Tax Treatment of Expenses Paid with PPP Loan Funds
Steve Leimberg’s Business Entities Email Newsletter – Archive Message #212
From: Steve Leimberg’s Business Entities Newsletter
Subject: Alan Gassman & Brandon Ketron on Revenue Ruling 2020-27 & Revenue Procedure 2020-51: Tax Treatment of Expenses Paid with PPP Loan Funds
***Special thanks to Steve Leimberg and the entire LISI team for allowing me to reproduce this material on GassmanLaw.com***
On November 18th, the Treasury released new guidance concerning the tax treatment of expenses paid with Paycheck Protection Program (PPP) loan funds. Newly issued Revenue Ruling 2020-27 expands on previously issued IRS Notice 2020-32 and provides that recipients of PPP loans may not deduct expenses paid with PPP funds in the year in which such expenses were paid or incurred if the taxpayer reasonably expects to receive loan forgiveness. The Ruling further states that non deductibility applies even if the taxpayer has not submitted an Application for Forgiveness by the end of the year.
The Treasury also released Revenue Procedure 2020-51 to provide a safe harbor and procedures for taxpayers to later deduct expenses paid with PPP loan funds if forgiveness is subsequently denied or the taxpayer decides to not apply for forgiveness.
These pronouncements give no guidance as to whether a “Schedule C” independent contractor or sole proprietor will have loss of a deduction for the amount that he or she is considered to have spent under the forgiveness rules, which do not require payment of any expenses whatsoever to allow the Schedule C taxpayer to receive full forgiveness, except to the extent of PPP loans received that are attributable to wages paid to non owners.
The authors will be discussing this and other recent developments related to PPP loans in a LISI webinar on Friday December 3rd at 3 PM EST, which can be registered for by clicking here.
The CARES Act specifically provides that there will be no income tax imposed upon the forgiveness of PPP loan debt. This provision of the CARES Act overrides Internal Revenue Code Section 61(a)(11) and the U.S. Supreme Court holding in the 1931 case of U.S. v. Kirby Lumber, which provide that the reduction or elimination of indebtedness in a business or investment context generally constitutes taxable income to the taxpayer.
As the result of this provision of the CARES Act, it was the understanding of borrowers and at least most members of Congress that PPP loans would not result in any tax liability for borrowers. This was confirmed by Senator Richard Neal, who is the Chairman of the House of Representative Ways and Means Committee, and Senator Chuck Grassley, who is the Chairman of the U.S. Senate Finance Committee, in statements made by them after the IRS issued Notice 2020-32.
What Congress and many tax advisers failed to consider was Internal Revenue Code Section 265, which provides that no deduction is allowed to the extent allocable to certain “classes of income other than interest (whether or not any amount of income of that class or classes is received or accrued)” (i.e. expenses paid that result in PPP loan forgiveness). On August 3, 2020, the IRS released Notice 2020-32 to confirm its position that Section 265 will apply to make otherwise deductible expenses non-deductible, to the extent that payment of such expenses results in PPP loan forgiveness.
The Notice did not address the timing of forgiveness, and many were left to wonder if expenses would be deductible in 2020 if forgiveness did not occur until 2021, or how to address the previously deducted expenses that become non-deductible once the SBA confirmed forgiveness.
The newly issued guidance addresses both of these questions as discussed in more detail below.
Revenue Ruling 2020-27 addresses two situations that apply to PPP borrowers that will have their loans forgiven. In the first situation, the business spends all PPP loan money in 2020 on permitted expenses and submits its Loan Forgiveness Application prior to the end of 2020; but does not receive confirmation of the loan forgiveness amount prior to the end of the year. In the second situation, the same facts apply, but the business does not submit its Loan Forgiveness Application until 2021.
While all PPP borrowers are not calendar year taxpayers, the vast majority are, so this newsletter is written as if all borrowers are on a calendar year to simplify the discussion. Fiscal year C corporations, charities that have unrelated taxable business income, those rare S corporations and partnerships that have fiscal years, and estates that operate businesses on a fiscal year basis may have some expenses that are not deductible in the fiscal year ending in 2020, and others that are not deductible in the fiscal year ending in 2021 if the applicable 8 to 24 week testing period occurred during both fiscal years. PPP borrowers can elect a period of no less than 8 weeks and no more than 24 weeks after the loan proceeds were received during which the PPP loan amount must have been expended at least 60% on payroll and permitted payroll related expenses. Certain items if interest, rent, and utilities can make up the rest of whatever is not spent on payroll to qualify for full forgiveness.
Applications for Forgiveness must be filed within 10 months of the end of the selected period in order to avoid paying interest on the outstanding balance until forgiveness is confirmed. Once the bank receives the Forgiveness Application, it is to be approved and submitted by the bank to the SBA within 60 days, and approved or disapproved by the SBA within 90 days of receipt from the lender. Some loans have already been forgiven through that process.
Revenue Ruling 2020-27 provides that expenses cannot be deducted by a calendar year taxpayer in 2020, if the taxpayer reasonably expects to receive forgiveness. The Ruling indicates that forgiveness can be reasonably expected as the CARES Act, and guidance published by the SBA, provide taxpayers with “clear and readily accessible guidance” to know by year end the amount of eligible expenses that have been spent to qualify for loan forgiveness.
Many advisors will be shocked to learn that the SBA gave “clear and readily accessible guidance” to the vast majority of taxpayers with respect to how the forgiveness rules work for them, so that they can have “a reasonable expectation of” having loan amounts forgiven. It certainly has not felt this way, as the SBA has regularly changed the rules since almost the beginning of the PPP program, and there is still significant uncertainty for PPP borrowers who had to reduce their workforce hours, or who reduced the ratable compensation of certain employees by more than 25%, even when their payroll and other expenses have greatly exceeded what was borrowed. At this point in time, however, it does seem clear that a great many borrowers will receive full forgiveness.
One of our favorite commentators, Tony Nitti (also known as the “Tax Geek”) covered this issue on November 19th on his Forbes Blog, noting that:
As anyone who has attempted to complete a PPP forgiveness application can attest, it is NOT an exact science. Required reductions resulting from a drop in headcount or slashed salary make it possible that a taxpayer who has spent far MORE than their loan proceeds may still not achieve full forgiveness. How is a taxpayer who has not yet applied for forgiveness supposed to determine the amount they “reasonably expect” to be forgiven? I have no idea; nor, do I suspect, does the IRS.
The Ruling also further explains and supports the IRS’s reasoning for treating expenses paid that result in loan forgiveness as non-deductible, citing cases such as Burnett v. Commissioner[i] which held that a deduction was not allowed for costs advanced by a law firm because the firm only provided assistance “to clients with claims that were likely to be successful and that the advances were ‘made to clients with the expectation, substantially realized, that they would be recovered.’” The Ruling cites a similar holding in Canelo v. Commissioner[ii], and notes that taxpayers with PPP loans have a reasonable expectation of reimbursement via loan forgiveness based on the eligible expenses paid or accrued during the 8 or 24 week covered period.
Revenue Procedure 2020-51 provides a safe harbor and procedures for taxpayers who either (1) do not apply for full forgiveness in 2020, or (2) as to which forgiveness that was expected in 2020 is denied.
In order to be eligible for this new safe harbor, the taxpayer must meet all three of the following requirements:
- The taxpayer paid or incurred eligible expenses with PPP loan funds in the 2020 taxable year and took no deduction whatsoever for the payment of such expenses because at the end of the 2020 taxable year the taxpayer reasonably expected to receive loan forgiveness.
- The taxpayer submitted the Loan Forgiveness Application in 2020, or intends to submit the Loan Forgiveness Application after 2020.
- During 2021 or thereafter, either (a) the lender notifies the taxpayer that forgiveness of all or part of the covered loan is denied, or (b) the taxpayer irrevocably commits not to seek forgiveness for some or all of the covered loan.
As mentioned above, the Revenue Procedure applies differently to a taxpayer that is not on a calendar year basis.
A taxpayer meeting the above criteria can either deduct the expenses on its 2020 tax return or an amendment thereto, or deduct the expenses in the year in which the loan forgiveness is denied. Taxpayers will likely be better off deducting expenses in the year in which forgiveness is denied if the 2021 economy is better than it has been in 2020 and/or the Biden administration is able to raise the income tax rates.
The taxpayer must also include a statement with the return on which the expenses are deducted entitled “Revenue Procedure 2020-51 Statement,” and must include the following:
- The taxpayer’s name, address, and social security number or employer identification number;
- A statement specifying whether the taxpayer is an eligible taxpayer under either section 3.01 or section 3.02 of Revenue Procedure 2020-51;
- A statement that the taxpayer is applying section 4.01 or section 4.02 of Revenue Procedure 2020-51;
- The amount and date of disbursement of the taxpayer’s covered loan;
- The total amount of covered loan forgiveness that the taxpayer was denied or decide to no longer seek;
- The date the taxpayer was denied or decided to no longer seek covered loan forgiveness; and
- The total amount of eligible expenses and non-deducted eligible expenses that are reported on the return.
Assuming that Congress and the present or future President do not step in to allow for the deductibility of expenses paid from forgivable PPP loan proceeds, and that the IRS is correct in their position, the question becomes whether the taxpayer reasonably expects to receive forgiveness. If forgiveness is reasonably expected, then expenses that are counted towards forgiveness can not be deducted in 2020. If the taxpayer does not reasonably expect full forgiveness, or plans to return the loan, such as if the taxpayer is now more concerned as to whether the “necessity standard” was met after release of Form 3509 (which is discussed in LISI Business Entities Newsletter #211 (November 19, 2020)) and applies to PPP borrowers who received more than $2,000,000 in aggregated loans, and requires extensive disclosure with respect to the financial situation of the borrower, then the applicable expenses may be deducted in 2020. If it later turns out that forgiveness was obtained, then the taxpayer will be required to essentially give the deduction back by either declaring the amount that was deducted to be income in 2021, or amending the 2020 tax return.
IRC SECTION 265
Internal Revenue Code Section 265 provides that expenses paid from tax-free income are not deductible for income tax purposes. The exact language of the 26 U.S. Code §265 which addresses this is as follows:
(a) General rule
No deduction shall be allowed for—
Any amount otherwise allowable as a deduction which is allocable to one or more classes of income other than interest (whether or not any amount of income of that class or classes is received or accrued) wholly exempt from the taxes imposed by this subtitle, or any amount otherwise allowable under section 212 (relating to expenses for production of income) which is allocable to interest (whether or not any amount of such interest is received or accrued) wholly exempt from the taxes imposed by this subtitle.
One possibility is that Section 265 does not apply because the PPP loan forgiveness is not tax-free by reason of any provision of the Internal Revenue Code. If the words “wholly exempt from the taxes imposed by this subtitle” can be read to mean that the exemption from tax is provided under “this subtitle”, then because the CARES ACT is not part of the Internal Revenue Code, then Section 265 would not apply. It is more likely that these words mean that when the income is for any reason “exempt from the taxes imposed by the subtitle” then the deductions will be lost.[iii]
THE TAX BENEFIT RULE, AND PERHAPS THERE WILL BE MANY YEARS OF LITIGATION UNDER PROTECTIVE CLAIMS FOR REFUND UNLESS CONGRESS ACTS
If Section 265 does not apply, then the Tax Benefit Rule probably will, but may allow the deduction of expenses in 2020, and income to the extent of forgiveness when determined.
The Tax Benefit Rule is well described in a Michigan Law Review article by Professor Patricia D. White, issued in 1983, which makes reference to the assistance of Ruth Bader Ginsburg’s husband, Martin Ginsburg, in the first footnote, and summarizes that the Tax Benefit Rule applies when an amount that is deducted in an earlier tax year is recovered by the taxpayer in a later year, which would have caused it to not be deductible.[iv]
An example of this would be when a taxpayer pays an expense that would normally be deductible, but then later receives a reimbursement of the expense that would have caused it to be non-deductible.
Justice Sandra Day O’Connor “in a fairly long opinion, punctuated by contentious footnotes held that the Tax Benefit Rule “ordinarily applies to require the inclusion of income when events occur that are fundamentally inconsistent with an earlier deduction.”[v]
In the Hillsboro National Bank case, the bank paid a state imposed property tax on behalf of its shareholders in 1972, but the tax was allegedly unconstitutional, and the state repaid the tax directly to the shareholders of the bank, instead of to the bank itself. The bank deducted the payment of the tax on its 1972 tax return, and the refunds to the shareholders in 1973 were not reported as income. The IRS succeeded (after going all the way to the U.S. Supreme Court) in requiring the bank to include the refund in its income under the Tax Benefit Rule.
In the companion case of United States v. Bliss Dairy, Inc., the taxpayer purchased cattle feed and the cost was immediately deducted. In the next taxable year, the company liquidated while owning most or all of the cattle feed, which was distributed to the shareholders tax-free under former Internal Revenue Code Section 336. The IRS successfully argued that the value of the cattle feed had to be included as income from the distribution of an asset having a fair market value exceeding its basis on the dairy’s final income tax return, because it already had the benefit of a deduction in the prior year.
Based upon these cases, one could conclude that the taxpayer having a PPP loan should be able to deduct expenses paid in 2020, and then include the forgiveness amount in 2021, but the IRS is having none of this.
Besides providing complexity, lost tax deductions and heartburn for advisors, there is also uncertainty with respect to whether a taxpayer can determine which deductions are lost, and how the loss of these deductions will impact other aspects of the taxpayer’s tax return.
For example, Toni Nitti points out in the above referenced Forbes post that an owner of a business that may be eligible for a Section 199A deduction, if sufficient W-2 wages are paid by the business, might have to reduce the amount of wages considered to have been paid under Regulation Section 1.199A-2(b)(1) because Treasury Regulation Section 1.199A-3(b)(2) provides that amounts will only be included in the calculation of “Qualified Business Income,” if they are “allowed in determining taxable income for the taxable year.” Toni points out that “a literal reading of the Regulations may cause the IRS to conclude that any wages that are non-deductible are not taken into account in computing QBI (Qualified Business Income), and thus are not included in the W-2 limit.”
Taxpayers who are uncertain as to whether they will receive forgiveness will therefore have the advantage of being able to choose whether expenses will be non-deductible in 2020 or 2021, making for more flexibility, but also more complexity. Stay tuned as we are hopeful that further guidance will be issued to address these outstanding issues.
LISI Business Entities Newsletter #212 (November 22, 2020) at www.leimbergservices.com Copyright 2020 Leimberg Information Services, Inc. (LISI). Reproduction in Any Form or Forwarding to Any Person Prohibited Without Express Permission. This newsletter is designed to provide accurate and authoritative information in regard to the subject matter covered. It is provided with the understanding that LISI is not engaged in rendering legal, accounting, or other professional advice or services. If such advice is required, the services of a competent professional should be sought. Statements of fact or opinion are the responsibility of the authors and do not represent an opinion on the part of the officers or staff of LISI.
[i] 356 F. 2d 755 (5th Cir. 1966) cert. denied 385 U.S. 832 1966
[ii] 53 TC 217, 225-226 (1969), aff’d 447 F.2d 484 (9th Cir.1971)
[iii] Income tax provisions of the Internal Revenue Code are under Subtitle A, but the PPP provisions of the CARES ACT is not under any subtitle of the Internal Revenue Code (Title 26), as they are contained in Title 15 of the US Code.
One author’s favorite subtitles were from the introduction to the movie Monte Python and the Holy Grail and read as follows:
Mønti Pythøn ik den Hølie Gräilen Røtern nik Akten Di Wik Alsø wik Alsø alsø wik Wi nøt trei a høliday in Sweden this yër?
See the løveli lakes The wøndërful telephøne system And mäni interesting furry animals
The characters and incidents portrayed and the names used are fictitious and any similarity to the names, characters, or history of any person is entirely accidental and unintentional.
Signed RICHARD M. NIXON
Including the majestik møøse A Møøse once bit my sister… No realli! She was Karving her initials on the møøse with the sharpened end of an interspace tøøthbrush given her by Svenge – her brother-in-law – an Oslo dentist and star of many Norwegian møvies: “The Høt Hands of an Oslo Dentist”, “Fillings of Passion”, “The Huge Mølars of Horst Nordfink”…
We apologise for the fault in the subtitles. Those responsible have been sacked.
Mynd you, møøse bites Kan be pretti nasti… We apologise again for the fault in the subtitles. Those responsible for sacking the people who have just been sacked have been sacked. Møøse trained by YUTTE HERMSGERVØRDENBRØTBØRDA Special Møøse Effects OLAF PROT Møøse Costumes SIGGI CHURCHILLMøøse Choreographed by HORST PROT III Miss Taylor’s Møøses by HENGST DOUGLAS-HOME Møøse trained to mix concrete and sign complicated insurance forms by JURGEN WIGG Møøses’ noses wiped by BJØRN IRKESTØM-SLATER WALKER Large møøse on the left hand side of the screen in the third scene from the end, given a thorough grounding in Latin, French and “O” Level Geography by BO BENN Suggestive poses for the Møøse suggested by VIC ROTTER Antler-care by LIV THATCHER.
The directors of the firm hired to continue the credits after the other people had been sacked, wish it to be known that they have just been sacked. The credits have been completed in an entirely different style at great expense and at the last minute. Executive Producer JOHN GOLDSTONE & “RALPH” The Wonder Llama Producer MARK FORSTATER Assisted By EARL J. LLAMA MIKE Q. LLAMA III SY LLAMA MERLE Z. LLAMA IX Directed By 40 SPECIALLY TRAINED ECUADORIAN MOUNTAIN LLAMAS 6 VENEZUELAN RED LLAMAS 142 MEXICAN WHOOPING LLAMAS 14 NORTH CHILEAN GUANACOS (CLOSELY RELATED TO THE LLAMA) REG LLAMA OF BRIXTON 76000 BATTERY LLAMAS FROM “LLAMA-FRESH” FARMS LTD. NEAR PARAGUAY and TERRY GILLIAM & TERRY JONES.
[iv] An Essay on the Conceptual Foundations of the Tax Benefit Rule, by Patricia D. White, Georgetown University Law Center, Michigan Law Review, Volume 82, Issue 3, 1983.
[v] See Hillsboro National Bank v. Commissioner, 103 S. Ct. 1134 (1983) at 1140 – 1153.