On November 18, the IRS provided clarification on the Paycheck Protection Program (PPP) and taxability. The IRS clarified 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:
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.
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.
Analysis Prior to Issuance of Rev, Rul. 2020-27
While 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, the IRS clarified on May 2 through Notice 2020-32 that the expenses paid with PPP debt that is ultimately forgiven are not deductible. This would include payroll costs, interest on a mortgage that qualifies as interest on a covered mortgage obligation, utility payments that qualify as covered utility payments, and rent that qualifies as payment on a covered rent that was paid with PPP funding that was ultimately forgiven. 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.
When Notice 2020-32 was released, many questions started circulating regarding whether the timing of the PPP debt forgiveness loan application could impact when the expenses paid with PPP debt that is ultimately forgiven would be denied for cash basis taxpayers. A cash basis taxpayer generally does not recognize income until cash is received and deducts expenses when paid. Therefore, it appeared that a cash basis taxpayer would not generate wholly exempt income under §265 in 2020, and therefore it was believed that a reasonable position was that the expenses paid with PPP would not be disallowed, until the debt forgiveness loan application was approved and would be included in income in 2021 under the tax benefit rule.
For example, assume that ABC Partnership, a cash basis taxpayer, received a PPP loan for $600,000. During the 24-week covered period, ABC Partnership utilized the entire $600,000 principal on payroll costs. ABC Partnership did not apply for debt forgiveness until January of 2021. Due to the partnership being a cash basis taxpayer, it was assumed that the PPP debt forgiveness did not become wholly exempt income until 2021 and therefore the expenses would not be disallowed until 2021. This would result in the payroll costs being deducted in 2020 and recaptured through the tax benefit rule as income in 2021. Under the related “tax benefit rule,” if a taxpayer takes a proper deduction and, in a later tax year, an event occurs that is fundamentally inconsistent with the premise on which the previous deduction was based the taxpayer must take the deducted amount into income.
So What’s Changed?
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.
Even though there are still a number of alternative positions that taxpayers may take in opposition to the IRS guidance, including the congressional intent and that Notice 2020‐32 may be flawed in its analysis of Section 265(a) applicability, depending on a taxpayer’s risk tolerance, they may still consider allowing the expenses to be deducted. However, this position may require Form 8275, Disclosure Statement, to be attached to the tax return.
Other Related Issues and Considerations
What if a portion of the PPP Debt Forgives is denied in a later year or the debt forgiveness application withdrawn?
Revenue Procedure 2020-51 provides a safe harbor for certain Paycheck Protection Program loan participants, whose loan forgiveness has been partially or fully denied, or who decide to forego requesting loan forgiveness, to claim a deduction for certain otherwise deductible eligible payments on
- The taxpayer’s timely filed, including extensions, original income tax return or information return, as applicable, for the 2020 taxable year; or
- An amended return or an administrative adjustment request (AAR) under section 6227 of the Internal Revenue Code (Code) for the 2020 taxable year, as applicable.
For taxpayers that decide to forego requesting loan forgiveness, the safe harbor also allows these taxpayers to claim a deduction for the otherwise deductible eligible payments on an original income tax return or information return, as applicable, for the taxable year in which the taxpayer decides to forego requesting forgiveness.
Consideration needed for flow-throughs benefiting from 199A deduction
It is important to note that flow-through entities that rely on 199A deductions may want to be careful of what expenses they are choosing to assign to PPP funding that is ultimately forgiven. While at least 60 percent of PPP principal balance must be utilized for payroll in order to achieve full PPP forgiveness, that still leaves some flexibility on how the remaining 40 percent of PPP funds are utilized. If payroll expenses are ultimately used for forgiveness, and the IRS guidance is followed, the payroll deduction will decrease.
For the 2020 taxable year, if a married filing joint partner has qualified business income and reports taxable income above 326,600 (163,300 for single taxpayers) they are subject to certain wage and/or qualified property limitations in order to maximize their 199A deduction, and ultimately decrease the highest individual income tax rate to approximately 30 percent. If the payroll deduction is limited, it could impact the amount of 199A deduction allowable.
Why is the timing of the disallowed expenses so important?
There is an overall drive to push more expenses into 2020, rather than 2021 mainly related to the federal net operating loss rules. 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. 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.
While the federal tax law is complicated enough, another layer of complexity is added when analyzing the state income impact. For example, whether the cancellation of debt will be considered income for New York State purposes depends on the type of entity. New York State Article 22 taxpayers (including individuals, partnerships, and estates) completely detached from any federal changes made to the Internal Revenue Code after March 1, 2020. This would mean for New York State partnerships that the PPP debt forgiveness would be deemed income and the expenses would be allowed. However, Article 9 taxpayers, C Corporations, would follow the federal treatment. It will be important to analyze state income tax positions in year-end planning as well.
Potential legislative clarification
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.
What To Do Next?
We all know 2020 has been a challenging year, and it appears that tax planning for 2020 will be no different. At this point in time, it would appear the best strategy would be to wait to see if any additional guidance will be passed by Congress before filing finalized 2020 tax returns. For purposes of 2020 estimated tax payments, the importance of modeling the various tax scenarios continues to be increasingly important. We encourage all taxpayers to work with their tax advisors to weigh the impact of CARES, Families First Coronavirus Response Act, and various other clarification that was issued in 2020 relating to Tax Cuts Jobs Act of 2017.
Please contact our experts today to learn more and discuss your specific situation.
The information and advice we are providing for this matter relates to COVID-19 legislative relief measures. Because legislative efforts are still ongoing, we expect that there may be additional guidance and clarification from regulators that could modify some of the advice and information provided to you, after the conclusion of our engagement. We, therefore, make no warranties, expressed or implied, on the services provided hereunder.