Accounting on Us
Your year-end tax planning should consider the position the IRS is taking on the non-deductibility of expenses.
PPP loan forgiveness – What’s deductible
Phillip R. McCollum, Jr., CPA, JD
Finally! 2020 is coming to an end. Many of you are preparing for the upcoming tax season and applying for Paycheck Protection Program (PPP) loan forgiveness. There have been many questions regarding what would be forgiven, what would be taxed and what the timetable for the whole process would be. Recently, the Internal Revenue Service issued guidance clarifying some of the questions but many are still unanswered.
Deductibility of expenses
The IRS provided forgiveness guidance on May 2, 2020, outlining its position that the expenses paid with PPP loan proceeds are not deductible expenses for tax purposes. On November 18, 2020, the IRS addressed timing issues and deductibility of related expenses with Rev. Rul. 2020-27 and Rev. Proc. 2020-51.
Rev. Rul. 2020-27 states if a taxpayer has a reasonable expectation of being granted forgiveness, the expenses paid will be non-deductible even if the taxpayer has not submitted an application for forgiveness by the end of their taxable year. The ruling outlines two situations clarifying this conclusion.
While the IRS is standing firm with expenses not being deductible, many are hoping this will change with the passage of a new Coronavirus relief bill. Given the current political climate and the legal precedent of IRS rules, there’s little chance of this changing any time in the near future. We suggest that your year-end tax planning addresses the position the IRS is taking on the non-deductibility of expenses.
Rev. Proc. 2020-51 provides flexibility for taxpayers who reasonably expected forgiveness at December 31, 2020 but, either due to a denial of forgiveness or an irrevocable decision to not apply, do not actually get forgiveness in 2021. Be careful here. It does not allow for deductibility of expenses if the loan is forgiven. It is only if part or all of the loan isn’t forgiven or a forgiveness application was not submitted.
R&D tax credits
Disallowing the deductions for expenses paid with PPP loan proceeds has had a particular impact on R&D tax credits. Internal Revenue Code Section 41(d)(1)(A) states that a taxpayer cannot claim an R&D tax credit on expenditures (employee wages tend to be a large component of the qualified research expenses “QREs”) that are not deductible. Consequently, any wages paid to employees using forgiven PPP loan proceeds are not eligible as QREs, thus, decreasing federal and state R&D credits.
So how do you allocate expenses taking into account the 60% and 40% allocation ratio between payroll and other expenses? Our advice is to list other qualifying expenses first, payroll costs not in the R&D function and then the payroll costs in the R&D function. This leads us to another dilemma. What if employees who perform R&D functions also perform non R&D functions such as accounting and finance? How does that type of breakdown get reported on the application for loan forgiveness? Can it even be broken down on the application? The questions will continue to grow and answers sought.
Section 163j limitation impact
For the interest expense limitation, if the limitation applies, the limitation impacts the amount of deductible business interest expense in a taxable year to 30% of the taxpayer’s adjusted taxable income (ATI) for the year. If your expenses paid with the PPP loan funds are not deductible, this will cause your ATI to be higher. As a result of higher ATI, more interest expenses would be deductible since the ATI would be higher when the nondeductible expenses are added back. Also, the qualifying (and nondeductible) expenses may include interest expense. Will the IRS provide any guidance on this particular issue since it initially appears to favor taxpayers?
So this brings us to another question of how do you allocate expenses taking into account the 60% and 40% allocation ratio between payroll and other expenses? Do you look at including interest expense in your forgiveness application in addition to payroll costs? More questions and scenarios to review and consider as we work through these issues.
Wages paid play a major role in the calculation of the QBI deduction for qualifying passthrough businesses. At this point, any payroll costs included in the non deductible expenses paid with PPP loan funds should not be included in the QBI calculation. Will the IRS address this favorably for Taxpayers? At this point, we assume that the IRS will not make any favorable changes to address this issue with the QBI deduction.
Payroll is one of the factors used in determining your state tax. Since payroll expenses are not deductible, how do you determine which wages to use to reduce your state apportionment? Should you take into account the impact of wages related to R&D qualified services? The answers will likely depend on what the state’s position on other tax law changes resulting from the CARES Act are. Is it likely you’ll want to look at other qualifying expenses first and then payroll costs?
We know this is confusing and stressful, with so many what ifs at play it makes your head spin. Don’t try to tackle this alone. If you have any questions regarding how this most recent IRS guidance impacts you, please contact us. We are staying on top of developments in the PPP loan program and will keep you updated. For more information and resources on COVID-19, see our coronavirus page.
Phillip R. McCollum, Jr., CPA, JD, Partner, specializes in tax planning, consulting and compliance work for privately held businesses and their owners. He can be reached at (480) 839-4900 or PhilMc@hhcpa.com.