IRS Confirms Deductibility Rules for Expenses Paid with PPP Funds; Issues Safe Harbor

(Parker Tax Publishing December 2020)

The IRS issued guidance on the deductibility of expenses paid with proceeds of a loan under the Paycheck Protection Program (PPP) which generally provides that such expenses are nondeductible if the loan is forgiven. However, the IRS also issued a revenue procedure which provides that those expenses may be deductible if the PPP loan is not forgiven, or is only partially forgiven. Rev. Proc. 2020-51; Rev. Rul. 2020-27.

Background

Sections 1102 and 1106 of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), signed into law on March 27, 2020, established the Paycheck Protection Program (PPP) as a new loan program administered by the U.S. Small Business Administration (SBA). The PPP was designed to assist small businesses adversely impacted by the COVID-19 emergency to pay payroll costs and other eligible expenses. Under the PPP, the SBA is permitted to guarantee the full principal amount of a covered loan, defined under Section 1102 of the CARES Act as a loan made under the PPP during the covered period. A covered loan may be forgiven under Section 1106 of the CARES Act.

The covered period for making covered loans refers to the period beginning on February 15, 2020, and ending on December 31, 2020. The covered period initially was to end on June 30, 2020, but the Paycheck Protection Program Flexibility Act of 2020, signed into law on June 5, 2020, extended the end date of the covered period to December 31, 2020.

An individual or entity that is eligible to receive a covered loan (eligible recipient) can receive forgiveness of the full principal amount of the covered loan up to an amount equal to the following costs incurred and payments made during the covered period: (1) payroll costs, (2) interest on a covered mortgage obligation, (3) any covered rent obligation payment, and (4) any covered utility payment (eligible expenses).

Under Section 1106(i) of the CARES Act, income from the forgiveness of a PPP loan is excluded from gross income. In May, the IRS issued Notice 2020-32, which clarified that no deduction is allowed for an eligible expense that is otherwise deductible if the payment of the eligible expense results in forgiveness of a covered loan. Notice 2020-32 relied on Code Sec. 265(a)(1) and Reg. Sec. 1.265-1, which provide that no deduction is allowed for any amount otherwise allowable as a deduction to the extent the amount is allocable to one or more classes of income other than interest wholly exempt from income taxes. This rule applies "whether or not any amount of income of that class or classes is received or accrued." The term "class of exempt income" means any class of income that is either wholly excluded from gross income under any income tax provision or wholly exempt from income taxes under the provisions of any other law.

On November 17, the IRS issued Rev. Rul. 2020-27 and Rev. Proc. 2020-51. Rev. Rul. 2020-27 discusses the deductibility of expenses paid with PPP funds and confirms, and expands on, the guidance previously issued in Notice 2020-32. Rev. Proc. 2020-51 provides a safe harbor which allows the deduction of PPP expenses if the taxpayer's PPP loan is not forgiven, or is only partially forgiven.

Rev. Rul. 2020-27

In Rev. Rul. 2020-27, the IRS describes two situations. In Situation 1, a taxpayer with a PPP loan uses the loan to pay eligible business expenses (i.e., payroll costs, mortgage interest, utility payments and rent) during the period beginning on February 15, 2020, and ending on December 31, 2020. In November 2020, the taxpayer applies 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 the taxpayer's payment of the eligible expenses, all requirements for forgiveness of the covered loan are satisfied. The lender does not inform the taxpayer whether the loan will be forgiven before the end of 2020.

In Situation 2, a taxpayer with a PPP loan paid the same types of eligible expenses as the taxpayer in Situation 1 paid during the covered period. However, unlike the taxpayer in Situation 1, the taxpayer in Situation 2 did not apply for forgiveness of the covered loan before the end of 2020, although his payment of the eligible expenses during the covered period satisfied all other requirements for forgiveness of the covered loan. The taxpayer in Situation 2 expects to apply for loan forgiveness of the covered loan in 2021.

The IRS observed that besides relying on Code Sec. 265(a)(1) and the regulations thereunder to conclude that taxpayers who have their PPP loans forgiven cannot deduct the related expenses for which the PPP loan was used, Notice 2020-32 also relied on authorities holding that deductions for otherwise deductible expenses are disallowed if the taxpayer receives or expects to receive reimbursement for such expenses. For example, the IRS noted, in Burnett v. Comm'r, 356 F.2d 755 (5th Cir. 1966), a lawyer advanced expenses to clients that the clients were obligated to repay only to the extent the lawyer was successful in obtaining recovery on the client's claim. The taxpayer argued that the advances were deductible trade or business expenses under Code Sec. 162 because there was no unconditional obligation on the part of the clients to repay the advances. The Tax Court rejected that argument, noting that the taxpayer provided assistance only to clients with claims that were likely to be successful and that the advances were made to clients with the expectation, substantially realized, that they would be recovered. On that basis, the Fifth Circuit affirmed the Tax Court's holding that the advances were not deductible.

The IRS noted that, in both Situation 1 and Situation 2, the taxpayers have a reasonable expectation of reimbursement. At the end of 2020, the reimbursement of the taxpayers' eligible expenses, in the form of covered loan forgiveness, is reasonably expected to occur - rather than being unforeseeable - such that a deduction is inappropriate. The loan forgiveness application procedures published by the SBA, the IRS observed, provide covered loan recipients like the taxpayers in Situation 1 and Situation 2 with clear and readily accessible guidance to apply for and receive covered loan forgiveness. Under these procedures, each taxpayer calculates the amount of its covered loan forgiveness on the basis of the eligible expenses paid or accrued in the covered period and submits a completed form and supporting documentation to their covered loan lender. Within 60 days of receipt of an application for forgiveness, their covered loan lenders are required to issue a decision regarding the taxpayers' applications. Accordingly, the IRS ruled that the eligible expenses of the taxpayers in both Situation 1 and Situation 2 are not deducible because there is a reasonable expectation of reimbursement.

Rev. Proc. 2020-51

In Rev. Proc. 2020-51, the IRS provides a safe harbor procedure under which a taxpayer may claim a deduction in the taxpayer's tax year beginning or ending in 2020 (2020 tax year) for certain otherwise deductible eligible expenses if (1) the eligible expenses are paid or incurred during the taxpayer's 2020 tax year, (2) the taxpayer receives a covered loan guaranteed under the PPP, which at the end of the taxpayer's 2020 tax year the taxpayer expects to be forgiven in a tax year after the 2020 tax year (subsequent tax year), and (3) in a subsequent tax 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. In this case, under Rev. Proc. 2020-51, the taxpayer 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 tax year; (2) an amended return or an administrative adjustment request (AAR) under Code Sec. 6227 for the 2020 tax year, as applicable; or (3) the taxpayer's timely filed, including extensions, original income tax return or information return, as applicable, for the subsequent tax year.

Compliance Tip: In order to deduct these expenses, the taxpayer must attach a statement, as described in Rev. Proc. 2020-51, to the return on which the taxpayer deducts the eligible expenses.

Finally, nothing in Rev. Proc. 2020-51 precludes the IRS from examining other issues relating to the claimed deductions, including the amount of any deductions taken and whether the taxpayer has substantiated the deduction claim. It also does not preclude the IRS from requesting additional information or documentation verifying any amounts described in the statement attached to the taxpayer's return.

For a discussion of the deductibility of expenses relating to nontaxable income, see Parker Tax ¶85,125.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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