Under the CARES Act, the amount of Paycheck Protection Program (PPP) loan forgiven is excluded from gross income. On May 2, 2020 the Department of the Treasury and the IRS released Notice 2020-32, which clarified that no deduction would be allowed for expenses paid from the forgiven loan. Many taxpayers and tax professionals were hopeful Congress or the IRS would reverse course and issue guidance allowing for the deduction of the expenses in alignment with the original intent of the PPP loan, but on November 18, 2020 the IRS released Rev. Rul. 2020-27, which re-affirmed that a taxpayer may not deduct expenses from PPP loan funds they reasonably expected to be forgiven.
On December 27, 2020 the President signed into law the $900 billion Covid-19 Relief Bill, passed by Congress on December 21, 2020, which supersedes the previous IRS guidance. Among other things, this bill clarifies that in alignment with Congress’s original intent “no deduction shall be denied, no tax attribute shall be reduced, and no basis shall be denied, by reason of the exclusion from gross income provided” by Section 1106 of the CARES Act. In short, the business expenses paid with forgiven PPP funds are tax-deductible. This provision applies both to loans under the original PPP and subsequent PPP loans. (Please note: California has not yet indicated if it will conform to this law).
This bill brings much needed clarity to the tax treatment of the forgiven PPP loan funds, however, some taxpayers with an overall loss in 2020 may run into an unexpected timing issue related to the deduction of the expenses depending on when their PPP loan was forgiven. In order for a taxpayer to fully deduct a loss they need to have sufficient tax basis in the business activity. For taxpayers who receive forgiveness in 2021 they will not be able to increase their tax basis in 2020 which could result in the 2020 loss being suspended due to insufficient stock or at-risk basis. If this is the case the loss would carry forward into 2021 and would be released when the loan is forgiven and tax basis is increased..
For example: Consider a sole shareholder of an S-Corporation. Going into the 2020 tax year the shareholder has basis in their stock of $100,000. During 2020 the entity took out a PPP loan for $500,000, which was used on qualifying expenses and will be fully forgiven in 2021. The 2020 loss, before considering the forgiveness, is $500,000. Since the loan forgiveness will not happen until 2021 the shareholder’s stock basis in the entity cannot be increased for the $500,000 in PPP loan forgiveness (non-taxable income) in 2020. As a result, their stock basis before considering the 2020 loss is still $100,000 and accordingly, they are only allowed to deduct $100,000 of the entity’s tax loss in 2020 and the remaining $400,000 will carry forward to 2021. In 2021 when the loan is forgiven, their stock basis will be increased by $500,000 and the prior suspended loss carryover of $400,000 will be released.