In April, the IRS issued Notice 2020-32 which stated that expenses paid for or incurred with PPP loan proceeds are not deductible if the loan is forgiven. The loan forgiveness process is lengthy and therefore, there is the potential that a taxpayer may have paid or incurred expenses in one tax year and may not be notified of their forgiveness until a later tax year. The Notice 2020-32 was silent on the timing of the loan forgiveness and disallowance of the deductions. This along with the original perceived intent of congress that the taxpayers should be allowed the deductions, has led to uncertainty as to whether such expenses would be deductible, and if deemed to be non-deductible, the timing of the disallowance of the deductions.
On November 18, the IRS issued Revenue Ruling 2020-27 to amplify Notice 2020-32 and to clarify the IRS position on the deductibility of these expenses. For purposes of both the Revenue Ruling and the earlier Notice, the IRS is applying Internal Revenue Code Section 265 for determining whether expenses may be deducted. IRC Section 265 prohibits the deduction of expenses that are allocable to income that is tax exempt income. By nature of the program, any PPP loan that is forgiven is treated as tax exempt income, therefore any expenses paid using PPP funds would be deemed to be non-deductible. Under the Revenue Ruling, the taxpayer cannot deduct expenses where the expenses were funded by a PPP loan and the taxpayer can reasonably expect such loan to be forgiven, even if forgiven in a later year. The Revenue Ruling also states that if the taxpayer has filed or expects to file its application for the forgiveness of the PPP loan, then the taxpayer would be in a position to reasonably expect the loan forgiveness, and the related expenses would then be considered non-deductible.
Revenue Ruling 2020-27 contains two example situations. In both situations, a taxpayer uses PPP loan proceeds to pay expenses that are eligible for forgiveness under the Coronavirus Aid, Relief, and Economic Security (CARES) Act (qualifying payroll, rent, etc.). In the first situation, the taxpayer knows the amount of eligible expenses and has applied for loan forgiveness before year-end but is not informed whether the loan will be forgiven by year-end. In the second situation, the taxpayer has satisfied all the conditions for loan forgiveness but does not apply for loan forgiveness in the current year but plans to do so in a subsequent year.
Based on the Revenue Ruling, taxpayers in both situations are prohibited from deducting expenses paid for with their PPP loan proceeds because each taxpayer, based on the facts provided, can reasonably expect the loans to be forgiven and have therefore generated tax exempt income.