In Revenue Ruling 2020-27, the IRS announced that taxpayers cannot deduct expenses paid for with the proceeds of a Paycheck Protection Program (PPP) loan that is forgiven, even if the PPP loan forgiveness occurs in a later tax year than the tax year in which the expenses are incurred.
When the PPP loan program was enacted earlier this year as part of the CARES Act, tax practitioners were concerned that if a taxpayer paid otherwise deductible expenses using the proceeds of a PPP loan that was forgiven, those expenses would not be deductible for federal income tax purposes because the Internal Revenue Code (IRC) and Treasury regulations provide that no deduction is allowed to the extent the amount is allocable to tax-exempt income. The CARES Act specifically provided that any cancellation of indebtedness income from a forgiven PPP loan is not subject to tax, but was silent as to the deductibility of expenses paid with proceeds from forgiven PPP loans.
In April, the IRS published Notice 2020-32 announcing its view that, because the CARES Act did not specifically allow deductions for expenses paid with the proceeds of a forgiven PPP loan, such deductions were not allowed because allowing those deductions would create a double tax benefit (i.e., the exclusion from income coupled with a deduction against other income).
Notice 2020-32 left open the question of whether expenses incurred in 2020 would be deductible in 2020 if a PPP loan is not forgiven until 2021 or later. In Revenue Ruling 2020-27, the IRS announced that the deductions are disallowed as long as, by the end of 2020, there is a “reasonable expectation” that the PPP loan will be forgiven. In both situations, because the taxpayers have satisfied the applicable criteria, the taxpayers expect that its PPP loans will be forgiven.
Revenue Ruling 2020-27 addresses two situations. In both, the taxpayer uses PPP loan funds to pay otherwise deductible expenses and satisfies the criteria to have the PPP loan forgiven. In Situation 1, the taxpayer applied for forgiveness by the end of 2020; whereas, in Situation 2, the taxpayer has not yet applied for forgiveness but expects to do so in 2021.
In both situations, the IRS ruled that the taxpayer cannot deduct the expenses because it has a reasonable expectation that the PPP loan will be forgiven. Therefore, it has a reasonable expectation that the forgiveness of the PPP loan will be excluded from income, and allowing a deduction for the otherwise deductible expenses (without express authorization by Congress) would create a double tax benefit.
This Revenue Ruling is unwelcome news for taxpayers who obtained PPP loans. Although most—but not all—members of Congress from both parties who have publicly addressed the issue have stated that they believe the intent of the PPP loan program was to allow the double benefit as a form of COVID-19 relief, it is unclear whether Congress will pass clarifying legislation. Absent such legislation, the IRS’s position is clear that the double benefit is not allowed.
The result could be problematic for entities that are treated as partnerships for federal income tax purposes, particularly if a partner transfers his or her interest before a PPP loan is forgiven. In that situation, the partner would have phantom income because the partnership would not be able to deduct expenses that actually were incurred in 2020 because of the expectation of forgiveness in a later year. But the partner will be required to reduce the basis for his or her partnership interest by the nondeductible expenses. Thus, in addition to the 2020 phantom income from the partnership, gain from the disposition of the partnership interest also would be increased.
The IRS still has not addressed the interaction between PPP loan forgiveness and the IRC Section 199A deduction. IRC Section 199A allows a deduction for qualified business income earned by partnerships, S corporations, and sole proprietors, but the deduction is capped at (i) 50% of W-2 wages, or (ii) 25% of W–2 wages plus 2.5% of basis of certain qualified property. There remains concern that wages that cannot be deducted because they are paid with the proceeds of a forgiven PPP loan may not be includible in the IRC Section 199A wage base.