As businesses continue to grapple with effects from the COVID-19 pandemic, many are turning attention to forgiveness of Payroll Protection Program (PPP) loans. Borrowers do not need to repay PPP loans as long as they satisfy a variety of conditions, including a requirement to spend PPP loan proceeds on qualifying expenditures such as payroll and rent. The IRS previously clarified in Notice 2020-32 that these expenditures are nondeductible for tax purposes. But in many cases, PPP loans will not be forgiven by the end of the tax year. In that case, it is uncertain how to treat the expenditures in the year incurred, and what to do in the year of loan forgiveness.
This question is pressing because it will impact the amount of estimated tax payments required to be made, and may also impact the assessment of uncertain tax positions that must be disclosed in financial statements. Until the IRS provides guidance on this question, either position described below has merit.
The IRS stated in Notice 2020-32 that no deduction is allowed for expenses that are allocable to income that is exempt from taxes. This rule is established in Section 265 of the Internal Revenue Code, and is designed to prevent a double tax benefit. In this case, the type of tax-exempt income depends on the nature of PPP loans as debt for tax purposes.
A PPP loan resembles in some ways a government grant instead of an obligation to repay. But a careful analysis of the circumstances reveals that a PPP loan should be treated as debt for tax purposes. Some critical factors used to determine indebtedness for income tax purposes include:
- Whether there is an unconditional obligation to pay at a fixed time or over a payment schedule;
- The right of the creditor to enforce payment; and
- A creditor’s reasonable expectation of repayment.
The way a PPP loan is formally documented, including the way it is categorized by the Small Business Administration (SBA), as well as the borrower’s uncertainty at the time of funding about ultimate forgiveness, make it fairly clear that PPP loans are debt for tax purposes. This means that the type of tax-exempt income resulting from PPP loan forgiveness pertains to canceled debt.
Among the pre-requisites to obtaining PPP loan forgiveness, a borrower must submit an application and then have this application approved. But these procedures often will remain in process on the last day of the borrower’s tax year. In this situation, the borrower will not know by that time whether the PPP loan was actually forgiven, and this raises the question about whether Section 265 will cause the related expenses to be nondeductible at that same time.
It is possible that Congress could take up future legislation to change the law, so that Section 265 would not apply to forgiven PPP loans. But until the time that the law changes, or until the time that the IRS otherwise provides an answer to this question, borrowers may consider either of two possibilities to comply with the nondeductible treatment of Notice 2020-32.
First Choice: Tax Benefit Rule in the Year of Forgiveness
As a general matter, tax returns can only be prepared on the basis of facts that are shown to exist by the last day of the tax year. This is a rule of practical necessity, because tax returns otherwise would be held in abeyance indefinitely until such time that related contingencies are resolved. Both the U.S. Supreme Court and the IRS have embraced this fundamental principle.
Turning then to the present situation, it is evident that forgiveness of a PPP loan cannot be established factually by the last day of a tax year when either: (1) the borrower has not submitted a forgiveness application by that time, or (2) the borrower’s application has not been approved by that time. Without evidence of loan forgiveness by the last day of the tax year, there cannot be tax-exempt loan forgiveness income by that time. Hence, Section 265 does not govern the tax treatment in the year expenses are incurred, so the expenditures out of PPP loan proceeds are deductible during such tax year.
This is not a free pass, of course, because the IRS position in Notice 2020-32 must eventually be reconciled. In the subsequent tax year when loan forgiveness is factually established, the previous tax deductions must be recaptured in order to comply with Notice 2020-32. This is accomplished pursuant to another fundamental principle of taxation – the tax benefit rule.
The tax benefit rule is triggered when a taxpayer obtains a tax benefit in one year, and it then discovers during a later tax year (based on facts that did not exist previously) that it is no longer entitled to the tax benefit. Hence, the tax benefit of the previous deductions cannot be retained when it is later discovered that the PPP loan is forgiven. Under the tax benefit rule, the taxpayer must recognize income at the time of PPP loan forgiveness in order to recapture the previous tax deductions. Furthermore, taxpayers are not permitted to amend the previous tax return in which the deductions were claimed; the tax benefit rule requires income inclusion in the subsequent year.
Second Choice: Nondeductible Expenses in the Year Incurred
The IRS does not often articulate “fallback” positions in published guidance, but it did in Notice 2020-32. Because the IRS offered a second rationalization for nondeductible treatment that is distinct from its primary position, the IRS opened the door to a second possibility about the timing of nondeductible treatment that is equally distinct.
In Notice 2020-32, the IRS alternatively provided that expenditures made from PPP loan proceeds are nondeductible when the borrower expects that such expenditures will be reimbursed. A number of courts also required this result in similar situations where the taxpayer had an expectation of reimbursement. It should be noted that an expectation of reimbursement is not the same thing as an established fact by the end of a tax year, but neither the courts nor the IRS addressed this incongruity.
Hence, a taxpayer following the alternative position in Notice 2020-32 cannot deduct expenditures out of PPP loan proceeds during the year that the expenses are incurred when: (1) there is an expectation of reimbursement, and (2) there is a sufficient probability of reimbursement.
Until such time that either Congress or the IRS resolves this question, taxpayers may consider either of these choices. For more information about the taxability of PPP loans, please contact us.
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