On Nov. 18, 2020, the IRS weighed in on whether expenses used to support Payroll Protection Program (PPP) loan forgiveness are deductible, assuming the forgiveness occurs in the year after the expenses are incurred (a “bifurcated loan”). In Rev. Rul. 2020-27, the IRS doubled down on its previous position by holding that expenses incurred in the year prior to forgiveness are also nondeductible.
Perhaps to mollify detractors of this position, in Rev. Proc. 2020-51 the IRS issued safe harbor provisions for deducting certain PPP forgiveness expenses. Before analyzing the new Revenue Ruling, we will look at the effects on taxpayers, the possibility that we have not heard the last on this topic, and the background.
What’s At Stake?
Bear in mind that, assuming the PPP loan is ultimately forgiven, the only thing at stake is the year in which nondeductible expenses must be reported (either 2020 or 2021). The good news is that even if you think you may want to deduct the expenses in 2020, you can wait until you file your 2020 tax return to make your decision.
Who Has the Last Say?
No sooner did the IRS weigh in than lawmakers from both sides of the aisle spoke out against it. Sen. Chuck Grassley (R-Iowa) and Sen. Ron Wyden (D-Oregon), each Party’s leader on the Senate Finance Committee, urged the IRS to change its position and argued that the new guidance deprives some small businesses of much-needed economic relief by forcing them to choose between getting their PPP loans forgiven and deducting the expenses incurred in applying for loan forgiveness. They indicated that they are working to include language in year-end legislation clarifying that taxpayers will qualify for expense deductions even if their loans are forgiven. That could be included in government spending legislation that Congress must pass by December 11 before federal funding runs out.
As we explained in our prior article, 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 IRS uses two alternative arguments to justify this treatment. The first alternative is based on Section 265 of the Internal Revenue Code, and is designed to prevent a double tax benefit. The second alternative is based on treating expenses as reimbursable expenses, concluding that if there is a reasonable expectation of reimbursement, the expenses are not deductible.
We concluded in our previous article that there are two possibilities for when expenses are deductible. The expense reimbursement rationale supports forgoing the deduction in 2020, while the Section 265 rationale supports deducting the expenses in 2021 and including that amount in income in 2021 if the loan forgiveness has not been established during 2020. We also concluded that until such time as the law changes or the IRS provides an answer to this question, borrowers may choose either of these two possibilities to comply with the nondeductible treatment discussed in Notice 2020-32.
We now have that guidance from the IRS.
In Rev. Rul. 2020-27, the IRS posited two potential bifurcated loan situations. In Situation 1, a taxpayer uses PPP loan proceeds for qualifying expenses during an eligible covered period in 2020, applies for forgiveness, and is assumed to have satisfied loan forgiveness requirements under the Coronavirus, Aid, Relief, and Economic Security (CARES) Act. The lender, however, does not inform the taxpayer whether the loan will be forgiven before the end of 2020.
In Situation 2, the taxpayer incurred the qualifying expenses during the covered period, but does not apply for PPP loan forgiveness by the end of 2020. Again, the IRS assumes that the taxpayer knows it is going to have its loan forgiven, and the taxpayer expects to apply for loan forgiveness in 2021.
Deducting Expenses in the Year Incurred and Recapturing Expenses in the Year of Forgiveness
As we stated previously, tax returns generally must be prepared on the basis of facts that are shown to exist by the last day of the tax year. Both the U.S. Supreme Court and the IRS have embraced this fundamental principle (what we will call the “sanctity of the accounting period”).
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. Section 265 provides that tax-exempt income does not need to be received or accrued during the tax year in order for expenses to be nondeductible. But when the facts do not evidence a fixed right to tax-exempt income by year end, Section 265 is inapplicable because no class of tax-exempt income (accruable or not) exists at that time. The sanctity of the accounting period prevents the introduction of subsequent year facts to determine the existence of tax-exempt income.
As a result, 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. When the loan is forgiven in a later year, the taxpayer then takes the previously deducted amounts into income under the so-called “tax benefit rule.”
The IRS Introduces an “Expectation” Criterion as Part of Section 265
Although the IRS describes Section 265 in its Revenue Ruling, it does not rely on it for treatment of a bifurcated loan. Instead, it relies on the expectation of reimbursement, which it describes as “related” to the tax benefit rule.
The IRS said that in either Situation 1 or Situation 2, neither taxpayer would be able to take deductions for PPP eligible expenses because of the taxpayer’s expectation for reimbursement. Moreover, the IRS extended the expectation criterion of expense reimbursements to Section 265, holding that a class of tax-exempt income exists for purposes of Section 265 when the taxpayer has an expectation of loan forgiveness.
In our earlier article, we agreed with this analysis for taxpayers who wanted to take the reporting position that the expenses are not deductible in the year incurred because the taxpayers expected the expenses to be reimbursed. But Section 265 does not involve expense reimbursements, and so the expectation criterion is not germane to Section 265. The IRS failed to reconcile the sanctity of the accounting period case law with the expectation of reimbursement cases, and merely held that the same expectation criterion applies to Section 265.
The IRS goes on to explain the tax benefit rule, which is triggered when an event occurs that is fundamentally inconsistent with the premise on which a previous deduction was based (for example, an unforeseen refund of deducted expenses). Under the tax benefit rule, a taxpayer’s expectations about events are relevant. However, the tax benefit rule is a different tax doctrine that is unrelated to Section 265, because the tax benefit rule is “related” (as the IRS noted) to expense reimbursements. Section 265, on the other hand, does not depend upon expense reimbursements. The IRS appears to have conflated these two principles by imprinting the expectation criteria from the tax benefit rule onto the operation of Section 265. There is no case law or other relevant authority that permits the IRS to reach this conclusion.
The distinction between Section 265 and situations involving expense reimbursements is precisely what the Ninth Circuit addressed in Manocchio v. Comm’r, 710 F.2d 1400 (9th Cir., 1983), aff’g 78 T.C. 989 (1982). The Manocchio Tax Court disallowed flight training costs under Section 265 that were incurred in one year and were reimbursed in a later year. The Ninth Circuit upheld the Tax Court’s decision not under Section 265, but instead under the anticipated expense reimbursement rationale. The Ninth Circuit went to some length to distinguish the expense reimbursement rationale from Section 265, and therefore, the expectation criterion was applied only to the expense reimbursement rationale. Furthermore, the Ninth Circuit’s decision is not an aberration, and both the Tax Court and the IRS have cited it favorably since the ruling.
Do You Have to Follow Rev. Rul. 2020-27?
Revenue Rulings do not carry the same authoritative weight as the Code or Regulations, as summarized here:
“Revenue [R]ulings do not have the force and effect of law, but rather are offered for the guidance of taxpayers, IRS officials, and others concerned; although they are entitled to some consideration, they do not control when contrary to statute or the expressed intention of Congress.” Storm Plastics, Inc. v. United States, 770 F.2d 148, 154 (10th Cir. 1985); see Dixon v. United States, 381 U.S. 68, 73-75 (1965).
Because the IRS made no attempt to reconcile the competing and equally relevant judicial doctrines (the sanctity of the accounting period, and the expectation of reimbursement), there continues to be support for deducting the expenses in the year incurred, and reporting those amounts in income to the extent the loan proceeds were used to pay such expenses in the year the loan is forgiven.
As a result, and as we concluded in our initial article, we believe there is merit to either position regarding the timing of deductions – deduct them in year one and include the amount in income in the year of forgiveness, or do not deduct them at all. And as mentioned above, taxpayers will have up until the filing of their 2020 returns to make the decision, and legislation may make the issue moot.
Rev. Proc. 2020-51
Because the IRS took the position that in all cases, the relevant expenses are nondeductible, it issued a procedure that essentially says taxpayers can deduct the amounts if it turns out all or a portion of the loan is not forgiven. This highlights the contradictory underlying assumption in the Revenue Ruling that taxpayers know for certain if their loans will be forgiven.
The safe harbor applies to taxpayers who:
- Apply for loan forgiveness in 2020;
- Intend to apply for loan forgiveness in 2021; or
- Decide in a subsequent year not to apply for loan forgiveness.
In each case, the taxpayer may deduct eligible expenses that it not deduct on a timely filed tax extended or amended return for the 2020 tax year. Or the taxpayer may elect to deduct the prior expenses in the year of forgiveness.
The IRS has spoken on the issue of deducting expenses used to qualify for PPP loan forgiveness, and has doubled down on its original analysis that such amount are not deductible even if there is a bifurcated loan. We believe the existing case law on the sanctity of the accounting period provides equally relevant and compelling authority for deducting the amounts in the year incurred. And no taxpayer is bound by an IRS Revenue Ruling in the event there is sufficient authority for the position taken.
Until such time as Congress weighs in with legislation that 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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