Some tax professionals felt fairly assured that businesses could deduct expenses funded with Paycheck Protection Program loans if they’re forgiven in a later tax year, but now the government may step in and shut that down.
The guidance would follow up on Notice 2020-32, 2020-21 IRB 837, in which the IRS said expenses funded with forgiven PPP loans weren’t deductible so as to avoid a double tax benefit. That led many tax and business advisers to point out that if the loans hadn’t been forgiven by the end of 2020 or the taxpayer’s fiscal year, technically they wouldn’t violate the notice to deduct expenses funded with the PPP loans.
Christopher W. Hesse of CliftonLarsonAllen LLP told Tax Notes he didn’t see the forgiveness of PPP loans as an overly complex or confusing issue. He said that if the IRS and Treasury issue guidance on the straddle-year issue, they need to address case law on the issue.
“If the PPP isn’t forgiven by year-end, it is a loan,” Hesse said. “Expenses are deductible. It’s that easy.”
Hesse said that in the next year, to the extent the PPP loan is forgiven, the taxpayer has tax benefit income under section 111. That follows the principles of Hillsboro National Bank v. Commissioner and United States v. Bliss Dairy Inc., 460 U.S. 370 (1983), he said.
“I’m surprised no one has mentioned the underlying principles,” Hesse added. “We have an annual accounting concept. We look at what we have at year-end, not events that happen after the end of the year.”
But the IRS and Treasury are now considering whether to address the issue head-on.
Edward S. Karl of the American Institute of CPAs said Treasury officials told him they anticipated issuing more guidance before the end of the year, and possibly by the end of November, generally stating that if a borrower has a reasonable expectation of loan forgiveness, the expenses can’t be deducted to the extent they’re paid for with the loan. That’s true regardless of when the loan is forgiven, Karl added.
The IRS and Treasury didn’t respond to Tax Notes’ requests for comments, but IRS Chief Counsel Michael Desmond said November 10 at the American Bar Association Section of Taxation virtual tax conference in Philadelphia that the government is considering more guidance.
The IRS has gotten many questions about PPP loan forgiveness guidance, “and we are certainly considering those questions,” Desmond said. “I would stay tuned and see what may come out of that, but certainly I’ve heard a lot of folks asking for guidance related to the loan forgiveness,” he said, noting that the PPP ends at the end of the year.
The loan program was created by the Coronavirus Aid, Relief, and Economic Security Act (P.L. 116-136), enacted March 27, and it 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 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 tax free. The initial covered period to spend the proceeds was just two months, but it was later extended.
The PPP was designed to provide quick liquidity to struggling businesses, and it largely worked — half a billion dollars in loans were granted to over 5 million businesses. But reports of abuse continue, and now some businesses that expected the forgiveness process to be fairly straightforward are having buyer’s remorse.
The government released a few rounds of forms and instructions to make forgiveness easier for borrowers of small amounts and those that didn’t have major workforce reductions. But recently the Small Business Administration released a questionnaire for borrowers of amounts greater than $2 million that some said appeared to move the goal posts.
The debate over the deductibility of expenses has raged since the CARES Act was enacted. Now, with Treasury and the IRS seemingly on the verge of clamping down on straddle-year planning with PPP loans, some hope the issue will be fixed legislatively.
A bipartisan group of lawmakers is pushing legislation (S. 3612) that would allow businesses to deduct expenses associated with their PPP loans. Senate Finance Committee member John Cornyn, R-Texas, has acknowledged the disagreement with the Trump administration on the issue, saying he and Treasury Secretary Steven Mnuchin don’t see eye to eye.
The AICPA is focusing on a legislative resolution to the problem.
“Our number one position is that we’re advocating for the legislative fix, which would basically overrule the notice the IRS put out,” Karl said. The notice seems to allude to the nondeductibility of the expenses when there’s an overlapping year, but it’s not clear, and that’s what Treasury plans to clarify, he added.
Same Notice, Different Arguments
Nathan T. Smith of CBIZ Inc. says Notice 2020-32 presents two arguments as to why expenses funded with forgiven PPP loans shouldn’t be deductible.
The first argument is based on section 265, which is predicated on tax-exempt income. Under section 265, a deduction isn’t allowed when it is allocable to tax-exempt income. But without tax-exempt income firmly established as a fact during the year that the expenses are incurred, section 265 cannot be triggered during that year, Smith told Tax Notes.
“This result follows from the basic requirement to base tax returns on facts that exist by the last day of the tax year, which the IRS also endorsed in CCA 201619009,” Smith said. “The courts have long held that any other system of tax reporting would be impractical, because tax returns would be held in abeyance indefinitely until the time that various contingencies get resolved.”
The so-called tax benefit rule emerged to address that problem, whereby gross income must be recognized in a later year when facts materialize to require a recapture of a tax benefit, Smith said.
The second argument in the notice, he noted, is that expenses aren’t deductible when there is an expectation of reimbursement.
“Consistent with a similar finding in TAM 7937007, the IRS position is that the year 1 expenses are nondeductible when there is a sufficient degree of certainty during year 1 for reimbursement during year 2,” Smith said.
Because the government offered two different positions for nondeductible treatment, the ancillary question about timing must be addressed discretely under each of those positions, Smith said. And as it turns out, the answer to the timing question appears to be different depending on which of the two positions from Notice 2020-32 a taxpayer chooses to follow, he added.
The primary and the alternative positions in Notice 2020-32 are distinct because receiving tax-exempt income isn’t the same as receiving an expense reimbursement, Smith said. He pointed to a few court decisions that held that expense reimbursements aren’t tantamount to gross income, and other cases showing instead that the reimbursement reduces the amount of the deduction. The rationale for that conclusion is that the taxpayer hasn’t made an expenditure or cost outlay, Smith said.
“On the other hand, the primary position that relies on section 265 relies on the existence of tax-exempt income — in this case loan forgiveness income,” Smith said. “So pick your poison — either tax-exempt income (income exists) or expense reimbursement (no income exists). Two different timing answers, depending on which one you pick.”