Since the inception of the PPP loan program, practitioners have feared that if a PPP loan is granted, federal income tax deductions for eligible expenses funded by the loan would be denied under one of several legal theories. In general, Section 265 (a) of the Internal Revenue Code (Code) does not allow otherwise permitted deductions if the expense falls within a “class” of income that is either exempt or non-taxable. In addition, authorities believe that deductions are not allowed if expenses are reimbursed or reimbursement is reasonably expected or reimbursement is foreseeable (for expenses incurred in a tax year prior to reimbursement). The purpose of these rules is to prevent a taxpayer from receiving a double benefit – a tax deduction related to income that is either tax exempt or excluded from income. Would a waived PPP loan that is excluded from income under the CARES Act constitute such a prohibited benefit?
In the IRS Notice 2020-32, published May 2, 2020, the IRS replied “Yes”. Citing Code Section 265 (a) (1) and the reimbursement authorities, the IRS determined that no deduction is allowed for eligible expenses in support of PPP loan issuance. Prohibiting deductions for reimbursable expenses that may be attributable to waived PPP loans prevents borrowers from enjoying this classic double tax benefit.
The notice is silent on the timing, effectively ignoring established precedent and raising the question of whether deductions for eligible expenses paid or accrued in a tax year are not allowed if the forgiveness occurs after the end of that year. According to Small Business Administration guidelines, a PPP borrower is required to apply to their lender for loan waiver. The process takes time and some borrowers may be refused forgiveness. So what happens if a PPP loan is outstanding at the end of a tax year, the taxpayer has paid or incurred qualified expenses that year, and the taxpayer has applied for a PPP loan waiver or not by the end of the year? Year?
In Rev. Rul. 2020-27, published November 18, 2020, the IRS determined that deductions for eligible expenses are not allowed if the borrower has a reasonable expectation that their PPP loan will be based on eligible expenses paid or accrued during the tax year is waived, regardless of whether or not the taxpayer has submitted an application for waiver by the end of the tax year.
The judgment was accompanied by Rev. Proc. 2020-51, which provides a safe haven for taxpayers to claim deductions for eligible expenses funded by a PPP loan. Eligible expenses are deductible if (i) the taxpayer has paid or incurred eligible expenses in his 2020 tax year for which no deduction was permitted under the “reasonable expectations” rule, (ii) the taxpayer applied for or intended to be waived, until the end of his 2020 tax year and (iii) in a subsequent tax year either (A) forgiveness has been refused in whole or in part or (B) the taxpayer irrevocably decides not to request forgiveness in whole or in part (including the withdrawal of his request for forgiveness) . The revenue process provides guidelines for taxpayers to apply for relief on an originally filed tax return, amended tax return, or request for regulatory correction.
The IRS may not have the final say. In response to the IRS announcements, Senate Finance Committee Chairman Chuck Grassley (R-Iowa) and ranking member Ron Wyden (D-Ore.) Issued a joint statement criticizing the central position of the IRS on that Eligible expenses are not deductible, and the other restrictions imposed by the “reasonable expectation” rule. The Senators condemned the IRS’s positions as inconsistent with the intent of Congress and reiterated their intention to reverse them in year-end legislation.