New IRS Restrictions on PPP Loans

Businesses who received PPP loans may receive forgiveness of the full principal amount of the loan up to an amount equal to eligible expenses paid or incurred during the covered period.

Section 1106(b) of the CARES Act lists eligible expenses as: (1) payroll costs, (2) interest on a covered mortgage obligation, (3) any covered rent obligation payment, and (4) any covered utility payment.

Such expenses are otherwise deductible as business expenses under Section 162 of the Internal Revenue Code (the “Code”). Treasury recently issued a Rev. Rul. 2020-27 detailing their stance on the deductibility of eligible expenses paid using PPP funds.

Takeaway

The IRS clarified on November 18 that small businesses who received loans under the PPP and incurred otherwise deductible expenses listed in section 1106(b) cannot deduct those expenses if they “reasonably expect” to receive forgiveness of the covered loan, even if they have not yet received or applied for forgiveness.

Year-End Tax Implications

In early May, Treasury issued a notice explaining businesses may not deduct eligible expenses if the payment of the eligible expense results in forgiveness of a covered loan. This led many taxpayers to believe that forgiveness would actually need to happen for the non-deductibility rule to apply, which for most businesses would not be until 2021 and would thus potentially allow for deductions in 2020.

This week’s guidance from the IRS goes even further and explicitly states that taxpayers cannot deduct otherwise deductible expenses if they “reasonably expect” to receive forgiveness, even if they have not yet submitted an application for forgiveness by the end of the taxable year. Many businesses who received PPP loans and used those funds for payroll costs and other eligible expenses anticipated deducting those expenses during the 2020 taxable year.

In such a situation, taxpayers could deduct as business expenses those paid with PPP funds in 2020 and would expect to include as gross income the amount forgiven as a discharge of indebtedness in 2021. This would even out to zero after the 2021 taxable year and still allow for small businesses struggling to survive through the COVID-19 pandemic to receive beneficial tax treatment in 2020.

Now, Rev. Rul. 2020-27 creates a situation where businesses who needed PPP loans to assist in funding their payroll costs and other essential business expenses are going to see an increased taxable income for 2020. Because section 1106(i) of the CARES Act established that the forgiven amounts of PPP loans would not be included in gross income, the tax consequences will still even out to zero after businesses receive forgiveness in 2021. While these two situations even out in the long-term, this ruling creates immediate problems for businesses who are in the midst of or have already completed a majority of, their year-end tax planning.

This Revenue Ruling likely decreases the incentive for businesses to apply for forgiveness before a new administration enters at the beginning of the year, and adds to the stress of many taxpayers at the end of an already difficult 2020 rather than allowing them to plan accordingly in 2021.

Congressional Changes Possible

Key members of Congress agree that the IRS’s interpretation poses an unfair burden on struggling businesses and have said they will seek legislation to change it. The bipartisan Small Business Expense Protection Act of 2020 was introduced in the Senate in May, and similar legislation is expected to proceed in the House soon. Congressional action could help the millions of taxpayers now facing the choice of a much higher tax bill or foregoing seeking forgiveness for their PPP loans, but it is unclear whether Congress will pass a bill in time to make a difference for the 2020 taxable year.

Written by Bruce Hendrick, David Heidenreich, and Kylie Jennings at Carrington Coleman.