A potential problem for S corporations that received PPP loan forgiveness who had accumulated earnings and profits involved the proper classification of the expenses paid with the PPP loan proceeds in the computation of the accumulated adjustments account (AAA).  A post by Dan Chodan, CPA on Twitter on January 3, 2022 pointed out that the IRS had now given guidance on this issue.[1]

The issue arose after Congress, in the Economic Aid to Hard-Hit Small Businesses, Nonprofits, and Venues Act signed into law on December 27, 2020, provided that expenses paid that led to the forgiveness of the PPP loan would be deductible for federal tax purposes, overriding IRS Notice 2020-32 that provided such expenses would not be deductible for federal tax purposes.

The problem arose when taxpayers went to compute their Accumulated Adjustments Account on Schedule M-2 of Form 1120-S.  While the 2020 instructions told taxpayers to omit tax-exempt income from the calculation of AAA, AAA was to be reduced by all deductible expenses.[2]  Tax software, following those instructions would move the tax exempt income to the Other Adjustments Account column but would normally not make any adjustment to move the expenses paid with the PPP loans into this account and out of the AAA account. This was true even though those instructions did state this account was to be adjusted for “tax-exempt income (and related expenses)…(emphasis added).”[3]

Under IRC §1368(e)(1)(A) and the instructions, a taxpayer’s basis would be increased by the PPP loan forgiveness per the Economic Aid to Hard-Hit Small Businesses, Nonprofits, and Venues Act, but the corporation’s AAA would not be increased as the income was exempt from tax.  But IRC §1368(e)(1)(A) specifically provided that “no adjustment shall be made for income (and related expenses) which is exempt from tax under this title…”.

Some advisers, this one included, believed that the treatment of this by most tax software was in error, noting that IRC §1368(e)(1)(A) provided that expenses related to tax-exempt income also did not reduce AAA, and that provision in the Code would override any language in the instructions that might appear contrary to that treatment.  Such advisers pointed out that the 2020 instructions did refer to expenses related to tax exempt income being an item to be reported in OAA.[4]

Such expenses had been labeled by the IRS in Notice 2020-32 as expenses related to the exempt PPP forgiveness income to justify the IRS position that such expenses could not be deducted prior to the late 2020 law change.  While the Economic Aid to Hard-Hit Small Businesses, Nonprofits, and Venues Act provided that such expenses could be deducted, it did not override the IRS conclusion that such expenses were related to the tax-exempt income—it was simply silent on that issue.

In the draft instructions for the 2021 Form 1120-S, the IRS has now stated their position—and it agrees that such expenses do not reduce the accumulated adjustments account.  Page 45 of the 2021 draft Form 1120-S instructions provides:

An S corporation should include tax-exempt income from the forgiveness of PPP loans on line 3 and report expenses paid with PPP loans that are forgiven on line 5 in column (d) of the Schedule M-2.[5]

Thus, returns prepared using the default treatments provided by most tax software will have understated AAA and overstated OAA for S corporations who received PPP loans and have treated the loan as forgiven when filing the 2020 S Corporation income tax return.

Revising this calculation should not require formally amending the 2020 S Corporation return, since the amount of AAA at the beginning of 2021 is not required to agree with that shown on the 2020 return by any provision of the IRC. Rather, the IRC simply requires that the S corporation use the proper amount of AAA to determine the tax status of any distributions.

If distributions in 2021 did not exceed AAA this adjustment would be all that is necessary to correct the reporting.

However, this change in treatment may require amending Forms 1099-DIV that might have been issued for 2020 when distributions exceeded AAA for S corporations that had accumulated earnings and profits. Similarly, the 2020 returns for shareholders who received those Forms 1099-DIV would need to be amended.

Failing to amend those returns could create later issues for the shareholder, since the IRS position would be that these distributions were not dividend distributions, and thus would have reduced the shareholder’s basis in his/her shares.  Thus, even though the shareholder had reported the distribution as income, they would end up with a basis reduction regardless—so it’s best to get the tax that was paid in error (in the IRS’s view) refunded to the taxpayer.

[1] https://twitter.com/danchodan/status/1478074397579694081?s=20 , January 3, 2021

[2] “2020 Instructions for Form 1120-S,” p. 45, https://www.irs.gov/pub/irs-pdf/i1120s.pdf (retrieved January 3, 2022)

[3] “2020 Instructions for Form 1120-S,” p. 45

[4] “2020 Instructions for Form 1120-S,” p. 45

[5] “2021 Instructions for Form 1120-S,” December 22, 2021 draft, p. 45, https://www.irs.gov/pub/irs-dft/i1120s--dft.pdf (retrieved January 3, 2022)