The IRS has added more clarification in the final Form 1120S instructions[1] about how expenses paid with PPP loan funds that lead to debt forgiveness should be treated in the computation of the accumulated adjustments account (AAA) and the other adjustments account (OAA).

On January 3, 2022, the IRS released draft instructions that first indicated that expenses paid with PPP loan proceeds should be treated as expenses related to tax exempt income under IRC §1368(e)(1)(A) and excluded from the calculation of AAA. However, some advisers weren’t sure how exactly this should be reported on Schedule M-2.

Line 2 of Schedule M-2 places the net ordinary income from line 1, page 21 into the AAA column and that will generally already be reduced by the expenses used for forgiveness which, though related to tax exempt income, were made deductible by the Comprehensive Appropriations Act, 2021 (CAA) in December 2020. 

While some (including this author) argued that the “other additions” line should be used to add the expenses back in computing AAA, not all were comfortable making that entry without explicit IRS instructions.  However, there was no other way to make the worksheet come to the result specified by the IRS while still following the implied instructions to put the net ordinary income on line 2, column (a).

The IRS has now explained that, yes, that is what the agency meant should be done, expanding the “Tip” by adding additional paragraphs not found in the original draft instructions:

PPP loans. An S corporation should include tax-exempt income from the forgiveness of PPP loans in column (d) on line 3 of the Schedule M-2.

An S corporation should report expenses paid this year with proceeds from PPP loans that were forgiven this year in column (d) on line 5 of the Schedule M-2.

If column (a) on line 2 or line 4 of the Schedule M-2 includes expenses paid with proceeds from forgiven PPP loans, an S corporation should report that amount in column (a) on line 3 and in column (d) on line 5 of the Schedule M-2.

If column (a) on line 1 of the Schedule M-2 includes expenses that were paid in a prior year with proceeds from PPP loans that were forgiven this year, an S corporation should report that amount in column (a) on line 3 and in column (d) on line 5 of the Schedule M-2.

Note that the last paragraph contains guidance for how to correct AAA if the amount reported on the return for the previous year erroneously had been reduced by such expenses paid in a prior year.

What the instructions do not say, but which an adviser should recognize, is that this “fix” only completely resolves the issue if the misclassified AAA did not have an impact on the prior year’s tax reporting.  As there was no underlying law change, this treatment should have been followed on 2020 returns as this author argued immediately following the passage of the CAA. 

IRC §1368(d)(1)(A)’s wording has not been changed for many years and the IRS had consistently taken the position these expenses related to the tax-exempt income from PPP loan forgiveness during 2020.  When Congress made such expenses deductible, it did not do so by making these expenses not related to tax-exempt income—the law just made that point irrelevant to claiming the deduction.

If the S corporation made distributions in 2020 and those distributions appeared to have exceeded AAA prematurely due to these expenses erroneously reducing AAA and the corporation had accumulated earnings and profits, amounts would have been reported as taxable dividends on Forms 1099-DIV by the S corporation and shareholders would have included these dividends in income and not used those amounts as distributions that reduced their basis in the S corporation stock.

If the Forms 1099-DIV are not reissued reporting the reduced dividends and the shareholders do not revise their returns, the IRS would still be able to reduce the shareholders’ basis in their S corporation shares by those distributions, as they were distributions that reduced the shareholders’ basis.  The fact the shareholder paid tax on the distribution is simply a mistake made by the shareholder and would not justify adjusting the shareholder’s basis upward to make up for the error.

As well, the shareholder would have likely paid additional tax on their 2020 individual income tax return he/she did not owe. So only if there were no erroneous Forms 1099-DIV issued by the S corporation for 2020 should making the adjustments as noted in the last paragraph of the IRS tip be the only step taken to adjust for the reporting issue for 2020.

[1] 2021 Instructions for Form 1120S, January 20, 2022, https://www.irs.gov/pub/irs-pdf/i1120s.pdf (retrieved January 22, 2022)