Uncertain Thankfulness: A Tax Deduction Denied & PPP Loan Forgiveness

By: Kate Roth

Under the CARES Act, PPP loans given to affected borrowers were potentially eligible for forgiveness without cancellation of indebtedness income. To qualify, an affected borrower must certify that (i) “the uncertainty of current economic conditions justifie[d] the loan request to support ongoing operations,” and (ii) the “funds [were] used to retain workers and maintain payroll.” Loan proceeds may be used to cover eligible expenses which includes payroll costs, mortgage interest, rent and utility payments. For complete forgiveness, at least 60 percent of the loan proceeds must be spent on payroll costs and all proceeds must be expended by the earlier of 24 weeks of the loan being disbursed or December 31, 2020.

Earlier this year, the IRS took the position that a taxpayer would be denied a deduction for eligible expenses funded by a PPP loan that was ultimately forgiven. The guidance was meant to prevent taxpayers from receiving the double tax benefit of tax-exempt loan forgiveness and deductions for expenses paid for with exempt loan proceeds. Under the CARES Act, however, PPP loan forgiveness is treated as tax-exempt income only if a borrower certifies that the loan was justified by a need arising from the COVID-19 pandemic and that funds were used to pay eligible expenses.

The determination of whether a loan will be forgiven will not occur until sometime in 2021 for many taxpayers. Taxpayers were uncertain of how to treat expenses paid in 2020 with PPP loan proceeds when the forgiveness determination occurs in 2021. In guidance released November 28, Treasury ruled that taxpayers could not deduct such PPP-funded expenses. Couched in the language of a reasonable expectation of forgiveness, Treasury reasoned that borrowers know, at the time of a loan forgiveness application, whether the funds were used for eligible expenses and, therefore, would likely be forgiven.

For an unaffected borrower, a reasonable expectation of forgiveness may not be as certain as Treasury states. In an effort to protect against abuse, the SBA has said that it will review forgiveness applications of all borrowers with loans of at least $2 million. The purpose of the review is to “evaluate the good-faith certification…that economic uncertainty made the loan request necessary.”

Many borrowers received PPP loans in anticipation of being adversely affected by economic fallout of the COVID-19 pandemic. Some borrowers may not have actually faced the anticipated financial hardship. For them, loan forgiveness remains uncertain under the SBA’s review guidelines. A borrower who receives a negative determination will (i) be required to pay regular and estimated taxes in 2020 as if the loan will be forgiven and (ii), when it is not forgiven in 2021, file an amended 2020 return claiming deductions for expenses paid with the loan proceeds.

Although Congress enacted coronavirus legislation with unprecedented speed to protect the American economy, for unaffected borrowers, PPP loans may not live up to the promise. This week, Americans are preparing for a unique Thanksgiving holiday. Reconciling Treasury’s reasonable expectation of forgiveness guidance with the SBA’s loan review process is likely not among the list of items for which unaffected borrowers will be thankful.

This update is prepared for the general information of our clients and friends. It should not be regarded as legal advice. For more information or assistance with tax issues arising from PPP loans, please contact any of the attorneys in our Tax Practice Group.

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