IRS Expands on Disallowance of Deductions for Expenses Paid With PPP Loan Proceeds

The Paycheck Protection Program (PPP) established under the CARES Act was among the tools used to assist small businesses suffering from the COVID-19 pandemic. PPP loans enabled small businesses throughout the US to continue to pay certain business expenses such as payroll costs, interest on covered mortgage obligations, rent, and utility payments (covered expenses). Under the PPP, the Small Business Administration (SBA) is permitted to guarantee the full principal amount of a covered loan based on covered expenses being paid or incurred during the period beginning February 15, 2020 and ending December 31, 2020 (the covered period).

On November 18, the Internal Revenue Service (IRS) issued Revenue Ruling 2020-27 (available here) and Revenue Procedure 2020-51 (available here). Both publications address the question of whether a taxpayer that received a PPP loan and paid or incurred certain otherwise deductible expenses may 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 covered loan based on the otherwise deductible expenses. Revenue Ruling 2020-27 makes clear that no such deduction may be taken, and Revenue Procedure 2020-51 provides a safe harbor in the event that the taxpayer’s request for forgiveness is denied or the taxpayer ultimately elects not to request forgiveness.

Revenue Ruling 2020-27 confirms the position announced by the IRS earlier this year in Notice 2020-32 that expenses paid with PPP loan funds are not deductible. In our May 1st alert (available here), we explained that Notice 2020-32 prohibits taxpayers from taking a deduction for an expense that is otherwise deductible if the payment of the expense results in forgiveness of a covered loan under the CARES Act, and if the income associated with the forgiveness is excluded from gross income.

The “results in” language in the notice sparked some confusion by implying that forgiveness needed to happen before this disallowance rule would apply. In practice, many businesses may not apply for forgiveness until 2021, and taxpayers that apply for forgiveness in 2020 may not receive confirmation of such forgiveness being granted until 2021. Some taxpayers wondered whether, if such forgiveness is delayed until 2021, they could claim deductions of covered expenses on their 2020 tax returns. Revenue Ruling 2020-27 clarifies that a taxpayer cannot deduct covered expenses that have been paid for using PPP loan proceeds if the taxpayer reasonably believes the loan will be forgiven, even if the taxpayer has not submitted an application for forgiveness of the covered loan by the end of such taxable year.

The Revenue Ruling provides two scenarios to illustrate the rule. In both examples, the taxpayer computes taxable income on the basis of the calendar year for federal income tax purposes and received a covered loan from a private lender in 2020.

Situation 1

During the Covered Period, Taxpayer A paid eligible expenses. In November 2020, Taxpayer A applied to the lender for forgiveness of the covered loan on the basis of the eligible expenses it paid during the covered period. At that time, and based on Taxpayer A’s payment of the eligible expenses, Taxpayer A satisfied all of the requirements of the CARES Act for forgiveness of the covered loan. The lender does not inform Taxpayer A whether the loan will be forgiven before the end of 2020.

Situation 2

During the covered period, Taxpayer B paid the same types of eligible expenses paid by Taxpayer A, but unlike Taxpayer A, did not apply for forgiveness of the covered loan before the end of 2020. Based on Taxpayer B’s payment of the eligible expenses during the covered period, Taxpayer B satisfied all other requirements under the CARES Act for forgiveness of the covered loan. Taxpayer B expects to apply to the lender for forgiveness of the covered loan in 2021.

In both fact patterns above, Taxpayer A and Taxpayer B each have a “reasonable expectation of reimbursement” at the end of 2020. Under the loan forgiveness application procedures established by the CARES Act and the SBA rules, the taxpayer calculates the amount of its covered loan forgiveness on the basis of eligible expenses paid or accrued in the covered period in 2020. Because reimbursement of both taxpayers’ eligible expenses, in the form of covered loan forgiveness, is reasonably expected to occur, the IRS determined that allowing a deduction for the expenses would be inappropriate.

Revenue Procedure 2020-51 offers a safety net in the event that the reasonable expectation of reimbursement turns out to be incorrect. The procedure creates a safe harbor rule that allows a taxpayer to deduct expenses originally thought to be non-deductible on a timely filed return or to amend the return in the subsequent taxable year.

Under Revenue Procedure 2020-51, a taxpayer may claim a deduction in the taxpayer’s 2020 taxable year for certain otherwise deductible eligible expenses if:

1. The eligible expenses are paid or incurred during the taxpayer’s 2020 taxable year;
2. The taxpayer receives a PPP loan (covered loan), which at the end of the taxpayer’s 2020 taxable year the taxpayer expects to be forgiven in a taxable year after the 2020 taxable year (subsequent taxable year), and
3. In a subsequent taxable year, the taxpayer’s request for forgiveness of the covered loan is denied, in whole or in part, or the taxpayer decides never to request forgiveness of the covered loan.

Revenue Procedure 2020-51 provides steps on how the taxpayer may claim the deduction. A taxpayer described in the revenue procedure may be able to deduct some or all of the eligible expenses on (1) the taxpayer’s timely filed (including extensions) original income tax return or information return, as applicable, for the 2020 taxable year; (2) an amended return or an administrative adjustment request for the 2020 taxable year, as applicable; or (3) the taxpayer’s timely filed (including extensions) original income tax return or information return, as applicable, for the subsequent taxable year. Finally, the Revenue Procedure details how a taxpayer may apply for the safe harbor rule by attaching a Revenue Ruling 2020-51 Statement to the return on which the taxpayer deducts non-deductible eligible expenses.

As a practical matter, we note that forgiveness for loans in many instances may occur prior to the due date for 2020 tax returns (which, with extensions, could be in the fall of 2021), in which case it may not be necessary to rely upon the safe harbor above (as taxpayers will have certainty as to the forgiveness of the PPP loans).

As we stated in our May 1 alert, it is not entirely clear that the approach taken by the IRS in Notice 2020-32 (and repeated in Revenue Ruling 2020-27) is consistent with the intent of Congress when it specifically provided that the cancellation of covered loans under the CARES Act would not result in cancellation of indebtedness income to borrowers. By eliminating the deduction, the tax benefit from the associated exclusion from income of the forgiven debt is offset. To reverse the IRS’s position, Congress will have to act. Several proposed bills have been introduced that would permit the denied deductions, but they remain stalled on Capitol Hill for the time being.

If your business was the recipient of a covered loan under the PPP, contact the attorneys and tax professionals of Arent Fox LLP to see how Revenue Ruling 2020-27 and Revenue Procedure 2020-51 impact your business.