Are Expenses Paid with Forgiven PPP Loan Proceeds Tax Deductible?

Year-End planning hits a brick wall of congressional inaction. Are expenses paid with forgiven PPP loan proceeds tax deductible or not?

See update to post from January 12, 2021 below.

The answer is similar to deciding who’s the best “picker” in Dueling Banjos.

Let’s begin this discussion with a little background and the intent of Congress. In the CARES Act (PL 116-136, §1102), the PPP provision was born. Without getting into the nuances of the 8-week vs. 24-week payroll covered period, suffice it to say the government intended to provide a means to keep payroll going for businesses suffering through the COVID-19 pandemic. If enough PPP money was spent on payroll (see previous blogs referencing the 75% or 60% rule), then the PPP loan would be forgiven in full. (§1106 of the CARES Act)

Well, almost as soon as the CARES Act was made law, inquiring minds began to ask a fundamental question:

“If qualified expenses are paid with tax-free money, are those expenses still tax-deductible?” 

The IRS was quick to reply to this concern and on April 30, 2020, released IRS Notice 2020-32, which states pretty clearly on page 6 of the Notice:

NON-DEDUCTIBILITY OF PAYMENTS TO THE EXTENT INCOME RESULTING FROM LOAN FORGIVENESS IS EXCLUDED UNDER SECTION 1106(i) OF THE CARES ACT To the extent that section 1106(i) of the CARES Act operates to exclude from gross income the amount of a covered loan forgiven under section 1106(b) of the CARES Act, the application of section 1106(i) results in a “class of exempt income” under §1.265- 1(b)(1) of the Regulations. Accordingly, section 265(a)(1) of the Code disallows any otherwise allowable deduction under any provision of the Code, including sections 162 and 163, for the amount of any payment of an eligible section 1106 expense to the extent of the resulting covered loan forgiveness (up to the aggregate amount forgiven) because such payment is allocable to tax-exempt income. Consistent with the purpose of section 265, this treatment prevents a double tax benefit.

As soon as the Notice was released, new questions emerged:

1. What if my loan is not forgiven?
2. What if my loan is forgiven in 2021?
3. Should I expect my loan to be forgiven and then react by amending my 2020 return if part or all of the loan ends up not being forgiven?

Congress did make a bipartisan attempt to answer your fears. Senate Bill 3612, the Small Business Expenses Protection Act of 2020, was introduced on May 5, 2020, to address this issue.  The goal was to permit reasonable and necessary business expenses paid with forgiven PPP money to still be deductible business expenses.  No action has been taken on this measure as of this blog’s date, so all we can do is wait as the final days of 2020 mercifully slip away.

Let’s attempt to answer (or at least, discuss) the questions posed previously from the standpoint of the dueling banjos—IRS vs. the legal and accounting community.

Question 1: What if my loan is not forgiven? 

Here we believe the dueling banjos agree. Indeed, if the loan is not forgiven, then we don’t have the IRS position of expenses being paid with tax-exempt income. The expenses paid with the PPP money are deductible business expenses. The legal and accounting community agree with this assessment, as well. However, the issue really revolves around when and if the PPP loan is forgiven.

Questions 2 and 3: What if my loan is forgiven in 2021? Should I expect my loan to be forgiven and then react by amending my 2020 return if part or all of the loan ends up not being forgiven?

Here’s where the banjos start their dueling. Per the IRS guideline, if you reasonably expect your PPP loan proceeds will be forgiven, you cannot deduct the expenses paid with the expected forgiven PPP money. If the reality after filing your forgiveness paperwork is that part or all your PPP loan was not forgiven, then you should go back and amend your 2020 tax return and claim the previously omitted expenses.

The legal and accounting community tends to disagree with this position. 

You can find many well educated and experienced writers who will state that only after the reality (SBA final approval or denial of loan forgiveness) of PPP non-forgiveness occurs must you address what you did on a 2020 filing. In other words, if you fully deducted 2020 expenses paid with PPP loan proceeds under the belief that you have no idea how SBA would respond, it would only be after a positive forgiveness result from SBA that you would add an income line item on your 2021 return (since that’s the year that loan forgiveness or lack thereof was finalized) for previously deducted PPP expenses. Amending the 2020 return would be unnecessary.

IRS does not agree or acquiesce to this position.

It is also worth noting that in IRS Notice 2020-32, the IRS uses IRC§265 for their rationale, which basically states that interest is not a deductible expense when tax-exempt income is involved.

If anyone has ever addressed debt forgiveness from the perspective of not including the forgiven debt in income under the rules provided (i.e., bankruptcy, insolvency, qualified farm or business property, qualified principal residence indebtedness, etc.),  you never had to go back and remove expenses that may have been deducted from the previously borrowed funds, which now are not being repaid. The unpaid debt was either included in income or excluded from income under the rules stated previously. If the debt forgiveness was not included as part of income, you had to adjust the basis of assets or tax preference items (see instructions for IRS Form 982).

In my opinion, it seems a stretch for the IRS to use §265 as their rationale for the position taken in Notice 2020-32.  Nevertheless, my opinion and a nickel will not even get you a cup of coffee.

Barring action by Congress, it may be aggressive to go against the IRS guidance of Notice 2020-32. However, as you all well know, the final decision is up to the taxpayer.  Your job is to present the options to the taxpayer and be prepared to defend the position.

Who knows, maybe we’ll get some guidance from our government soon, and we can forget all about this mess and just enjoy Steve and Kermit dueling away.

We all could use a little Deliverance about now…

Update 1: IRS adds a new verse to Dueling Banjos on November 18

IRS released Revenue Ruling 2020-27 on November 18, which would appear to put this matter to rest at least until Congress takes additional action. The Revenue Ruling uses the language of “reasonably expect” regarding PPP loan forgiveness. By that statement, the ruling concludes, if a borrower reasonably expects to receive PPP loan forgiveness, then the expenses paid with anticipated tax-free PPP proceeds are not tax-deductible. The accompanying press release from Treasury encourages borrowers to file for forgiveness sooner than later. Perhaps the reality of PPP loan forgiveness can be known by the borrower before year-end.

In conjunction with Revenue Ruling 2020-27, the IRS issued guidance in Revenue Procedure 2020-51, which includes a safe harbor provision for taxpayer borrowers. The safe harbor rules permit a taxpayer to claim deductions for expenses paid with PPP loan proceeds and initially left off the 2020 return because the borrower anticipated the PPP loan would be forgiven. When the loan forgiveness is finalized, and the borrower learns that loan forgiveness is not granted for all or part of the PPP borrowing (or if the borrower decided not to request forgiveness), the safe harbor permits a taxpayer to claim the previously omitted PPP related expenses on a 2020 return not yet filed, an amended 2020 return, or in 2021 if not claimed on the 2020 filing.

The purpose is to allow taxpayers to deduct expenses either in 2020 or 2021 when they discover their expenses were not paid in whole or part with tax-free money (the part of the PPP loan not forgiven or requested to be forgiven).

The key here continues to be the IRS position that expenses are not deductible when paid with tax-free dollars. Forgiven PPP proceeds are tax-free dollars, in the opinion of the IRS. Another item worth noting is that taxpayer borrowers can only deduct expenses equal to the amount of PPP borrowing not forgiven in the event of partial forgiveness.

Taxpayer borrowers applying the safe harbor provision must attach a statement to what they are doing by following the instructions outlined in the Rev. Proc.

Congress appears to be firing back with a verse of their own in response to the IRS Revenue Ruling. It looks like there is increasing bipartisan support for Senate Bill 3612, which hopefully can spell the final chord to this rendition of dueling banjos.

Stay tuned!

Update 2: The “final” shot (at least for now) is fired when President Trump signed the Consolidated Appropriations Act (CAA) on December 27, 2020.

Congress now allows expenses paid with tax-free PPP money to be tax-deductible (Sec. 304 of CAA). This part of the new law, in essence, replaces Rev. Rul. 2020-27 that the IRS issued in November, which had told us expenses paid with tax-free money would not be deductible. Hopefully, this simplification alleviates some of the angst we all faced for the last eight weeks or so. Remember that Congress makes the laws while the job of the IRS is to enforce those laws.

So now we know, without speculation or discussion, that the law of the land is expenses paid with tax-free PPP funds are deductible.

Caution: Watch out for states decoupling from this position as well as other federal tax cuts. For example, in Illinois, the governor has proposed just such a decoupling in order to save hundreds of millions of dollars in the state budget.

Perhaps you can spend the extra time you now have deciding who won the dueling banjo contest between Steve Martin and Kermit the Frog…

by Tom O’Saben, EA