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On October 26, 2020, the U.S. Small Business Administration (“SBA”) published a notice seeking comment on two Loan Necessity Questionnaires (Form 3509 for “for-profit” entity borrowers and Form 3510 for “non-profit” entity borrowers) that are to be submitted by borrowers who have received Paycheck Protection Program (“PPP”) loans and are seeking forgiveness of those loans pursuant to section 1106 of the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”).

Form 3509 states that the purpose of the form “is to facilitate the collection of supplemental information that will be used by SBA loan reviewers to evaluate the good-faith certification that you made on your PPP Borrower Application . . . that economic uncertainty made the loan request necessary.”  Recall that the borrower’s good faith certification with respect to the necessity of the loan was to be based on information available to the borrower at the time of certification.  Many questions on the form, however, ask for information as to actions and events that have occurred well after the borrower’s request for the PPP loan.  For example, the borrower must advise whether after March 13, 2020, the borrower was ordered by a state or local authority to shut down or alter its business due to Covid-19.  If so, the borrower must provide information as to the start and end dates of the shut down or how the business had to be altered to remain in business and what the additional costs were to make the alterations.  The borrower also must advise whether at any time after March 13, 2020, the borrower voluntarily ceased or reduced its operations due to Covid-19, and if so, why.  Moreover, the borrower must advise whether after March 13, 2020 and before the end of the loan forgiveness covered period it began any new capital improvement project that was not due to Covid-19, and if so, the amount of the cash outlay.  These and other requests for information on Form 3509 raise new questions whether, in each audited case, the SBA will conclude that the borrower’s certification – that economic uncertainty at the time of the loan request made the request necessary to support the ongoing operations of the borrower – was not made in good faith, meaning that the borrower’s PPP loan will not qualify for forgiveness by its lender.

If the PPP loan is forgiven, recall that section 1106(i) of the CARES Act provides that, for federal income tax purposes, any amount which otherwise would be includible in gross income of the borrower by reason of PPP loan forgiveness is to be excluded from the borrower’s gross income.  Thus, section 1106(i) overrides general principles of federal income tax law that require the taxpayer to include in income the amount of any indebtedness that was discharged without repayment.

One of the requirements for forgiveness of the PPP loan is that the proceeds thereof must be used to pay for eligible expenses, such as payroll costs, interest on a mortgage, utility costs, and rent.  Under federal income tax principles, these expenses generally would qualify as deductions against gross income on the borrower’s federal income tax return.  But the IRS earlier this year advised in Notice 2020-32 that no deduction would be allowed for these expenses if the PPP loan was forgiven.  While there was debate over whether the IRS position represented the intent of Congress in enacting the CARES Act, the IRS continued its position first in Notice 2020-32 when it issued Revenue Ruling 2020-27 on November 18, 2020.

In that revenue ruling, the IRS presented two situations.  In the first, the taxpayer received a PPP loan and used all of the proceeds to pay for eligible expenses.  In November of 2020, the taxpayer applied to the lender for forgiveness of the loan.  Notably, the ruling assumes that based on the taxpayer’s payment of eligible expenses, the taxpayer satisfied all requirements for forgiveness, including the requirement that the borrower’s certification that economic uncertainty at the time made the loan necessary to support its ongoing operations was appropriate.  In the second situation, the facts were essentially the same (that is, the IRS again assumed that based on the taxpayer’s payment of eligible expenses, the taxpayer satisfied all requirements for forgiveness) except that the taxpayer had not applied for forgiveness from its lender by the close of 2020.

In its analysis, the IRS concluded that in each of the two situations the taxpayer had a reasonable expectation of reimbursement of its eligible expenses (reimbursement by forgiveness of the PPP loan).  Therefore, the IRS concluded that the taxpayer was not entitled to claim a deduction of its eligible expenses on its 2020 federal income tax return.

The problem with the revenue ruling is that it does not address the uncertainty created by the SBA’s release of Form 3509 several weeks prior to the release of the revenue ruling.  That is, given the requests for information contained in Form 3509, can taxpayers who received a PPP loan now have a reasonable expectation that their PPP loans will be forgiven?

What is a taxpayer to do when it is unsure whether the loan will be forgiven?  Should the taxpayer deduct the eligible expenses on its 2020 federal income tax return and file an amended return for 2020 when it subsequently learns that the loan has been forgiven?  Should the taxpayer instead not deduct its eligible expenses on its 2020 return and file an amended return deducting the eligible expenses in the event that it is determined that the loan does not qualify for forgiveness?  What about the possibility of Congress enacting legislation providing that the eligible expenses are deductible even if the PPP loan is forgiven as part of any economic stimulus legislation?

The IRS attempted to deal with this uncertainty in Revenue Procedure 2020-51, released at the same time as Revenue Ruling 2020-27.  In that revenue procedure, the IRS established a safe harbor for taxpayers to deduct eligible expenses paid with the proceeds of a PPP loan to the extent the loan has not been forgiven when the taxpayer files its 2020 federal income tax return.  The safe harbor applies when the taxpayer (1) paid eligible expenses with the proceeds of a PPP loan in 2020 and reasonably expects that the PPP loan will be forgiven, (2) submits or intends to submit an application for PPP loan forgiveness, and (3) in 2021 either forgiveness is denied for all or part of the loan or the taxpayer irrevocably forgoes seeking loan forgiveness, e.g. the taxpayer withdraws its application for forgiveness.

If a taxpayer meets the above qualifications, it may deduct otherwise deductible eligible expenses which were paid for with the proceeds of a PPP loan pursuant to one of two safe harbors; however, the amount of the deduction will be limited to the amount of the unforgiven PPP loan principal.  The first safe harbor permits taxpayers to take these deductions on an original or amended 2020 tax return.  The second safe harbor permits a taxpayer to deduct its eligible expenses on its 2021 tax return so long as in 2021 the taxpayer irrevocably decides not to seek forgiveness or its application for forgiveness is denied.  In either case, the taxpayer must attach a “Revenue Procedure 2020-51 Statement” to its return containing the information set out in Section 4.04 of the revenue procedure.

The problem with Revenue Procedure 2020-51 is that it fails to address the situation in which (1) the taxpayer’s PPP loan has not been forgiven or forgiveness has not been denied by the time the taxpayer files its 2020 federal income tax return, (2) the taxpayer makes and does not withdraw its application for forgiveness, and (3) in 2021 or a subsequent year the PPP loan is determined to qualify for forgiveness.  Again, given the uncertainty after the issuance of SBA Form 3509, taxpayers with outstanding PPP loans are left with difficult choices for filing 2020 federal income tax returns, because claiming a deduction in a 2020 return with forgiveness in a subsequent year could lead to an assessment of interest and penalties even if the taxpayer files an amended return for 2020 returning the deduction of eligible expenses to income.

Tax attorneys at Liskow & Lewis can help in the analysis of these difficult decisions.

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