For-profit paycheck protection program (PPP) borrowers – and their tax advisors – have wondered whether they can claim tax deductions in TY 2020 for forgivable expenses paid with PPP loan proceeds if their PPP loan will not be forgiven until TY 2021. In recently-released Rev. Rul. 2020-27, the IRS has answered the question in the way we all expected: a borrower may not claim a tax deduction for forgivable expenses that the borrower paid or incurred to the extent the borrower reasonably believes the expense will result in PPP loan forgiveness in a subsequent tax year. While this is consistent with accounting and IRS practice, it is not likely to be politically popular with members of Congress already looking for ways to decouple PPP forgiveness from the deductibility of those expenses.
When Congress created the PPP, it included a provision that turned off the cancellation of debt (COD) rules to ensure that PPP loan forgiveness would not result in taxable income. However, Congress was silent about whether borrowers could continue to deduct forgivable expenses (payroll costs, mortgage interest, rent and utilities). In Notice 2020-32, the IRS provided an answer, which we discussed in this article. Pursuant to Notice 2020-32, a borrower may not claim a deduction for a forgivable expense that resulted in PPP loan forgiveness.
After the IRS issued Notice 2020-32, Congress passed the Paycheck Protection Program Flexibility Act (Flexibility Act). The Flexibility Act, in relevant part, extended the covered period for paying or incurring forgivable expenses from eight weeks to 24 weeks. The Flexibility Act also extended the deferral of principle and interest payments on PPP loans from six months after origination to the date of the forgiveness determination, provided that the borrower applies for forgiveness within 10 months of the end of its covered period.1 Because of these changes, the taxable year of most PPP borrowers will end (generally on December 31, 2020) before they secure PPP loan forgiveness (sometime in 2021).
The IRS, however, limited the “no deduction” rule of Notice 2020-32 to the extent that the forgivable expense resulted in actual forgiveness. This created a timing problem: how should borrowers treat forgivable expenses that have not resulted in forgiveness by the end of the borrower’s tax year?
Rev. Rul. 2020-27
The IRS has resolved this timing problem in a taxpayer-unfavorable manner: the borrower may not claim a deduction to the extent that the borrower reasonably expects to receive forgiveness. Thus, if a borrower has submitted a PPP loan forgiveness application by the end of the year (in which the borrower certifies its entitlement to forgiveness), then the borrower may not claim a tax deduction for the requested forgiveness amount. Even if the borrower has not submitted a PPP loan forgiveness application by the end of the year, the borrower still may not claim a tax deduction for the forgiveness amount it reasonably expects to request when it files the forgiveness application. Thus, delaying a forgiveness application is not likely to alter the current year income tax treatment.
The IRS-mandated approach meshes well with the financial statement (i.e., book) treatment recommend by most accountants with whom we work. For book purposes, we understand that general accepted accounting principles (GAAP) generally requires income recognition of the PPP forgiveness when the borrower reasonably believes that the loan will be forgiven – presumably no later than the date the borrower applies to their lender for forgiveness and certifies entitlement. (Apologies to all of our loyal readers with CPA training who no doubt cringe at our lawyerly oversimplification of the accounting rules.) For most calendar year taxpayers, this means that their 2020 financial statements will recognize anticipated forgiveness as income and have offsetting expenses. For tax purposes, those same taxpayers will have a similar net result, but it will be obtained by excluding PPP forgiveness from gross income and also excluding a like amount of otherwise-deductible expenses.
As with Notice 2020-32, we believe that the IRS’s extension of its “no deduction” rule is a reasonable interpretation of existing law. The IRS based its position in Notice 2020-32 on IRC § 265. The IRS based its reasonable expectation extension of Notice 2020-32 on case law in which courts upheld a deduction disallowance for an amount for which a taxpayer reasonably expected reimbursement in a subsequent year. Accordingly, as a legal matter, we find no fault with the IRS’s analysis.
As a political matter, however, we expect opposition to the IRS’s position. As we noted in our article last week, members of Congress have already publicly disagreed with the IRS’ deduction position announced in IRS Notice 2020-32. Senators Cornyn (Majority Whip), Grassley (Finance Committee Chair), Wyden (Ranking Member of the Finance Committee), Rubio and Carper introduced the Small Business Expense Protection Act of 2020 (S. 3612). This bill, if enacted (or incorporated into another stimulus bill), would ensure that PPP loan forgiveness has no impact on the deductibility of forgivable expenses. We expect the issuance of Rev. Rul. 2020-27 will secure the attention of both Congress and their constituents.