The Coronavirus Aid, Relief, and Economic Security Act (“CARES”) clearly states that PPP loan forgiveness will result in cancellation of debt income that is not taxable. In addition, the IRS clarified through Notice 2020-32 that the expenses paid with PPP debt that is ultimately forgiven are not deductible. The IRS relied on §265 in the Notice, which provides that no deduction is allowed to a taxpayer for any amount otherwise allowable as a deduction that is allocable to income that is wholly exempt from the tax.
The IRS has provided clarification through Rev Rule 2020-27 that the timing of the debt relief application being filed by the taxpayer is irrelevant for taxpayers in determining the timing of the disallowance of expenses incurred in 2020 if, at the end of such taxable year, the taxpayer reasonably expects to receive forgiveness of the covered loan on the basis of the expenses it paid or accrued during the covered period, even if the taxpayer has not submitted an application for forgiveness of the covered loan by the end of such taxable year.
The following example was provided in the Ruling:
Situation:
During the period beginning on February 15, 2020, and ending on December 31, 2020 (covered period), Taxpayer B paid eligible expenses. These expenses include payroll costs, interest on a mortgage that qualifies as interest on a covered mortgage obligation, utility payments that qualify as covered utility, and rent that qualifies as payment on a covered rent obligation under section 1106 of the CARES Act. B did not apply for forgiveness of the covered loan before the end of 2020, although, considering B’s payment of the eligible expenses during the covered period, B satisfied all other requirements under section 1106 of the CARES Act for forgiveness of the covered loan. B expects to apply to the lender for forgiveness of the covered loan in 2021.
Analysis:
Although B did not complete an application for covered loan forgiveness in 2020, at the end of 2020, B satisfied all other requirements under section 1106 of the CARES Act for forgiveness of the covered loan and at the end of 2020 expected to apply to the lender for covered loan forgiveness of the covered loan in 2021. Thus, at the end of 2020 B both knew the amount of its eligible expenses that qualified for reimbursement, in the form of covered loan forgiveness, and had a reasonable expectation of reimbursement. The reimbursement in the form of covered loan forgiveness was foreseeable. Therefore, pursuant to the foregoing authorities, B may not deduct B’s eligible expenses in 2020.
Based on the IRS guidance, it’s clear that the IRS position for cash and accrual basis taxpayers is to disallow the expenses paid with PPP debt that will ultimately be forgiven in 2020 if the taxpayer reasonably expects to receive forgiveness of the covered loan.
It now appears, due to the issuance of this ruling, that taking a position that the disallowance of expenses should occur in 2021 and not 2020 would be a more aggressive position than before the issuance of this ruling.
If a net operating loss is generated in the 2020 taxable year, under the CARES act the rules were modified to allow the net operating loss to be carried back five years and carried forward indefinitely and not be subject to an income limitation. Accordingly, there is an overall drive to push more expenses into 2020, rather than 2021 mainly related to the federal net operating loss rules. The ability to carryback the loss five years generally allows a higher effective tax rate to be offset and therefore has a more significant cash impact. However, if a loss is generated in 2021 there is no carryback allowed at the federal level, and the loss can be carried forward indefinitely but can only offset 80 percent of taxable income.
Many taxpayers are still holding out hope that there will be a Congressional law that clarifies and solidifies the intent of the bipartisan congressional leaders in that expenses paid with PPP debt that is ultimately forgiven are indeed deductible. However, the longer it takes for Congress to act, the more nervous taxpayers become. Stay tuned for more guidance on this issue.
The information presented here should not be construed as legal, tax, accounting, or valuation advice. No one should act on such information without appropriate professional advice and after a thorough examination of the particular situation.