Earlier this year, the IRS released Notice 2020-32, which clarified that borrowers may not deduct business expenses funded with Paycheck Protection Program (PPP) loan proceeds if (1) the payment of the expenses will result in forgiveness of the PPP loan and (2) the income associated with the forgiveness of the PPP loan proceeds is excluded from gross income. As the end of the year approaches, taxpayers with PPP loans, who may not have applied for or received forgiveness, needed guidance as to whether they may deduct expenses paid with PPP loan proceeds if the loan is not forgiven by year-end. To address this concern and other related issues, on November 18, 2020, the IRS released Rev. Rul. 2020-27 and Rev. Proc. 2020-51. In Rev. Rul. 2020-27, the IRS ruled that a borrower who received a PPP loan may not deduct 2020 expenses funded by the loan proceeds if, at the end of the 2020 tax year, the borrower reasonably expects that the loan will be forgiven. In contrast, Rev. Proc. 2020-51 contains a safe harbor allowing a borrower to deduct eligible expenses incurred in the 2020 tax year if its request for loan forgiveness is ultimately denied, in whole or in part, or if the borrower decides not to apply for PPP loan forgiveness.
As the end of the year approaches, taxpayers should take three steps in light of this guidance: (1) verify whether the expenses they have paid qualify them for forgiveness of a PPP loan; (2) if they have not already applied for PPP loan forgiveness, make a final decision on whether they intend to do so; and (3) adjust their estimated taxes to reflect any nondeductible expenses based on the fact that the taxpayer reasonably expects that the loan will be forgiven.
Borrowers Cannot Deduct Expenses Funded with PPP Loan Proceeds If They Reasonably Expect that the Loan Will Be Forgiven
Rev. Rul. 2020-27 addressees the deductibility of expenses funded with PPP loan proceeds in two different situations. In the first situation, the borrower satisfied all requirements for forgiveness of the PPP loan and submitted a PPP loan forgiveness application, but the forgiveness application has not been approved before the end of 2020. In the second situation, the borrower also satisfied all the requirements for forgiveness of the PPP loan but did not apply for forgiveness before the end of 2020. Instead, the borrower expects to apply for forgiveness in 2021. In both situations, the IRS concluded that the borrower is not entitled to deduct the expenses that were paid in 2020 by the PPP loan proceeds because the borrower has a “reasonable expectation” of forgiveness of the PPP loan in 2021. A borrower has a reasonable expectation of forgiveness if the borrower satisfies all requirements under section 1106 of the CARES Act for forgiveness and either has applied or will apply for PPP loan forgiveness.
Borrowers should closely examine whether they meet the requirements under Section 1106 of the CARES Act prior to preparing their tax returns and consult their tax and legal advisors. Even if a borrower concludes that it can deduct some or all of the expenses paid for with PPP loan proceeds, the borrower should consider whether it is beneficial to deduct such expenses on its 2020 return because, if the PPP loan is ultimately forgiven, the tax benefit doctrine will recapture the deductions as income on the borrower’s 2021 tax return.
While the position taken by the IRS is not surprising, many taxpayers will understandably be disappointed. This denial of deductions effectively eliminates any benefit the taxpayer receives from the fact that no cancellation of indebtedness income is recognized on the forgiveness of a PPP loan; in general, taxpayers are left no better off than they would have been if they were required to recognize cancellation of indebtedness income on the forgiveness of the PPP loan but were entitled to deduct qualifying expenses. This lack of benefit seems contrary to the Congressional intent, which was to provide additional benefits to struggling and small businesses during the COVID-19 pandemic. For more information regarding the implications of the IRS’s decision to deny deductions of expenses funded by PPP loans, see our previous alert here.
Borrowers Can Deduct Expenses Funded with the PPP Loan Proceeds If the Loan is Not Forgiven
Rev. Proc. 2020-51 provides a safe harbor for taxpayers with a reasonable expectation of forgiveness whose PPP loans, either in whole or in part, are not forgiven. A borrower is eligible for the safe harbor if: (1) the borrower paid expenses in 2020 with the PPP loan proceeds in which no deduction was permitted because the borrower reasonably expected the PPP loan to be forgiven; (2) the borrower applied or intended to apply for loan forgiveness at the end of the 2020 taxable year; and (3) the borrower’s PPP loan is not forgiven because the borrower either received notice that the PPP loan forgiveness was denied, either in whole or in part, or irrevocably decided not to seek forgiveness for some or all of the PPP loan.
Under the safe harbor, an eligible borrower may either (1) deduct the expenses on its original income tax return or information return for the 2020 taxable year; (2) deduct the expenses on an amended return (or AAR under Section 6227 of the Internal Revenue Code, as amended, in the case of a partnership); or (3) deduct the expenses in the subsequent tax year. The deduction may not exceed the amount of expenses for which the borrower was denied forgiveness or the amount of expenses for which the borrower decides to no longer seek forgiveness.
In order to take advantage of the safe harbor, the borrower must attach a statement to his or her return for the years in which the borrower deducts the expenses under the safe harbor. The statement must be titled “Revenue Procedure 2020-51 Statement” and include information specifically enumerated in Rev. Proc. 2020-51.