legislation to override the IRS’ interpretation and might allow full deductibility of these PPP expenses regardless of forgiveness amount of the PPP loan. The IRS might also release more guidance to answer the multitude of questions that have popped up due to these Revenue Ruling and Revenue Procedure. We are continuously monitoring the situation and shall be providing updates on subsequent developments on this topic as and when they are released.
Rest assured, we are always there to get the best out of the law for you and your business!
The information contained within this article is provided for informational purposes only and is not intended to be a substitute for obtaining accounting, tax, or financial advice from a professional accountant.