IRS Crushes Hopes Of Deducting PPP-Paid Expenses Before Forgiveness Approval; But Questions Remain

I’m not proud to admit it, but I hate a lot of things. I don’t mean that certain things annoy me or I have a general distaste for them; I mean I hate them. I hate country music. I hate Newark Airport. I hate Tom Brady and jean shorts and the Full House reboot. 

But I hate none of those things with the intensity with which I hate PPP loans. 

It’s not that I’m against the idea of the government advancing money to small businesses to keep them afloat during an unprecedented global pandemic. That’s cool with me. No, what I hate about PPP loans is that they consistently force me to confront what I hate most of all: 

Being wrong. 

And I am ALWAYS wrong about PPP loans. I’ve been wrong so much, in fact, that it’s a wonder why anyone would still read anything I write about PPP loans. 

When the loans were first made available as part of the CARES Act back in April, I told people it was a come one, come all-style gold rush. After all, the legislative text simply required that the “the uncertainty of economic conditions as of the date of the application makes necessary the loan request to support the ongoing operations of the recipient,” and given that we were, you know…in the midst of a nationwide shutdown, I thought it was safe to say there was considerable “economic uncertainty,” and that the government wouldn’t press the issue as to whether this standard had been met. 

But I was wrong.

By mid-April, after public backlash arose when news broke of a couple of high profile borrowers grabbing their share of the PPP pie, the Small Business Administration quickly diverged from the seemingly broad invitation found in the CARES Act, instead demanding that all borrowers rethink their need for the loan and to strongly consider repaying the amount before mid-May. That change in tone continues in the present day with the recent release of Form 3509, which requires borrowers of more than $2 million in PPP proceeds to respond to a number of questions regarding their financial status over the past six months; questions that the loan was in no way, shape or form preconditioned upon. This has caused many borrowers to do the unthinkable: to refrain from applying for forgiveness of the loan because it worked, and they didn’t suffer as much financial pain over the past few months as originally anticipated. 

Then, when the CARES Act was finalized in April, I explained to my clients here in Aspen that the PPP would be a lifeline to get them through the offseason, when payroll is relatively low but exorbitant rent charges remain. After all, the Act simply required that PPP loans be used for payroll, mortgage interest, rent or utilities, with no limit applied on any particular type of expense. 

But again, I was wrong. 

Even before the ink had dried on many applications, the SBA changed the game, providing that the amount spent on non-payroll costs could not exceed 25% of the total costs eligible for forgiveness. While this amount was eventually increased to 40% in June, the cap came as crushing news to rent-heavy seasonal businesses who had already taken out significant loans.

And of course, when I originally read Section 1106 of the CARES Act — which diverted from conventional tax principles to provide that any forgiveness of a PPP loan would be tax-exempt to borrowers — I laughed off those in the industry who suggested that the IRS would apply Section 265 of the Code to render those expenses paid with forgiven PPP proceeds as nondeductible. In fairness, while I thought that might be the right answer, I assumed the IRS would give deference to Congressional intent given the nature of the troubling times that gave rise to the PPP loans in the first place. 

But, you guessed it…I was wrong.

By early summer, the IRS had released Notice 2020-32, applying Section 265 to PPP loans, and establishing the Service’s position that all expenses paid with forgiven funds would be nondeductible, forever changing the math on the benefits of the borrowing and leaving more than a few business owners with a bad case of buyer’s remorse. 

Remarkably, Notice 2020-32 offered me a chance to then double-down on my stupidity. To me, whether the expenses paid with PPP proceeds were deductible hinged on whether forgiveness was obtained; as a result, I strongly maintained that those expenses did NOT become nondeductible until that “condition subsequent” occurred. As a result, if a business were filing its 2020 tax return before word on its forgiveness application had come down from the SBA, the expenses would be fully deductible. After all, we have a little something called the “tax benefit” rule, which allows a taxpayer a full deduction if at the time of filing the return, no event has occurred to render the amount nondeductible. Then, if a future event occurs that is fundamentally inconsistent with the premise on which the previous deduction was based (for example, an unforeseen refund of deducted expenses, or in this case, the forgiveness of a loan), the taxpayer must take the deducted amount into income. Applying the principles of Section 111 to PPP loans, the taxpayer would be entitled to a full deduction in 2020, with a potential income pick-up in 2021 when the loan was forgiven. 

But for one final(?) time, I was wrong.

Yesterday, the IRS published Revenue Ruling 2020-27, in which the Service, relying on a few pieces of judicial precedent, took the controversial position that expenses paid with PPP loans are not deductible if at the time of filing the return for the year the expenses would ordinarily be deducted, forgiveness of the loan was “reasonably expected to occur.” 

According to the Ruling, it matters not whether the application for forgiveness has been filed by the time the tax return is ready to go; rather, what matters is that the taxpayer apparently knows, in their heart of hearts, that the loan will ultimately be forgiven. After all, as the Ruling explains, “Section 1106(b), (d), and (g) of the CARES Act, and the supporting loan forgiveness application procedures published by the SBA, provide covered loan recipients…with clear and readily accessible guidance to apply for and receive covered loan forgiveness,” a sentence which I would have found laughable had the lies contained within it not ruined the past six months of my life.  

Thus, it would appear that if a taxpayer “reasonably expects” to have its PPP loan forgiven, expenses paid with the loan proceeds are not deductible on the taxpayer’s 2020 tax return, even though forgiveness, if achieved at all, may not be received until late in 2021.

Unfortunately, the Ruling does not explain what causes the taxpayer to have a “reasonable expectation” that the loan will be forgiven. In the two scenarios in the Ruling, it appears that the taxpayer spent at least as much as it borrowed on eligible expenses, and presumably, was eligible for full forgiveness. Thus, it stands to reason that if a taxpayer does not apply for FULL forgiveness, only those expenses up to the amount of forgiveness applied for are nondeductible. 

But in the second scenario in the Ruling, the taxpayer had not yet applied for forgiveness at the time they filed their tax return for the year the expenses were paid. As anyone who has attempted to complete a PPP forgiveness application can attest, it is NOT an exact science. Required reductions resulting from a drop in headcount or slashed salary make it possible that a taxpayer who has spent far MORE than their loan proceeds may still not achieve full forgiveness. How is a taxpayer who has not yet applied for forgiveness supposed to determine the amount they “reasonably expect” to be forgiven? I have no idea; nor, do I suspect, does the IRS. 

And what happens if the taxpayer guesses wrong? If they deny deductions in 2020 only to discover in 2021 that a lesser amount of forgiveness is granted? 

Contemporaneous with the release of Revenue Ruling 2020-27, the IRS published Revenue Procedure 2020-51, which provides a safe harbor for those taxpayers who did, in fact, guess wrong in 2020, or more likely, who extend their 2020 return and get a decision on forgiveness PRIOR to the filing of the return. 

Taking the latter circumstance first, the Revenue Procedure provides that a taxpayer CAN deduct expenses paid with PPP funds on an originally filed 2020 return provided they meet all of the following requirements: 

1. The taxpayer paid or incurred eligible expenses in the 2020 tax year for which no deduction is permitted under Revenue Ruling 2020-27 because at the end of the 2020 tax year the taxpayer reasonably expects to receive forgiveness of the covered loan based on those eligible expenses (“non-deducted eligible expenses”);
2. The taxpayer submitted before the end of the 2020 taxable year, or as of the end of the 2020 taxable year intends to submit in a subsequent taxable year, an application for covered loan forgiveness to the lender; and, 
3. In a subsequent taxable year, the lender notifies the taxpayer that forgiveness of all or part of the covered loan is denied.

In simpler terms, this means that if a taxpayer has “non-deducted eligible expenses” for 2020, those expenses may nonetheless be deducted on the taxpayer’s 2020 tax return if the taxpayer gets word that forgiveness is disallowed, in whole or in part, before filing its 2020 return. Likewise, the Revenue Procedure provides that if a taxpayer decides before filing its 2020 return NOT to apply for forgiveness, the expenses may be deducted on that return. 

And if a taxpayer files its 2020 return with nondeductible expenses but guesses wrong as to the amount of forgiveness it will achieve? The Revenue Procedure gives taxpayers the choice of amending the originally filed 2020 return to adjust the disallowance, or alternatively, deducting the improperly disallowed expenses for 2020 in the year forgiveness is determined. Thus, if a taxpayer disallows $100 of expenses on its 2020 return in anticipation of $100 of forgiveness, but only $60 of forgiveness is granted, the taxpayer can either amend the 2020 return to claim the extra $40 of deduction, or deduct the $40 on its 2021 return. 

Revenue Ruling 2020-27 and Revenue Procedure 2020-51 fail to address two major outstanding questions, however. First, what does a self-employed taxpayer filing on Schedule C do? After all, forgiveness of PPP proceeds for a self-employed taxpayer is predicated not on how the money was spent in 2020 — as it is for all other taxpayers — but instead is a purely mathematical result based on the self-employed taxpayer’s 2019 income from the business. If expenses paid with PPP proceeds for a self-employed taxpayer are not directly correlated to the ultimate forgiveness, how does one determine what amount is nondeductible? More importantly, should ANY amounts be nondeductible. I say no, but again, my history in this realm is less than impressive.

But there is perhaps a bigger issue. We now know that if at the end of 2020, a taxpayer reasonably expects that forgiveness will be achieved — and if they don’t get word to the contrary prior to filing the return — the expenses paid with PPP funds are nondeductible. But which expenses? Say a taxpayer borrows $100,000, and then incurs $160,000 of eligible costs: 

• $100,000 of W-2 wages, 
• $20,000 of retirement contributions and health insurance costs, and 
• $40,000 of mortgage interest and utilities. 

The taxpayer applies for forgiveness using the full $160,000 of costs. Forgiveness is ultimately limited to $100,000, which is both the principal balance of the loan and the amount for which the mortgage interest and utilities do not exceed 40% of the total. 

Thus, under Revenue Ruling 2020-27, the taxpayer has $100,000 of nondeductible expenses on its 2020 return. But which expenses are nondeductible? Do they get to pick and choose? 

The answer may be critical, particularly if the owner of the business is eligible for a Section 199A deduction that may be limited by the W-2 wages paid by the business (for more on Section 199A, read here). Under Reg. Section 1.199A-2(b)(1), W-2 wages for purposes of the Section 199A limitations do not include any amount which is not properly allocable to “qualified business income.” In turn, Reg. Section 1.199A-3(b)(2), in defining qualified business income, states that amounts are only included in QBI if they are “allowed in determining taxable income for the taxable year.” 

Or, you could get there another way. Because the wages paid with PPP funds end up being allocable to tax-exempt income, those wages are not “allocable” to QBI and shouldn’t count towards the W-2 limit.

Now I confess, these connections are not perfectly clear, and the result I’m reaching is contrary to the intent of the Section 199A W-2 limit, which was to incentivize businesses to hire people and pay wages. Nondeductibliity of those wages, one would think, should have no bearing on whether they are included in the W-2 limit; after all, the wages were paid, and someone is paying tax on them. But a literal reading of the regulations may cause the IRS to conclude that any wages that are nondeductible are not taken into account in computing QBI, and thus are not included in the W-2 limit. 

As a result, going back to our example where a taxpayer has $160,000 of expenses, with $100,000 of those expenses nondeductible, it would behoove them to add back $40,000 of mortgage interest and utilities, $20,000 of non-compensation payroll costs, and only $20,000 of W-2 wages. If they instead add back $100,000 of W-2 wages, the Section 199A deduction may be negatively impacted.

A similar issue arises under Revenue Procedure 2020-51, which as we discussed, gives the taxpayer the choice — if it turns out expenses that were previously nondeductible become deductible upon receiving final word on forgiveness — of whether to deduct those amounts on an amended 2020 return or the 2021 return. With that flexibility, a taxpayer must consider on which return would additional W-2 wages be more valuable from a Section 199A perspective? 

As has been the case with all things PPP, this most recent guidance only serves to 1) give rise to more questions, and 2) remind me that I was wrong about the PREVIOUS guidance, which is why I hate this stuff even more than the idea of Tom Brady, sitting around Newark Airport in a pair of jean shorts, listening to country music and watching Fuller House.