Covering Your Assets: IRS releases clarification on taxation for forgiven PPP loans (Voices)

The IRS on Nov. 18 released Revenue Ruling 2020-27, the fact pattern of which follows:

A taxpayer received a loan guaranteed under the Paycheck Protection Program (PPP) authorized under section 7(a)(36) of the Small Business Act (15 U.S.C. 636(a)(36)) (covered loan), and paid or incurred certain otherwise deductible expenses listed in section 1106(b) of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), Pub. L. No. 116-136, 134 Stat. 281 (March 27, 2020).

The questions at hand was, “Can the taxpayer deduct those expenses in the taxable year in which the expenses were paid or incurred if, at the end of such taxable year, the taxpayer reasonably expects to receive forgiveness of the covered loan based on the otherwise deductible expenses?”

The Revenue Ruling looked at two fact patterns. The first was the taxpayer had applied for forgiveness, and was expecting to receive the forgiveness, even though the lender had not notified them of that before the end of the taxable year. The second fact pattern was a taxpayer who had not applied for forgiveness by the end of the year, but still believed they would be forgiven eventually.

The ruling goes on to explain that an individual or entity that is eligible to receive a covered loan (eligible recipient) can receive forgiveness of the full principal amount of the covered loan up to an amount equal to the following eligible expenses that are paid or incurred during the covered period: (1) payroll costs, (2) interest on a covered mortgage obligation, (3) any covered rent obligation payment, and (4) any covered utility payment.

Under section 1106(i) of the CARES Act, for purposes of the Code “any amount which (but for [section 1106(i)]) would be includible in gross income of the eligible recipient by reason of forgiveness described in [section 1106](b) shall be excluded from gross income.”

Section 1106(i) of the CARES Act excludes the forgiven amounts from gross income regardless of whether the income would be (1) income from the discharge of indebtedness under section 61(a)(11) of the Code, or (2) otherwise includible in gross income under section 61 of the Code.

On May 2, 2020, the Department of the Treasury and the Internal Revenue Service (IRS) released Notice 2020-32, 2020-21 IRB 837 (May 18, 2020), which clarifies that no deduction is allowed for an eligible expense that is otherwise deductible if the payment of the eligible expense results in forgiveness of a covered loan.

Authorities addressing reimbursement further hold that an otherwise allowable deduction is disallowed if there is a reasonable expectation of reimbursement. See Burnett v. Commissioner; in Burnett, a lawyer advanced expenses to clients that the clients were obligated to repay only to the extent the lawyer was successful in obtaining recovery on the client’s claim. The court affirmed the Tax Court’s holding that the advances were not deductible.

Under the related “tax benefit rule,” if a taxpayer takes a proper deduction and, in a later tax year, an event occurs that is fundamentally inconsistent with the premise on which the previous deduction was based (for example, an unforeseen refund of deducted expenses), the taxpayer must take the deducted amount into income.

The Supreme Court applied the tax benefit rule in Hillsboro National Bank v. Commissioner, 460 U.S. 370 (1983). In that case, the Court observed that “[t]he basic purpose of the tax benefit rule is to achieve rough transactional parity in tax … and to protect the Government and the taxpayer from the adverse effects of reporting a transaction on the basis of assumptions that an event in a subsequent year proves to have been erroneous. Such an event, unforeseen at the time of an earlier deduction, may in many cases require the application of the tax benefit rule.”

The Revenue Ruling concluded that BOTH situations have a reasonable expectation of reimbursement. At the end of 2020, the reimbursement of both taxpayer’s eligible expenses, in the form of covered loan forgiveness, is reasonably expected to occur — rather than being unforeseeable — such that a deduction is inappropriate.

This means that most taxpayers that have generally spent their PPP loan proceeds by the end of the calendar year will have higher taxable income as a result.

Just a reminder — the fourth quarter estimated tax payment is due January 15, 2021, and any shortfall in 2020 taxes is due April 15, 2021. Business owners should determine how much additional tax will be due because of this Revenue Procedure. Many practitioners had assumed that the year of taxation would be the year of forgiveness.

These rules are general in nature; consult your CPA to get insight how these new rules impact your specific situation.

Mike Bosma, CPA, is Principal-in-Charge of the Reno office of CliftonLarsonAllen LLP. His NNBW column, “Covering Your Assets,” focuses on effective planning strategies for every business owner. Reach him for comment at mike.bosma@claconnect.com.