Tax Effect of PPP Loan Forgiveness
The time has come for businesses to start the application process for Payroll Protection Program (PPP) loan forgiveness. Last week, the IRS released Revenue Ruling 2020-27 which provides clarification on PPP loan forgiveness and deductibility of expenses incurred with PPP proceeds. Below is a summary for business owners. Please feel free to contact us if you have questions about how this applies to your situation.
In June we sent out information regarding the Payroll Protection Program, but the question since then has been how this affects the 2020 income. The Internal Revenue Service has provided more guidance in the form of Revenue Ruling 2020-27. This revenue ruling clarifies how the expenses paid with the Payroll Protection Loan should be accounted for on the 2020 returns along with what happens in 2021 if the loan is not fully forgiven.
The Internal Revenue Service took the stand early on, that the PPP loan funds are not taxable income, but based on IRC §265(a)(1), the expenses paid with non-taxable income are non-deductible. This concept is easy enough when the receipt of the PPP funds, payment of expenses and forgiveness happen all in one year. However, this scenario is not going to happen for many businesses.
Revenue Ruling 2020-27 provides two scenarios to assist taxpayers:
Taxpayer paid eligible expenses during the covered period of February 15, 2020 to December 31, 2020, including payroll costs, qualified interest on mortgage obligations, utility payments and rent. Taxpayer, then applies for loan forgiveness based on those eligible expenses and satisfies all requirements under section 1106 of the CARES Act for forgiveness of the loan. The lender, however, does not inform the taxpayer whether the loan will be forgiven before the end of 2020.
In this scenario, the taxpayer, when applying for loan forgiveness, knew the amount of their eligible expenses that qualified for reimbursement and had a reasonable expectation of reimbursement in the form of loan forgiveness. Therefore, taxpayer may not deduct the eligible expenses paid in 2020.
Assuming the same circumstances in Scenario 1, with the taxpayer paying the same eligible expenses. Unlike Scenario 1, the taxpayer does not file for loan forgiveness before the end of 2020 but expects to file in 2021. The taxpayer has fulfilled all requirements for loan forgiveness when considering all eligible payments and expects to receive loan forgiveness in 2021.
In this scenario, the taxpayer knew the amount of their eligible expenses that qualified for reimbursement and had a reasonable expectation of reimbursement in the form of loan forgiveness. Therefore, even though the taxpayer has not yet applied for loan forgiveness, they may not deduct the eligible expenses paid in 2020.
In summary, when looking at the effect to the 2020 deductions, expenses used to qualify for loan forgiveness will be non-deductible. As a result, most businesses will have an increase to net taxable income by the amount of the PPP loan.
The IRS followed up Revenue Ruling 2020-27 with Revenue Ruling 2020-51 which addresses a safe harbor provision for taxpayers who are denied full or partial forgiveness of the PPP loan. These taxpayers have two options in the year forgiveness is denied.
Option 1:Go back and amend the 2020 tax returns to deduct the expenses associated with the denied portion of the loan.
Option 2: Deduct the applicable expenses in the year loan forgiveness is denied.
Sole proprietorships reporting on Schedule C are also subject to these Revenue Rulings when their loans were obtained to cover payroll costs for employees. Those taxpayers who do not have employees and obtained the PPP loans as owner compensation replacement, currently do not have guidance available.
Even though future legislative guidance may overrule the IRS position, taxpayers need to plan based on the current rules available. Please contact our office if you would like to discuss your 2020 taxable income, and potential tax liability.