Deductibility of Expenses Paid for with PPP Loan Proceeds
New York, NY — December 8, 2020
The Paycheck Protection Program ("PPP") has presented another dilemma when planning projected taxes for 2020 and 2021. At the time of initiation of the PPP, Congress said the forgiveness of the loan proceeds when used for the purpose intended is "tax-free". The IRS has turned that on its head and stated that if the forgiveness is tax-free, the expenses can't be deducted! We expect Congress and/or the IRS will provide further guidance on this issue. In the meantime, nothing needs be done at the moment except to plan for the fourth quarter 2020 estimated tax installment due January 15, 2021.
Below is a historic description of the PPP and our recommendations on planning payments. As more information becomes available, we will keep you informed.
When Congress enacted the Paycheck Protection Program in March, they stipulated that if the borrower used the loan proceeds to pay certain eligible expenses, the amount of the loan up to such eligible expenses would be forgiven under the law and such forgiveness would not be treated as taxable income to the borrower.
In April, the IRS retorted with Notice 2020-32 disallowing the deduction for any payroll or other expenses that resulted from the tax-free forgiveness of the PPP loan. They rested their justification on IRC Section 265 which disallows expenses incurred in the production of tax-free income. This provision is typically applied to interest and other investment expenses incurred in the production of tax-free municipal interest income; in such situations, the expense never equals the amount of the tax-free income.
There was a lot of chatter that Congress would override the IRS interpretation as contrary to legislative intent; however, to date, there hasn't been even a preliminary motion to that effect. In June, Congress pushed the tire down the road by extending the testing period from 8 to 24 weeks; accordingly, the issue of forgiveness is just coming to the forefront now. Many applications for loan forgiveness are now in process; however, the bulk of the forgiveness will not happen until early 2021.
In November we saw the presidential election indicating an expected change in Administrations come January. The new administration has promised to raise taxes on Day 1 assuming that they have the legislative support for that. Congress is now contemplating an additional stimulus bill which may contain further PPP Loans for specified industries and could clarify their intent with respect to the deductibility of expenses on forgiven PPP Loans. There has been much criticism of the Treasury/IRS's position, both from public as well as bipartisan Leadership of the Senate Finance Committee.
In light of all the uncertainty, tax professionals are grappling with how to handle the disallowance of expenses – in particular as it relates to the debt forgiveness. When should the debt forgiveness take place? 2020 or 2021 when rates could be higher? Normally the instinct is to defer income (expense disallowance) based on the time value of money.
To "eliminate" this speculation, on November 18, 2020, the IRS issued Revenue Ruling 2020-27, which addresses when a borrower under the PPP) should exclude the expenses as deductions when determining taxable income if used to obtain forgiveness of their PPP loan. In short, for a calendar year taxpayer, the expenses are non-deductible for year-end 2020 if there is a reasonable expectation of forgiveness, regardless of whether the borrower files a forgiveness application in 2020 or 2021 and of when the actual forgiveness event occurs. The ruling does not address fiscal year taxpayers, nor does it address how to allocate non-deductible expenses among the various expenses used for the loan forgiveness application.
Rather than clarifying the issue, the IRS ruling only fuels the controversy and begs the questions as to what to do. Given the uncertainty as to the ultimate outcome, it is best to keep options open by paying in what is required to avoid or minimize penalties for underpayment of 2020 taxes and defer the deduction or non-deduction of the expenses until the 2020 return is filed. To that effect:
Base 2020 payments on the prior year if it will safe harbor the taxpayer's estimates. If prior year tax base exceeds the current year projection and no further clarity is provided by January 15, 2021 decide whether to pay in an additional amount assuming the expenses are non-deductible.
Alternatively, pay in estimates assuming the expenses are deductible with the risk of three months of underpayment of estimated tax interest and wait for further guidance in April before extension payments are due.
If no clarity is provided by April, build the disallowance into the extension payment and wait to see what guidance is issued before the return is due six months later.
These recommendations and guidelines depend on specific client facts and circumstances, risk tolerance to penalties, and cash position, just to name two. Please feel free to contact your PW advisor if more information is requested.
Perelson Weiner is a full service Certified Public Accounting and consulting firm dedicated to serving the needs of successful entrepreneurs, high net worth individuals and families and international companies doing business in the United States. Perelson Weiner LLP is a member of the Center for Public Company Audit Firms and the Private Company Practice Section of the American Institute of Certified Public Accountants (AICPA). The firm is a member of PrimeGlobal, the third largest association of independent accounting firms in the world, comprised of over 350 highly successful independent public accounting firms in 90 countries.