In an earlier article we had discussed reports that the IRS was planning to issue guidance to block borrowers from claiming a deduction for expenses they expected to use for Paycheck Protection Program (PPP) loan forgiveness even if they had not yet applied for or received forgiveness.[1] Now that shoe has dropped with the issuance of Revenue Ruling 2020-27.[2]

IRS Original Primary Theory – It’s a Deduction Related to Tax Exempt Income

The IRS issued Notice 2020-32 in April that took the position that expenses that led to the obligation to repay a PPP loan being forgiven could not be deducted. In the ruling, the IRS spends virtually the entire notice outlining a justification for denial of the deduction that relies on treating the forgiveness income as tax exempt income once CARES Act §1106(i) is considered (which provides the forgiveness will not be taxable to the borrower), triggering IRC §265(a)(1) which bars a deduction for expenses related to tax exempt income.

However, in the very last paragraph before the contact information, the IRS poses an alternative theory for why the expenses cannot be deducted:

The deductibility of payments of eligible section 1106 expenses that result in loan forgiveness under section 1106(b) of the CARES Act is also subject to disallowance under case law and published rulings that deny deductions for otherwise deductible payments for which the taxpayer receives reimbursement. See, e.g., Burnett v. Commissioner, 356 F.2d 755, 759-60 (5th Cir. 1966); Wolfers v. Commissioner, 69 T.C. 975 (1978); Charles Baloian Co. v. Commissioner, 68 T.C. 620 (1977); Rev. Rul. 80- 348, 1980-2 C.B. 31; Rev. Rul. 80-173, 1980-2 C.B. 60.[3]

As Nathan Smith of CBIZ Inc. remarked in an article published in Tax Notes Today Federal on November 11[4] discussing speculation that the IRS would issue a ruling dealing with the status of payments made when, at year end, no forgiveness had been obtained, the two theories advanced by Treasury appear to lead to different results prior to forgiveness being obtained.

Because the government offered two different positions for nondeductible treatment, the ancillary question about timing must be addressed discretely under each of those positions, Smith said. And as it turns out, the answer to the timing question appears to be different depending on which of the two positions from Notice 2020-32 a taxpayer chooses to follow, he added.

The primary and the alternative positions in Notice 2020-32 are distinct because receiving tax-exempt income isn’t the same as receiving an expense reimbursement, Smith said. He pointed to a few court decisions that held that expense reimbursements aren’t tantamount to gross income, and other cases showing instead that the reimbursement reduces the amount of the deduction. The rationale for that conclusion is that the taxpayer hasn’t made an expenditure or cost outlay, Smith said.

“On the other hand, the primary position that relies on section 265 relies on the existence of tax-exempt income — in this case loan forgiveness income,” Smith said. “So pick your poison — either tax-exempt income (income exists) or expense reimbursement (no income exists). Two different timing answers, depending on which one you pick.”[5]

As was noted in our article, the Supreme Court’s ruling in Bliss Dairy would seem to require use of the tax benefit rule, giving a deduction in the current year and then picking up income in the following year if the “tax exempt income” view is correct. But if this is an expected reimbursement, then a taxpayer would not be allowed a deduction even if the reimbursement had not yet been received.[6]

So Let’s Go With Reimbursement as Our Primary Theory…

Revenue Ruling 2020-27 bars a deduction for expenses paid prior to receiving PPP loan forgiveness if a taxpayer has a reasonable expectation of receiving forgiveness based on those expenses. The holding provides:

A taxpayer that received a covered loan guaranteed under the PPP and paid or incurred certain otherwise deductible expenses listed in section 1106(b) of the CARES Act may not deduct those expenses in the taxable year in which the expenses were paid or incurred if, at the end of such taxable year, the taxpayer reasonably expects to receive forgiveness of the covered loan on the basis of the expenses it paid or accrued during the covered period, even if the taxpayer has not submitted an application for forgiveness of the covered loan by the end of such taxable year.[7]

While the IRS in the analysis does note that the original ruling discussed the “tax exempt income” with a deduction denial under §265(a)(1) theory, this time only a single paragraph is devoted to that justification.[8]

The bulk of the analysis of the law this time turns to the reimbursement theory to disallow the deduction.

Notice 2020-32 also relied on authorities holding that deductions for otherwise deductible expenses are disallowed if the taxpayer receives reimbursement for such expenses. Authorities addressing reimbursement further 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’d 447 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.

In Burnett, a lawyer advanced expenses to clients that the clients were obligated to repay only to the extent the lawyer was successful in obtaining recovery on the client’s claim. The taxpayer argued that the advances were deductible trade or business expenses under section 162 of the Code because there was no unconditional obligation on the part of the clients to repay the advances. The court noted that the taxpayer provided assistance only to clients with claims that were likely to be successful and that the advances were “made to clients with the expectation, substantially realized, that they would be recovered.” 356 F.2d at 758. On that basis, the court affirmed the Tax Court’s holding that the advances were not deductible. Similarly, in Canelo v. Commissioner, 53 TC 217, 225-226 (1969), aff’d 447 F.2d 484 (9th Cir.1971), a personal injury law firm advanced litigation costs on behalf of its clients, and the clients had no obligation to repay the costs unless their case was successful. The law firm deducted the litigation costs in the year paid and included the reimbursed costs in income in the year of reimbursement. The law firm screened clients to reduce the risk that the advanced costs would not be repaid and took cases when there was a “good hope” of recovery. The court determined that the law firm’s advances operated as loans to its clients for which the law firm had an expectation of reimbursement. Therefore, deductions for the advances under section 162 were not allowed. See also Herrick v. Commissioner, 63 T.C. 562 (1975) (similar effect); Silverton v. Commissioner, T.C. Memo. 1977-198 (1977) (similar effect).[9]

Examples

The ruling provides us with two examples of applying this holding.

Situation 1, Revenue Ruling 2020-27

During the period beginning on February 15, 2020, and ending on December 31, 2020 (covered period), Taxpayer A (A) paid expenses that are described in section 161 of the Internal Revenue Code (Code) and section 1106(a) of the CARES Act (eligible expenses). These expenses include payroll costs that qualify under section 1106(a)(8) of the CARES Act, interest on a mortgage that qualifies as interest on a covered mortgage obligation under section 1106(a)(2) of the CARES Act, utility payments that qualify as covered utility payments under section 1106(a)(5) of the CARES Act, and rent that qualifies as payment on a covered rent obligation under section 1106(a)(4) of the CARES Act. In November 2020, pursuant to the terms of section 1106 of the CARES Act, A applied to the lender for forgiveness of the covered loan on the basis of the eligible expenses it paid during the covered period. At that time, and based on A’s payment of the eligible expenses, A satisfied all requirements under section 1106 of the CARES Act for forgiveness of the covered loan. The lender does not inform A whether the loan will be forgiven before the end of 2020.

Based on the foregoing, when A completed its application for covered loan forgiveness, A knew the amount of its eligible expenses that qualified for reimbursement, in the form of covered loan forgiveness, and had a reasonable expectation of reimbursement. The reimbursement, in the form of covered loan forgiveness, was foreseeable. Therefore, pursuant to the foregoing authorities, A may not deduct A’s eligible expenses.

In the alternative, section 265(a)(1) disallows a deduction of A’s otherwise deductible eligible expenses because the expenses are allocable to tax-exempt income in the form of reasonably expected covered loan forgiveness.[10]

Situation 2, Revenue Procedure 2020-27

During the covered period, Taxpayer B (B) paid the same types of eligible expenses that A paid in Situation 1. B, unlike A, did not apply for forgiveness of the covered loan before the end of 2020, although, taking into account B's payment of the eligible expenses during the covered period, B satisfied all other requirements under section 1106 of the CARES Act for forgiveness of the covered loan. B expects to apply to the lender for forgiveness of the covered loan in 2021.

Although B did not complete an application for covered loan forgiveness in 2020, at the end of 2020, B satisfied all other requirements under section 1106 of the CARES Act for forgiveness of the covered loan and at the end of 2020 expected to apply to the lender for covered loan forgiveness of the covered loan in 2021. Thus, at the end of 2020 B both knew the amount of its eligible expenses that qualified for reimbursement, in the form of covered loan forgiveness, and had a reasonable expectation of reimbursement. The reimbursement in the form of covered loan forgiveness was foreseeable. Therefore, pursuant to the foregoing authorities, B may not deduct B's eligible expenses.

In the alternative, section 265(a)(1) disallows a deduction of B's otherwise deductible eligible expenses because the expenses are allocable to tax-exempt income in the form of reasonably expected covered loan forgiveness.

Note that in both cases the bulk of the reasoning supporting the answer relies on the reimbursement theory. In each case, a short sentence is added to the end to mention a §265(a)(1) tax exempt income theory.

Is It a Reimbursement?

It’s not clear to this author that the reimbursement theory is necessarily the proper way to view this program, since it’s pretty clear that Congress consistently referred to it as a loan program in the CARES Act. As well, the inclusion of §1106(i)’s rules on not picking up the forgiveness as taxable income also seems to argue in favor of the view that Congress was enacting a loan program—reimbursements would not have been income to the taxpayer. Thus, §1106(i) becomes a provision that does nothing under the law.

It is reasonable to suspect that the reason the IRS led with the tax exempt income theory in Notice 2020-32 and devoted most of the analysis to that view is because while you might argue this has the same effect as viewing the transaction in the form of a reimbursement, it’s pretty clear that Congress had chosen the form of a loan for the structure rather than making the amounts into a advance reimbursement that would need to be returned if not used for appropriate purposes.

But when the Paycheck Protection Program Flexibility Act (PPPFA) greatly lengthened the time period for spending the funds and applying for forgiveness without having to make payments on the loans, the IRS now faced the situation where many (and perhaps most) borrowers with calendar year ends would not have received a forgiveness decision by December 31. So now the question of whether the expense could be disallowed based on being paid from tax exempt income before any such tax exempt income was generated became a real problem for the agency.

What the IRS appears to be doing now is trying to argue substance over form in this case. And, clearly, the IRS has won numerous cases against taxpayers by taking that position to treat a transaction differently from its formal structure. But note that the primary justification for allowing such a restructuring is that the taxpayer was in charge of establishing the form of the transaction. In this case, the borrower had no choice about the structure of this program—it was a loan.

At the time Notice 2020-32 was released, the PPP loan program was structured to make it likely most borrowers would apply for forgiveness well before their year end unless that fiscal year end was in the summer. The issue of timing was not going to arise in that context, as the borrower would have received forgiveness by the end of the calendar year, by far the most popular fiscal year end.

And even if reimbursement would be allowed as a possible route to non-deductibility, the IRS conceded in Notice 2020-32 and even in this ruling that it is possible to view it as a loan that is forgiven.

The switch in emphasis from “tax exempt income-no deduction under IRC §265(a)(1)” to “no deduction due to expected reimbursement” presumably has taken place because the IRS recognizes the relative weakness of their position on timing in the loan scenario if forgiveness has not yet taken place.

IRS Addressing the Tax Benefit Rule

If we accept that these expenses will be eventually non-deductible if forgiveness is obtained, the primary argument for allowing a deduction initially if no forgiveness is obtained by the year end is that the tax benefit rule will serve to pick up the income in a later year.

The IRS does address the issue in their ruling, arguing the following:

Under the related “tax benefit rule,” if a taxpayer takes a proper deduction and, in a later tax year, an event occurs that is fundamentally inconsistent with the premise on which the previous deduction was based (for example, an unforeseen refund of deducted expenses), the taxpayer must take the deducted amount into income. See section 111 of the Code (providing that gross income does not include income attributable to the recovery during a taxable year of any amount deducted in any prior taxable year to the extent such amount did not reduce the amount of tax imposed by chapter 1 of the Code). The Supreme Court applied the tax benefit rule in Hillsboro National Bank v. Commissioner, 460 U.S. 370 (1983). In that case, the Court observed that “[t]he basic purpose of the tax benefit rule is to achieve rough transactional parity in tax . . . and 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.” Id. at 383.[11]

Those who have read articles arguing for a deduction of such expense and later inclusion of income under the tax benefit rule may note those articles refer to Bliss Dairy for their support. What is of interest is that the Supreme Court decided Hillsboro and Bliss Dairy at the same time in the same opinion. So is the opinion internally inconsistent?

Not really. While the quote noted by the IRS is in the opinion, when the Court looked at a case with the following facts in the very same opinion, the Court found the tax benefit rule applied and did not suggest the original deduction should have been disallowed as the reversal was clearly foreseeable at the end of the tax year:

A cash basis taxpayer (Bliss Dairy) claimed a deduction for feed purchased just before the end of the taxpayer’s fiscal year ended June 30, 1973. The vast majority of the feed was not used by June 30, 1973.
The taxpayer liquidated the corporation on July 2, 1973 (two days later) and distributed the feed to the shareholders. Under the then existing version of IRC §336 the corporation did not recognize any gain when this feed was transferred out to the shareholders in liquidation.
Under the then in force “one-month liquidation rule” of §333 the shareholders were also able to limit the amount of gain they recognized on disposing of their stock. Under those rules, they were able to allocate a portion of the basis in their stock to the feed.
Finally, they continued to operate the dairy as an unincorporated entity, claiming a deduction again for the grain that was used.[12]

While the decision found that Bliss was required to reverse the deduction for the portion of the feed on hand at the date of the liquidation under the tax benefit rule, it is important to note that it was clearly foreseen that Bliss would be liquidating immediately after that year end—in fact, that was the key to their tax planning strategy to effectively get a double deduction.

The Court did not use the IRS approach proposed in Revenue Ruling 2020-27 to find the tax benefit rule inapplicable, as no deduction should have been allowed for the year ended June 30, 1973. Rather, the Supreme Court agreed with the IRS position at that time that the deduction was allowed, but once the event occurred inconsistent with the deduction (in this case, the one-month liquidation) the tax benefit rule forced a reversal of the deduction related to the feed that would be distributed to the shareholders.

Again, a skeptic might assume that the IRS intentionally ignored the Bliss facts in this ruling but cited a sentence in the decision to give the appearance they were dealing with the well-known criticism of denying the deduction in this case (see, your case supports our position!), but without having to deal with those pesky facts that were the basis of the position for those citing Bliss.

So What Does a Taxpayer Do?

This is where things get complicated. It certainly appears there is still a reasonable basis to argue that if the expenses aren’t deductible eventually, it’s via the §265(a)(1) nontaxable income standard the IRS emphasized in Notice 2020-32. And, if that is the case, the event inconsistent with a deduction had not occurred by year end if there was not forgiveness granted—no tax-exempt income yet existed to which the deduction could relate. And you can argue this view is consistent with the treatment of the program as a loan with a later forgiveness of indebtedness, which is the only view Congress expressed in the CARES Act. The “reimbursement” construct is one that was created by the IRS.

So it is possible to claim the deduction on the return and simply disclose the position on a Form 8275. That would serve to limit the taxpayer’s exposure to penalties.

But a taxpayer that takes this position needs to be aware of some key facts:

The IRS is not likely to concede this issue if the return is pulled for examination, nor is it likely that an appellate conferee will go against this ruling of the National Office unless the IRS has already been defeated on the issue in court.
Taking this issue to Court entails a very significant amount of expense that the taxpayer will need to pay up front, and they aren’t likely to win an award of these expenses by the court even if the taxpayer prevails.
Even if the taxpayer decides not to take the matter to court, there will still be the costs of representation and dealing with the examination, which could include a period of dealing with proposed penalties and the mere fact the IRS may raise other issues as long as they are looking at the return.

So the client needs to understand the uncertainty that exists here, as well as the fact that it may simply not prove to be cost-effective to take the more aggressive position to claim the deduction if the IRS challenges that position—and that might be the case even if the taxpayer ultimately prevails.

There is still a possibility that Congress will address the deductibility of these expenses in legislation in the next few months. One option that should be given to taxpayers is to extend the return to see if Congress does act to allow the deduction.

What if My Reasonable Expectation of Forgiveness Turns Out to Be Mistaken?

Assuming a taxpayer follows the IRS ruling and does not deduct the expenses on their 2020 return, what happens if the taxpayer later finds that some or all of the loan is not going to be forgiven? Does the taxpayer now have to go back and amend the 2020 return?

The situation does create a quirky problem. Generally, the Supreme Court has ruled that we have an annual tax system and the results have to be based on applying facts there were at least knowable at year end to the law ultimately in effect at that time. When the forgiveness applicable is fully or partially denied by the lender in 2021, that is a fact that was not knowable at the end of 2020. But it’s also clear the expense was actually paid in 2020 and was only not deducted because we believed the amount would be reimbursed—a belief that proved, ultimately, to be in error.

To deal with this conundrum the IRS has released Revenue Procedure 2020-51[13] to provide a safe harbor to deal with some of these issues.

A taxpayer who meets the following tests is eligible to use the safe harbor:

The taxpayer paid or incurred eligible expenses in the 2020 taxable year for which no deduction is permitted because at the end of the 2020 taxable year the taxpayer reasonably expects to receive forgiveness of the covered loan based on those eligible expenses (non-deducted eligible expenses);
The taxpayer submitted before the end of the 2020 taxable year, or as of the end of the 2020 taxable year intends to submit in a subsequent taxable year, an application for covered loan forgiveness to the lender; and
In a subsequent taxable year, the lender notifies the taxpayer that forgiveness of all or part of the covered loan is denied.[14]

As well, a taxpayer may use this safe harbor by meeting the following requirements:

The taxpayer meets the first two requirements cited under the immediately preceding test; and
In a subsequent taxable year, the taxpayer irrevocably decides not to seek forgiveness for some or all of the covered loan. For example, a taxpayer that determines that it will not qualify for covered loan forgiveness and withdraws the application submitted to the lender would be such a taxpayer.[15]

Taxpayers meeting one of those two sets of conditions can make use of one of two options to deal with deducting these expenses for which no forgiveness will be granted.

Deduct the expenses on the 2020 tax return. A qualified taxpayer may deduct non-deducted eligible expenses on the taxpayer’s timely filed, including extensions, original income tax return or information return, as applicable, for the 2020 taxable year, or amended return or AAR under section 6227 of the Code for the 2020 taxable year, as applicable;[16] or
Deduct the expenses on the 2021 tax return. A qualified taxpayer may deduct non-deducted eligible expenses on the taxpayer’s timely filed, including extensions, original income tax return or information return, as applicable, for the subsequent taxable year (normally a 2021 taxable year).[17]

The ruling clarifies that if a taxpayer applies for forgiveness and has amounts formally denied (the taxpayer meets the first set of conditions to use the safe harbor), the taxpayer may use the second safe harbor but is not required to formally elect to use the safe harbor to deduct the expenses in the subsequent tax year. Such a taxpayer would only need to use the safe harbor to claim the deduction for the 2020 tax year.

The procedure provides the deduction is limited as noted:

A taxpayer applying …[one of the safe harbors] may not deduct an amount of non-deducted eligible expenses in excess of the principal amount of the taxpayer’s covered loan for which forgiveness was denied or will no longer be sought.[18]

A taxpayer making use of this safe harbor must attach a statement to the tax return containing the following information:

The taxpayer’s name, address, and social security number or employer identification number;
A statement specifying whether the taxpayer is an eligible taxpayer under either section 3.01 or section 3.02 of Revenue Procedure 2020-51;
A statement that the taxpayer is applying section 4.01 or section 4.02 of Revenue Procedure 2020-51;
The amount and date of disbursement of the taxpayer’s covered loan;
The total amount of covered loan forgiveness that the taxpayer was denied or decided to no longer seek;
The date the taxpayer was denied or decided to no longer seek covered loan forgiveness; and
The total amount of eligible expenses and non-deducted eligible expenses that are reported on the return.[19]

The IRS concludes by noting that merely because this procedure is used for a particular expense, the IRS can still look at the underlying details of an expense and challenge it for other reasons:

Nothing in this revenue procedure precludes the IRS from examining other issues relating to the claimed deductions for non-deducted eligible expenses, including the amount of the deduction and whether the taxpayer has substantiated the deduction claim. It also does not preclude the IRS from requesting additional information or documentation verifying any amounts described in the statement described in section 4.04 of this revenue procedure.[20]

[1] Ed Zollars, “Guidance Denying Deduction for PPP Forgivable Expenses Even if Forgiveness Not Granted by Year End Reported to Be on the Way from Treasury,” Current Federal Tax Developments website, November 14, 2020, https://www.currentfederaltaxdevelopments.com/blog/2020/11/14/guidance-denying-deduction-for-ppp-forgivable-expenses-even-if-forgiveness-not-granted-by-year-end-reported-to-be-on-the-way-from-treasury (retrieved November 19, 2020)

[2] Revenue Ruling 2020-27, November 18, 2020, https://www.irs.gov/pub/irs-drop/rr-20-27.pdf (retrieved November 19, 2020)

[3] Notice 2020-32, https://www.irs.gov/pub/irs-drop/n-20-32.pdf (retrieved November 19, 2020)

[4] Eric Yauch, “PPP Borrowers Brace for Potentially Problematic IRS Guidance,” Tax Notes Today Federal, 2020 TNTF 218-1, November 11, 2020 , https://www.taxnotes.com/tax-notes-today-federal/partnerships/ppp-borrowers-brace-potentially-problematic-irs-guidance/2020/11/11/2d5zd (retrieved November 19, 2020)

[5] Eric Yauch, “PPP Borrowers Brace for Potentially Problematic IRS Guidance,” Tax Notes Today Federal, 2020 TNTF 218-1, November 11, 2020

[6] Ed Zollars, “Guidance Denying Deduction for PPP Forgivable Expenses Even if Forgiveness Not Granted by Year End Reported to Be on the Way from Treasury,” Current Federal Tax Developments website, November 14, 2020

[7] Revenue Ruling 2020-27, p. 8

[8] Revenue Ruling 2020-27, pp. 3-4

[9] Revenue Ruling 2020-27, pp. 4-5

[10] Revenue Ruling 2020-27

[11] Revenue Ruling 2020-27

[12] Hillsboro National Bank v. Commissioner, 460 US 370 (consolidated with United States v. Bliss Dairy Inc., 81-930)

[13] Revenue Procedure 2020-51, November 18, 2020, https://www.irs.gov/pub/irs-drop/rp-20-51.pdf (retrieved November 19, 2020)

[14] Revenue Procedure 2020-51, Section 3.01

[15] Revenue Procedure 2020-51, Section 3.02

[16] Revenue Procedure 2020-51, Section 4.01

[17] Revenue Procedure 2020-51, Section 4.02

[18] Revenue Procedure 2020-51, Section 4.03

[19] Revenue Procedure 2020-51, Section 4.04

[20] Revenue Procedure 2020-51, Section 4.05