On November 18, the Internal Revenue Service (IRS) issued Rev. Rul. 2020-27 regarding the ability of businesses that received Paycheck Protection Program (PPP) loans to deduct expenses. The PPP was created in April of 2020 to provide financial support to small businesses struggling during the COVID-19 pandemic.
The new guidance states that if a business’s PPP loan is forgiven, any otherwise deductible expenses that were paid using the loan, such as payroll or rent, are not deductible for income tax purposes. Usually, these types of expenses are deductible when paid with revenue generated directly from the business. However, the IRS guidance states that the loan forgiveness results in a form of tax-exempt income to the business, and Section 265 of the tax code generally disallows deductions associated with tax-exempt income. Moreover, the IRS guidance states that general tax law principles disallow a deduction for an otherwise deductible expense when there is a reasonable expectation of reimbursement.
This guidance applies to businesses that have their PPP loan forgiven by the end of 2020. It also extends to businesses whose PPP loans are not forgiven by the end of the year, but have a reasonable expectation of forgiveness (even if the business has not yet filed for loan forgiveness). As long as a business reasonably believes its loan will be forgiven in the future, any otherwise deductible expenses related to the loan’s forgiveness are not deductible. On the other hand, if a business’s PPP loan is not forgiven, that business would be able to deduct those expenses, but it would have to repay the loan with 1% interest.
So what does all of this mean for your small business? Unfortunately, if the guidance remains unchanged, it will likely result in an increased tax bill for many small businesses. If businesses are prevented from deducting otherwise allowable expenses on their income tax return, their taxable income will increase. As a direct result, their 2020 taxes will be higher. This most recent guidance is only the latest in a long line of bad news relating to the PPP and small businesses distressed by the pandemic. Since its inception, the PPP has been riddled with allegations of fraud and abuse. Additionally, the PPP’s unclear guidelines left many business owners confused and uncertain about the program’s effects and consequences.
Many businesses were hopeful they would be sheltered from having to pay taxes on government assistance they received this year. Some even viewed the PPP loans as a grant from the government to help them stay afloat during the pandemic. However, this guidance will likely place enormous financial pressure on already strained small businesses. As a result, the IRS is facing mounting pressure to reconsider its guidance. However, the IRS may view itself as bound by general tax principles and Section 265, and unable to unilaterally declare the expenses deductible. As a result, many are calling on Congress for legislative intervention to make clear that the expenses are deductible. One current item of legislation is the Small Business Expense Protection Act of 2020, which would permit these deductions for small businesses. You can support these efforts by contacting your local congressperson and urging them to help pass this legislation.
Depending on your business’s situation, it may be beneficial to wait to file for PPP loan forgiveness. There is a possibility that these guidelines may be amended or overruled over the next few months. If Congress does pass legislation that would allow for these types of deductions, it is unclear whether it would retroactively apply to businesses that filed for loan forgiveness before the legislation was passed. Businesses that received PPP loans may also wish to consider filing tax return extensions for their 2020 income tax returns until there is more clarity on this issue. In the meantime, it is important for businesses to stay up to date on the latest announcements and news regarding the PPP loans.
As the COVID-19 pandemic continues to affect businesses, Axley is committed to helping you and your business navigate these difficult times.