By: Jackie McGuire, CPA – Client Service Manager
The Paycheck Protection Program (PPP) established by the CARES Act in March 2020 provided loans to eligible small businesses. If the borrower used the loan proceeds to pay certain eligible expenses, then the amount of the loan up to eligible expenses could be forgiven and the loan forgiveness amount would not be treated as taxable income to the borrower.
However, the IRS issued Notice 2020-32 in April 2020. That notice states that expenses associated with tax-exempt income are not deductible. This IRS notice was consistent with historical IRS guidance regarding non-taxable income and related expenses.
Simply put, if the forgiven loan is not included in taxable income then the expenses paid with the forgiven loan are not to be included as tax deductions. Therefore, businesses could potentially have an unexpected tax liability at the end of the year.
Many business owners and financial planning practitioners alike were unhappy with the position that the IRS has taken because this guidance goes against Congress’s intent when they created the PPP loans. The IRS Notice could negatively impact businesses that are still struggling.
On November 18, 2020, the IRS and Treasury issued much-awaited guidance in the form of Revenue Ruling 2020-27 and Revenue Procedure 2020-51 and clarified their position:
Revenue Ruling 2020-27 states that a taxpayer that received a PPP loan and paid or incurred eligible expenses may not deduct those expenses in the taxable year in which those expenses were paid or incurred, if at the end of such taxable year the taxpayer reasonably expects to receive forgiveness of the loan even if the taxpayer has not submitted an application for forgiveness of the loan by the end of the taxable year. In other words, because the expectation of forgiveness is reasonable, rather than unforeseeable, the deduction of expenses is considered inappropriate for 2020 tax returns.
Another common question: What if a taxpayer who expected to receive loan forgiveness in 2020 later finds out in 2021 that they were denied, and the loan wasn’t actually forgiven? This is where Revenue Procedure 2020-51 comes in. This revenue procedure sets forth a safe harbor, which allows the deduction of qualified expenses on a taxpayer’s 2020 or 2021 tax return in the event that the taxpayer had a reasonable expectation of loan forgiveness as of December 31, 2020 but subsequently learned that their request for loan forgiveness was denied.
The criteria to be eligible for safe harbor includes the following:
- The taxpayer must have paid or incurred eligible expenses in the 2020 tax year for which no deduction was permitted because, at the end of the 2020 tax year, the taxpayer reasonably expects to receive loan forgiveness
- An application for PPP loan forgiveness is submitted before the end of the 2020, or at the end of the 2020 tax year the business intends to submit an application for PPP loan forgiveness in 2021
- The PPP loan participant is notified by their lender in 2021 that forgiveness of all or part of their PPP loan is denied
If a taxpayer intends to utilize the safe harbor procedures and deduct eligible expenses, a statement titled “Revenue Procedure 2020-51 statement” must be attached. This statement must include information as to why they are utilizing the safe harbor, the amount and date of the PPP loan, the amount of denied loan forgiveness and the amount of eligible expenses the taxpayer is deducting.
While this recently issued guidance wasn’t the answer that many were hoping for, it does provide guidance on the position that the IRS will take on this matter.
Armed with this knowledge, business owners should do tax planning before year-end to get an understanding of what the impact of these non-deductible expenses could be and to prepare accordingly before tax returns are filed.
Given that this is 2020 and anything is possible, there could be changes in the law if Congress were to pass additional legislation in the near future.
As always, if you have any questions related to your specific situation, please contact one of our team members.
Jackie McGuire, CPA
Client Service Manager