SBA PPP: IRS Clarifies Deduction Issues

Borrowers of Paycheck Protection Program (“PPP”) loans, which are guaranteed by the Small Business Administration (“SBA”), have reached the end of their covered periods, and many are in the process of seeking forgiveness of their PPP loans.  Unfortunately, questions remained about the federal income tax consequences of potential loan forgiveness and timing and eligibility of deductions.

While the CARES Act specifically excludes from income the forgiveness of a PPP loan as discharge of indebtedness income, the IRS ruled earlier this year in Notice 2020-32 that a borrower could not take a deduction for an expense that would otherwise be deductible “if the payment of the expense results in forgiveness of a covered loan.”  For calendar-year borrowers that completed their covered period in 2020, but that will not get a determination of forgiveness of their PPP loan until 2021, this created uncertainty regarding how to treat the deductions while the loan is outstanding. 

Notice 2020-32 caused consternation among tax practitioners.  Were compensation deductions allowed to be taken in 2020 if PPP proceeds were used to pay those expenses even if the PPP loan is not forgiven yet?  If so, would a business need to file an amended return if it obtained forgiveness in 2021 after filing its tax return?  Or should the deductions be allowed in 2020, and then disallowed on the 2021 tax return, in the amount forgiven?  We outlined these issues in an earlier post.

On November 18, 2020, the IRS released Revenue Ruling 2020-27.  The IRS ruled that a taxpayer cannot take a deduction for expenses paid using PPP funds in the 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 on the basis of the expenses it paid or accrued during the covered period.” The IRS specified that this result would not change even if the taxpayer waited until 2021 to submit an application for forgiveness.

While the IRS did not detail what would constitute a “reasonable expectation”, the fact that a PPP borrower submits a forgiveness application would seem to indicate that the PPP borrower believes a reasonable expectation exists for forgiveness.  Presumably, if all or a portion of a PPP loan is not forgiven until after a PPP borrower files its income tax return, the PPP borrower could amend its 2020 income tax return to take deductions that were incurred with PPP loan proceeds that were not forgiven.

In its Ruling, the IRS relied on Section 265(a)(1) of the Code, which disallows an otherwise deductible expense when the expenses are allocable to “tax-exempt income,” such as a forgiven PPP loan. In addition, the IRS relied on the “reimbursement rule,” which provides that if it is foreseeable that a taxpayer will be reimbursed for an otherwise deductible expense, the deduction will be disallowed. The IRS found that under either theory, a deduction cannot be allowed in 2020.

Some practitioners, and even some of the Congressional sponsors of the CARES Act, disagree with the IRS’ conclusions.  But unless Congress takes action, PPP borrowers should be careful to analyze with their tax advisors the risks of taking deductions on 2020 tax returns that were paid with PPP funds. 

When analyzing eligibility, compliance, or other issues related to the PPP loans, both lenders and borrowers should ensure they have consulted the proper sources. If you have any questions regarding the SBA PPP loans, or other aspects of the CARES Act, please contact a Baird Holm LLP attorney.