In an update to our previously released alert on this topic, Wednesday evening the Internal Revenue Service (IRS) released Revenue Ruling 2020-27 addressing the open issue of whether expenses paid with Paycheck Protection Program (PPP) loan proceeds could be deducted in a tax year prior to the tax year in which PPP loan forgiveness is determined. Revenue Ruling 2020-27 discusses the following two situations:
Situation 1 – Taxpayer A received a PPP loan, used the funds to pay eligible expenses during its covered period, satisfied all requirements under the CARES Act for forgiveness of the loan, and applied for forgiveness prior to the end of 2020. The lender does not inform Taxpayer A whether their loan will be forgiven by the end of 2020.
Situation 2 – Taxpayer B received a PPP loan, also used the funds to pay eligible expenses during its covered period, also satisfied all requirements under the CARES Act for forgiveness of the loan, but does not intend to apply for forgiveness until sometime in 2021.
The holding reached by the IRS in Revenue Ruling 2020-27 is that, in both Situation 1 and Situation 2, the expenses are not deductible in the year paid (2020) even if the application for forgiveness is not filed by the end of the year in which the expenses are paid. In determining their holding, the IRS’ position is that both Taxpayer A (Situation 1) and Taxpayer B (Situation 2) have a reasonable expectation of receiving forgiveness of their PPP loan on the basis of the expenses paid during their respective covered periods, because they know the amount of the eligible expenses that qualify for reimbursement in the form of loan forgiveness by the end of the 2020 tax year.
To provide some background, earlier this year, the IRS issued Notice 2020-32 which indicated that no deduction would be allowed for eligible expenses otherwise deductible if the payment of those eligible expenses resulted in the forgiveness of a PPP loan (see our release discussing Notice 2020-32). The IRS’ position is consistent with IRC Section 265(a)(1), and the Regulations thereunder, which provide that expenses allocable to tax-exempt income are not deductible. The Regulations further clarify that this expense disallowance rule applies whether income is received or accrued. The IRS also relied on several authoritative cases that held that deductions for otherwise deductible expenses are disallowed where the taxpayer receives reimbursement for the expense or has a reasonable expectation of reimbursement.
There is much commentary amongst professionals about how the intent of the CARES Act, specifically the PPP loan program, was to have the loan forgiveness be tax-free and the expenses paid with the loan proceeds deductible. Thus, the IRS’ holding in Revenue Ruling 2020-27 is contradictory to the intent of the PPP loan program. Further, there appears to be bipartisan support in favor of allowing taxpayers to have both tax-free loan forgiveness and deductible expenses. At this time, however, it is undetermined if Congress will fix this with the passing of the next stimulus package.
If 2020 wasn’t already complicated enough, this adds yet another wrinkle to the already complex year-end tax planning process. Many taxpayers may find themselves with a significant amount of unexpected taxable income. Further, pass-through entities such as partnerships, LLCs, and S-corporations operating in New Jersey will need to consider the impact of this Ruling on the new NJ BAIT which is available for 2020 to electing taxpayers. See our alert on the NJ BAIT here. Please reach out to your WG Advisor if you have questions or if you’d like to discuss these issues further.