The Paycheck Protection Program (PPP) is a key component of the CARES Act passed in late March 2020. The PPP program provided loans to businesses struggling in the wake of the economic impact of COVID-19. PPP loan proceeds used by businesses to pay employee compensation and other eligible expenses are eligible to be forgiven. In other words, businesses are not required to pay the loans back if they meet the criteria outlined in the PPP program.
Drawbacks of the PPP
Congress explicitly stated in the CARES Act that PPP loan forgiveness would be tax-free income to the business. However, the CARES Act did not provide how to treat the expenses paid with PPP loan proceeds. The IRS clarified in Notice 2020-32 that their interpretation is that any expense paid with forgiven PPP funds would make those expenses nondeductible. According to the IRS, since the PPP forgiven loans are deemed tax-exempt income, the related expenses associated with that tax-exempt income are nondeductible.
This conclusion from the IRS comes as a surprise to many businesses since it could result in higher tax bills. For example, assume a business with $1M of receipts incurred $1.2M of salary expense. However, this business received a $250,000 PPP loan that was ultimately forgiven. Assuming that no other expenses were incurred in 2020, the tax impact is as follows:
- The business would generally have a 2020 taxable loss of $200,000 ($1M – $1.2M). That net operating loss could be carried back five years under other provisions of the CARES Act and may trigger a tax refund from the carryback.
- However, under this IRS guidance, $250,000 of the $1.2M salary expense is considered nondeductible. That means the business has 2020 taxable income of $50,000 ($1M – $1.2M + $250,000). The business will actually owe income tax in 2020 on its $50,000 of taxable income and won’t have any net operating loss to carryback.
Timing is Everything
While digesting the IRS guidance, the next question businesses and their advisors asked is when these expenses are deemed nondeductible. The loan forgiveness applications may or may not be filed in 2020. Even if they are filed in 2020, the businesses may not receive confirmation from lenders on whether their PPP loans were forgiven entirely. If the loans are not forgiven until 2021, does that mean the expenses are nondeductible then?
The IRS has since cleared up those timing-related questions associated with when to treat the expenses as nondeductible.
In Revenue Ruling 2020-27, the IRS described two potential scenarios in terms of timing of the PPP loan’s forgiveness and its impact on the expense deduction. In both scenarios, the conclusion of the IRS is that if a business reasonably expects to receive loan forgiveness, then the expenses should be treated as nondeductible in the 2020 tax year. This conclusion holds true regardless of when the actual PPP loan forgiveness application is filed or when the lender approves actual forgiveness. This revenue ruling eliminated the potential of waiting until PPP forgiveness occurs to treat those related expenses as nondeductible on your tax return.
Although with this answer, another question arose. Assume a company reasonably expected all of its PPP loan to be forgiven. Under this revenue ruling, the business would treat all the related expenses as nondeductible on their 2020 return. What happens if that company submits its forgiveness application, but the bank doesn’t grant full PPP loan forgiveness? Perhaps the business didn’t use all the funds on eligible expenses or couldn’t produce the documentation required by the lender. Are the expenses that were treated as nondeductible on its 2020 return lost forever?
Luckily, the IRS also issued guidance for this scenario in the form of Revenue Procedure 2020-51. In this announcement, the IRS offers two alternatives that companies can take:
- File an amended 2020 tax return to deduct the amount of expenses equal to the PPP loan amount in which forgiveness was denied (or no longer sought to be forgiven).
- Treat the amount of expenses in which forgiveness was denied as a deductible expense on their 2021 tax return.
Therefore, the IRS is granting a small silver lining if your business seeks PPP loan forgiveness and is denied forgiveness either in its entirety or partially.
Assistance to Navigate the Guidance
While not necessarily taxpayer-friendly, this IRS guidance does offer a clear resolution for companies wondering how to treat the expenses reimbursed by PPP loans. This guidance also means companies and their owners may need to run new tax projections to determine what proper estimated tax amounts may be required. Be sure to reach out to your CRI advisor for assistance with both the PPP forgiveness aspect as well as tax planning associated with the nondeductible expenses.