Deductibility of PPP Loan Expenses and Tax Planner Software

On January 6, 2021, the IRS released yet another set of guidance for the Paycheck Protection Program (PPP). Revenue Ruling 2021-2 states that otherwise deductible expenses covered by PPP loans can be deducted on a business’s tax return.

The deductibility of program expenses has been a hot topic ever since the loan program was introduced in March, and up until now, deductions have been disallowed. IRS Notice 2020-32 (released in May 2020), Revenue Ruling 2020-27, and Revenue Procedure 2020-51 (both released in November 2020) all agree that PPP expenses are not deductible if the loan has been (or is likely to be) forgiven. Revenue Ruling 2021-2, the first PPP guidance of 2021, makes all three of these directives obsolete. This applies retroactively to first-round loans and prospectively to second-round loans.

More About Revenue Ruling 2021-2

The Consolidated Appropriations Act, 2021, which Congress passed just before the new year, altered the PPP in a few major ways, but the deductibility of program expenses is the most notable. Revenue Ruling 2021-2 is the IRS’s interpretation of this law change.

PPP loans are intended to help businesses pay for certain qualified expenses – payroll, rent, mortgage interest, supplier costs, and a few other expense categories – during a specified “covered period.” If loan proceeds are used on these qualified expenses, the loan is likely to be forgiven. Before Revenue Ruling 2021-2 was published, eligible PPP expenses were rendered nondeductible if the loan was (or was expected to be) forgiven. Not being able to deduct these otherwise deductible expenses worried many business owners. Without those business deductions, taxable incomes would rise, and business owners would be forced to pay large tax bills during a time when their organizations were already struggling financially. Revenue Ruling 2021-2 brought some form of relief to these business owners.

In addition to allowing deductions for eligible program expenses, the Revenue Ruling affirms that forgiven PPP loans are not includible in gross income. In most circumstances, cancellation of debt will increase taxable income, but PPP loan forgiveness is excluded from this requirement.

Other PPP Tax Considerations

Although most PPP activity will not affect a business’s tax return, there are certain instances where it may.

Timing of Deductions

Now that business expenses funded with the proceeds of a forgiven (or forgivable) PPP loan are deductible, the timing of expense recognition is not as much of a concern. Businesses can deduct these costs as if they were any other deductible business expense whether they have applied for forgiveness or anticipate that their loans will be forgiven.

Interest Payments

If a business uses their loan proceeds in an unqualified manner or fails to use those proceeds within the covered period, their request for loan forgiveness may be fully or partially denied. If they are forced to repay some or all their PPP loan, they will owe interest to their lender at the stated interest rate. Because PPP loans are considered true Federal debt, the associated interest payments are deductible.

Employee Retention Tax Credit

The Consolidated Appropriations Act, 2021 reverses prior guidance that stated businesses receiving the Employee Retention Tax Credit (ERTC) could not also receive PPP funding.

The ERTC is a refundable credit that rewards businesses for retaining employees during the coronavirus health crisis. There are actually 3 ERTC credits you need to be aware of:

Type 1: ERTC Section 206 – 2020 Only (50% of qualified wages of eligible employees and can be taken against employment taxes rather than income taxes)

Type 2: ERTC Section 207 – 2021 Only (70% of qualified wages)

Type 3: ERTC Section 302 – Both 2020 and 2021, Disaster Related Instances Only (Not related to COVID) (40% of qualified wages)

The Consolidated Appropriations Act, 2021 permits businesses to both claim the ERTC and request a PPP loan, although loan proceeds cannot be used to pay for payroll expenses that are used to claim the ERTC.

Tax Basis and Tax Attributes

Revenue Ruling 2021-2 offers taxpayers yet another win: loan forgiveness will not affect partners’ or shareholders’ tax bases or tax attributes.

Because PPP loan proceeds are not includible in gross income, the IRS views those proceeds as tax exempt income. This means that owners can increase the tax basis in their S corporation stock or partnership interest by their ratable share of the loan. Typically, when debt is forgiven, taxpayers are required to reduce their tax bases to reflect that debt reduction, but Revenue Ruling 2021-2 makes clear that PPP loan forgiveness is relieved of this requirement.

Increasing tax basis for PPP loan proceeds is a big win for many small business owners. In 2020, a year when many businesses are reporting tax losses, business owners want as much tax basis in their ownership shares as possible. If they have insufficient tax bases, they must suspend those losses and deduct them in another year. Being able to raise their bases by the loan proceeds may give them enough tax basis to take their share of the business loss in 2020.

How These Changes Affects Tax Planning

A second round of PPP loans may be able to give your clients a strong foothold as they wade into the uncharted waters of 2021. And the other changes introduced in the Consolidated Appropriations Act, 2021 – allowing deductions for eligible PPP expenses, permitting basis increases for loan proceeds, and allowing PPP participants to take the ERTC – will only compound the benefits to your client’s tax position. Take a moment to give your clients a bit of good news.

As you begin working on their 2020 tax return, talk to them about their intentions with the PPP loan program in 2021. Do they plan to get a second-round loan? Have they sought forgiveness for first-round loans? Do they understand how their tax basis in their business affects their personal income tax return? If you can ask these questions now, you can help your clients make proactive choices in other areas of their tax return to produce the optimal tax position in 2021.

A comprehensive tax planner software can help you suggest the best tax moves to make. Our Corvee tax planner software is dynamic, which means that you can change just one assumption or multiple assumptions in your client’s tax plan and see what results from those changes. For example, our software can help answer the question, “Is it good to take bonus depreciation in 2020 when the business is reporting a loss?” Or, “Is there a tax credit that can reduce taxable income in 2021, or is it best to seek those credits when we have more income?” All these questions – and many more – can be answered with our tax planner software. If you’d like to see how it works, we’d love to show you. Simply request a demo today.