IRS Says No 2020 Deduction if PPP Forgiveness Reasonably Expected in 2021

On November 18, 2020, IRS issued Rev. Rul. 2020-27, directing that a taxpayer who received a Paycheck Protection Program loan and paid otherwise deductible expenses with the proceeds, may not deduct those expenses in the year they were incurred if the taxpayer reasonably expects to receive forgiveness of the loan. In conjunction with this guidance, the IRS issued Rev. Proc. 2020-51 providing “safe harbor” instructions for later deducting these expenses if the loan is not ultimately forgiven. Although it will not be popular, this guidance alerts taxpayers to the IRS position on this important subject prior to the calendar year end.

Rev. Rul. 2020-27

The guidance was provided to give taxpayers instructions as to how to comply with Notice 2020-32, issued May 2, 2020. In this now infamous guidance, the agency relied upon Treas. Reg. § 1.265-1 to find that a forgiven loan under the PPP—excluded from gross income under the CARES Act—results in a “class of exempt income” for which IRC § 265(a) disallows allocable expenses to the extent of the resulting loan forgiveness.

In support of its new rule, IRS states:

Authorities addressing reimbursement hold that an otherwise allowable deduction is disallowed if there is a reasonable expectation of reimbursement. See Burnett v. Commissioner, 356 F. 2d 755 (5th Cir. 1966) cert. denied, 385 U.S. 832 (1966); Canelo v. Commissioner, 53 TC 217, 225-226 (1969), aff’d447 F.2d 484 (9th Cir.1971); Charles Baloian Co. v. Commissioner, 68 T.C. 620 (1977); Rev. Rul. 80-348, 1980-2 C.B. 60; Rev. Rul. 79-263, 1979-2 C.B. 82.

None of the cited cases, however, have a similar fact pattern or relevant legal analysis. In Burnett, the taxpayer was a lawyer who had advanced litigation costs to a client. The costs were advanced with a reasonable expectation that the client would repay the money. The court denied the lawyer’s corresponding deduction, ruling that the advance was, in reality, a loan to the client, not an IRC § 162 business expense, since the lawyer had an expectation, at the time he took the deduction, that the amount would be substantially repaid. Canelo was a tax court case with similar facts and the same general holding: an advance of litigation costs to a client with a reasonable expectation of repayment is a loan, not a business expense. It’s difficult to see how these cases apply to the analysis of expenses paid with PPP loans since payroll expenses, rent, utilities, and mortgage interest comprise typical business expenses. The source of the funds used to pay these bills does not transform their character as expenses. The real question is whether a deduction for those expenses is an improper tax benefit if the loan is later forgiven.

Charles Baloian Co. is a bit more relevant because it involved an actual business expense, moving expenses. In this case, the taxpayer was leasing a building that was to be demolished. The redevelopment agency demolishing the building agreed to pay the taxpayer’s relocation expenses. The process required the taxpayer to submit a claim for the expenses it expected to incur and the agency would ultimately reimburse the business. In May, the agency reviewed the taxpayer’s submitted costs and issued an “authorization” to incur the costs.

One month later, the taxpayer incurred the actual expenses. It deducted the moving expenses on its return for the fiscal year ending June 30, and the following January, the agency reimbursed the actual expenses. The IRS sought to disallow the deduction based upon two theories: (1) the accrual basis taxpayer’s right to reimbursement matured before the expense was deducted when the agency issued the authorization letter, and (2) the deduction was allocable to tax-exempt income and should be disallowed under IRC § 265, which, inter alia, denies deductions for expenses allocable to such income.

The court did not address the second argument (the one IRS has made with respect to PPP loans) because it ruled in favor of the IRS on the first argument, which depended upon the fact that the business was an accrual basis taxpayer. The court stated that there was a well-settled rule that an accrual basis taxpayer is not allowed a deduction for an expense for which he has a fixed right to reimbursement through insurance or otherwise. A right to reimbursement is sufficiently fixed so as to deny the related expense deduction when such right has matured without further substantial contingency.¹ Again, these facts are very distinguishable from those of a PPP loan. In this case, the taxpayer was later reimbursed for expenses already paid. With PPP, the expenses are paid with proceeds from a loan that is later forgiven.Discharge of debt is very different from reimbursement.  Furthermore, this holding is only applicable to accrual basis taxpayers.

Finally, the IRS pulls a quote from Hillsboro National Bank v. Commissioner, 460 U.S. 370 (1983), to support its position that the tax benefit rule (which would allow the deduction in the year of the expense and inclusion of income in a later year) does not apply. The basic purpose of the tax benefit rule, the Court stated, is:

to protect the Government and the taxpayer from the adverse effects of reporting a transaction on the basis of assumptions that an event in a subsequent year proves to have been erroneous. Such an event, unforeseen at the time of an earlier deduction, may in many cases require the application of the tax benefit rule.

The agency relies on this quote to support its position that the tax benefit rule procedure (such as that applied in Hillsboro’s companion case of Bliss Dairy) doesn’t apply unless the subsequent year event is unforeseen. PPP forgiveness, IRS urges, is not unforeseen. It should be noted that the Court in Hillsboro found that the taxpayer was not required to recognize income under the tax benefit rule (despite having taken a deduction). The bank was not required to include in gross income the value of taxes it had paid on behalf of its shareholders and deducted, even though those taxes were refunded to the shareholders in a later year after a change in law.  "As long as the payment itself was not negated by a refund to the corporation, the change in character of the funds in the hands of the State does not require the corporation to recognize income," the Court held.

What’s Ahead

If nothing changes, some taxpayers will likely challenge the IRS guidance issued today, as well as the initial Notice 2020-32. Those taxpayers who deducted expenses on fiscal year returns may need to amend.

Perhaps this guidance will encourage Congress to address this issue. It has been urged by many lawmakers that they did not intend to limit the deductibility of expenses when they excluded forgiven loan proceeds from gross income. A simple fix would save many headaches and rescue struggling businesses from yet another hardship.

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¹ The court noted that the fact that actual payment had to await the performance of certain ministerial or mechanical acts on the part of a third person or governmental agency did not render the payment contingent.