The IRS closed the door on taking deductions funded with forgiven small business loans, and with Congress dragging its feet on addressing the issue, businesses are wondering if timing can be used as a workaround.
Some recipients of the Paycheck Protection Program loans are skeptical about whether the IRS’s position disallowing deductions funded with loans that are later forgiven is even correct, and some are considering not following the recent guidance on the topic.
Other businesses are wondering whether they can take deductions on their 2020 tax returns for expenses like rent and paying employees if their loans aren’t forgiven until 2021.
The loan program was created by the Coronavirus Aid, Relief, and Economic Security Act (P.L. 116-136), enacted March 27, and gave employers options to keep paying their workers during the coronavirus pandemic. Those options include the PPP and an employee retention tax credit that provides a fully refundable credit against the employer’s portion of payroll taxes. However, only $10,000 in wages per employee can be counted for all calendar quarters, and the credit is capped at $5,000 per employee.
An employer must forgo that credit if it wants to apply for a PPP loan, and jump through several other hoops to qualify for the loan. But if an employer does qualify and a specific portion of the proceeds is used to fund payroll costs over a covered period, the loan is forgiven on a tax-free basis. The initial covered period to spend the proceeds was just two months, but it was later extended.
Right after the CARES Act was enacted, practitioners wondered if the tax-free forgiveness of the loans would pose problems for deducting expenses funded with the proceeds.
The IRS addressed the issue by releasing Notice 2020-32, 2020-21 IRB 837, and said that to the extent the loan forgiveness under the PPP is excluded from income, it’s considered a “class of exempt income” under regulations promulgated under section 265.
“Consistent with the purpose of section 265, this treatment prevents a double tax benefit,” the IRS said.
Timing Is Everything
Adam Sweet of Eide Bailly LLP said some businesses are wondering if they can take the expenses with PPP proceeds in 2020 if the loans aren’t forgiven until the next year.“Most lenders still are not ready to process forgiveness applications, and so it appears full forgiveness, for most borrowers, may not occur until 2021,” Sweet said. “For borrowers with PPP loans forgiven in 2021, there is no ‘class of exempt income’ in 2020, and therefore some wonder if a borrower could deduct its PPP expenditures on its 2020 tax return.”
Sweet, formerly of the IRS Office of Chief Counsel, said there could be some form of equitable recoupment on the 2021 tax return when the loan is actually forgiven.
“This issue is also currently live for fiscal-year entities,” Sweet said. “For instance, businesses with a June 30 tax year may be preparing tax returns this fall — after filing extensions — and deciding whether to deduct PPP expenditures because the PPP loan was not forgiven as of June 30.”
And some businesses suggest the underlying rationale of Notice 2020-32 is questionable, particularly given that Congress clearly intended a tax benefit when providing that a forgiven PPP loan doesn’t result in income, Sweet said.
“There may be taxpayers who therefore take a position contrary to Notice 2020-32, perhaps with a disclosure, and it will be interesting to see if any IRS audits and eventual court cases result,” Sweet added.
Congress still can’t seem to decide how — and whether — it will address the issue.
Ryan L. Losi, a CPA at Piascik, said it’s not until the loan is forgiven that the taxpayer would have a triggering event under Notice 2020-32. The bank formally releasing the taxpayer’s debt will be the triggering event, and the year in which in that happens will be decisive, Losi said.
“I think the majority of taxpayers are still going to have that loan on their books as of December 31,” Losi said. “My argument is the whole issue of deductibility for salary and rent — it’s not an issue until 2021.”
However, it still puts businesses in a tight spot this year.
Third-quarter estimated payments for businesses were due September 15, and fourth-quarter payments are due January 15, Losi noted. The conservative position is to not take the deductions funded with PPP loan proceeds for the 2020 tax year, but few businesses are interested in taking that position, he added.
For businesses that don’t opt for the conservative position, the 2021 tax return becomes more interesting. Losi said that in 2021, a business that takes the deductions in 2020 might have an item of income in 2021, which he referred to as a book-tax difference that would show up on a taxpayer’s Schedule M-1, “Reconciliation of Income (Loss) and Analysis of Unappropriated Retained Earnings per Books.”
“I’ve been telling business owners to call their congressman and lay into them, because they opened this can of worms and they haven’t closed it,” Losi said.
While businesses and practitioners are still figuring out what to do with expenses funded with PPP proceeds, the IRS has also muddied the waters, according to one practitioner.
The IRS on September 11 released Announcement 2020-12, 2020-41 IRB 1, which said lenders don’t need to file information returns or furnish payee statements to report the amount of forgiven loans. Under section 6050P, an applicable entity that discharges at least $600 of a borrower’s indebtedness generally must file Form 1099-C, “Cancellation of Debt,” with the IRS and furnish a payee statement to the borrower.
The announcement waives that requirement for PPP forgiveness, which raises several questions, Monte Jackel of Jackel Tax Law said.
“Is this an invitation to claim expenses of PPP loans as deductible despite the IRS guidance to the contrary?” Jackel asked. “Or is it saying that the PPP loan is not indebtedness? Or is it really the rationale stated?”
Jackel said the announcement implies, but doesn’t state, that the PPP is indebtedness under the tax law and implies that reporting on Form 1099-C is technically required. It also says taxpayers might get confused about getting the form even though the canceled debt is excluded from gross income under the CARES Act.
“This is odd because Form 1099-C is issued to taxpayers who may be able to exclude the item from gross income under section 108,” Jackel said.