Article by: Jeff Skolnick, CPA, M.S. Taxation
On Wednesday November 18th, 2020 the IRS issued guidance on the disallowance of otherwise deductible expenses that are paid with forgiven PPP funds.
Revenue Ruling 2020-27 and Rev Proc 2020-51 are the latest releases explaining Notice 2020-32 which the IRS issued on May 2, 2020.
Notice 2020-32 stated that loan proceeds received under PPP which were forgiven were similar to tax exempt income. The Internal Revenue Code states that expenses related to tax exempt income are not deductible. Let’s take an example of a taxpayer borrowing $100,000 from a home equity loan. Home equity interest incurred after 2017 is not tax deductible unless it is for improvements on a home, however, it may be deductible as investment interest. Investment interest is deductible only to the extent of investment income. If the taxpayer incurred $4,000 of investment interest expense but only earned $2,000 of investment income (interest income and certain dividend and capital gains income that are taxed at ordinary (not long-term capital gain tax rates) are considered to be investment income), then only $2,000 would be deductible and the remaining $2,000 would carryforward to future years when additional investment income can be used to allow the deduction. If the taxpayer had $4,000 or more of investment income, then the entire $4,000 of interest expense becomes deductible. If, however, the proceeds were invested in tax exempt bonds, there would be no taxable interest income and therefore none of the interest expense would be deductible. The IRS used this logic to state that the expenses paid with PPP proceeds (payroll costs, rent, utilities and mortgage interest) would not be deductible if the proceeds of the PPP loan are forgiven.
Revenue Ruling 2020-27 gives two examples of taxpayers that received PPP funds in 2020. Both taxpayers used the PPP funds for their intended purpose (payroll, rent, utilities and mortgage interest). The first taxpayer applied for forgiveness of their PPP loan in 2020 but did not have an answer by December 31, 2020 as to whether the loan was forgiven. The second taxpayer did not apply for forgiveness until 2021 but just as the first taxpayer had done, used the proceeds to pay only eligible expenses within the covered period.
Ruling 2020-27 states that since both taxpayers reasonably expected forgiveness then expenses paid with the forgiven PPP funds were not deductible. Keep in mind, even though neither taxpayer had received an answer on forgiveness just the reasonable expectation of forgiveness is enough to disallow the deductions.
You could file for an extension of the return in question, either by March 15th for S corporations or by April 15th for sole proprietorships, partnerships, or C corporations. An extension of time allows taxpayers an additional 6 months to file a return and taxpayers should have answers by the extended due date.
Revenue Procedure 2020-51 explains that a taxpayer that has part of their forgiveness denied may deduct expenses paid with PPP proceeds that are not forgiven. This may be done on either a timely filed 2020 tax return, an amended 2020 return if the original return was filed and did not include such expenses, or on the taxpayer’s 2021 tax return.
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Jeff Skolnick, CPA, M.S. Taxation