OK people, I'm not going to lie…
This is complicated. I've worked hard to lay this out as easily and cleanly as possible so you have the best information possible to make a decision with but this is somewhat hard to follow.
Despite the complexity, it will be up to you to decide. I can't decide for you.
The IRS has issued Revenue Procedures (worth noting these are not "laws" but interpretations of laws) that states, based on a variety of cases, that any expenses paid that are attributable a "non-taxable class of income" are not deductible. This means that for anyone who received PPP funds, and used it appropriately, the loan forgiveness (which would normally be income) is not taxable. However, the offsetting expenses would be reduced, thereby creating an increase in taxable income equivalent to the amount of the PPP Loan.
Currently, if you run your income statement from your books, the income in there will not be consistent with the taxable income we'll have on your return. We will take the entire amount of the PPP Loan and reduce your expenses on the return. This will result in an increase in taxable income by the entire amount of your PPP loan. This will have a variety of long-term effects on your books/return – namely the books won't match the return for an extended period of time and banks or other users of the data (if you have them) might be confused. It could also, in some cases, require additional costs or increase your audit risk because of the odd adjustments that must be made.
The year is ending and almost no one has actually gotten forgiveness yet. The IRS recently issued additional procedures that stated that if you have a "reasonable expectation of forgiveness" that the expenses are still not deductible. So even if you plan to apply next year you still need to reduce your 2020 expenses for tax purposes.
In addition, there are two bills in the US House and one in the US Senate, that will render the IRS opinions moot and the expenses deductible. The issue being, of course, that we need to FILE returns likely before those bills are passed into law. The IRS position is that you should reduce expenses and, if the law changes, go back later and file an amended return to get a refund.
CFOAndrew, and myself personally, take issue with these things for several reasons – which we'll discuss below.
Do not apply for forgiveness, pay back the loan (the interest rate is very low) over either two years or five years (depending on when you got the loan). This is the least desirable because, even if you pay, say, 40% income tax on the loan you would still be left with 60% cash on hand. Compared to paying back 100% there are very few use cases where only keeping 60% of the "free money" is preferable to just getting a loan.
You'll basically pay tax on the entire amount of the loan you got. This has the upside of being the most conservative thing you can do - the IRS can't challenge you because you are doing whatever they say. The obvious downside being that you'll owe between 25% and 40% of your loan proceeds in additional tax this year. If you choose this option, and it is later determined that the expenses should have been deductible, you can file an amended return later and receive a refund of the taxes paid.
A lot of people don't realize this but the IRS rule are NOT black and white. The IRS does a lot of interpretation of laws and then tax professional interpret those interpretations and then take positions on returns. The IRS audits returns, people fight, and they go to court to decide whose interpretation is correct.
Generally, this process pertains to pretty esoteric stuff — the kind of things that 'normal' people don't see or experience. Most people only run into the everyday stuff that has widely been decided and everyone knows what to do with. There is no "interpretation" any more on those sort of tax items. PPP loans has pushed this process into the light because there are hundreds of thousands of "normal people" who are going to affected but this.
We are not the only people that believe this. I've spoken with numerous tax professionals and attorneys across the country and the general consensus is in agreement: "it's wrong". Of course, you must have a basis for why it is wrong. Ours is multi-faceted, but the first and major argument has to do with the legal concept of "superplusage".
This concept basically states that a government authority should not interpret a law that in a way that makes sections of the law "inoperable". Meaning- if Congress put it IN the law, it is probably there for a reason, don't make sections irrelevant. The CARES Act has lots of sections, but about the PPP there are three that are relevant. They say (and I'm paraphrasing HEAVILY HERE):
Our argument is that the IRS interpretation (that the expenses are not deductible) has the effect of rendering Section 3 irrelevant. Because the result of the IRS interpretation is that, if they deleted Section 3 in its entirety, the end result on taxable income would be the same. This violates the surplusage canon.
There are other issues (e.g. don't pull in other section, some loans were received by Schedule C's who have no expenses to reduce thereby producing a discriminatory benefit) but we think that this one major argument is enough to tear the whole thing down.
If you are audited and we don't reduce the expenses the IRS will adjust your income tax due and ding you for tax and penalties. We would then appeal it and, under the current set-up, we would lose that appeal and take the IRS to tax court. Yes, to fully defend the position we would have to go tax court and argue the point. This assumes, of course, that no one else has already gone to tax court and argued it — if they have, we would just be piggybacking on that case.
If we lose you would be on the hook for four things: tax, interest, failure to pay penalty, and what is called an "Accuracy related" penalty (section 6662).
Nothing we can do here. If the argument fails you'll owe tax which will put you in the same position as if you had taken Option B.
If you owe money they'll charge interest. Not a huge rate but you'll owe it. Nothing we can do about it. That will be additional money that you would have saved had you gone with Option B from the get-go. Consider it your option cost.
Another item we can't do much about. If you owed tax and didn't pay it, they'll run more money against it – about a 6% a year increase.
This is the big one, it is a 20% to 40% increase. That's a big deal. BUT it is only assessed if the position you took you did not have "reasonable basis" for your argument. I think that with the case law we have built as our defense they will have a hard time arguing that our position was "unreasonable". We might lose, but we have a valid point.
It is also worth noting that there are preparer penalties directly as well. By signing the return, and if we lose some of these arguments, I would be assessed penalties directly. This has nothing to do with the taxes you might owe. So I have some skin in the game too – we're not just playing with your money.
As I have said before in investing, money isn't made in the upside, it is made in what you don't lose. Here is how we hedge the positions:
Most of you are small clients and there is no central database the IRS has access to of who got PPP loans or not. They can access the data, certainly, but there is no automated way to check your returns to see if adjustments were made. And since there is no standard way to adjust expenses they would only know if you did it properly by manually checking your returns. Currently returns are audited at a less than 5% rate – so there is a good chance that we can take the position, and no one will ever know that we did.
The IRS audits people years after the fact. There is a good chance given the bi-partisan appeal to clarifying congress's intent that some time in the next two years Congress will fix the law (as mentioned, there are already three bills drafted to do this). So, by the time the IRS audits you, your position might end up being the correct one all along. I encourage you to write to your Congress people and Senators to help them understand the impact of this issue.
We have done research and built our own position around the surplusage canon. I am not a lawyer and this not legal advice, but here is a nice summary of the surplusage canon:
Although the author includes some criticisms and limitations of the canon, there is a collection of other cases, my favorite:
Hibbs v. Winn, which is a Supreme Court case. There, SCOTUS said the following, with a helpful citation to a statutory construction treatise (emphasis mine):
The rule against superfluities complements the principle that courts are to interpret the words of a statute in context. See 2A N. Singer, Statutes and Statutory Construction § 46.06, pp. 181-186 (rev. 6th ed. 2000) ("A statute should be construed so that effect is given to all its provisions, so that no part will be inoperative or superfluous, void or insignificant…" (footnotes omitted)). If, as the Director asserts, the term "assessment," by itself, signified "[t]he entire plan or scheme fixed upon for charging or taxing," Brief for Petitioner 12 (quoting Webster's New International Dictionary of the English Language 166 (2d ed. 1934)), the TIA would not need the words "levy" or "collection"; the term "assessment," alone, would do all the necessary work.
And an even longer standing rule, from 1883:
"It is the duty of the Court to give effect, if possible, to every clause and word of a statue, avoid, if it may be, any construction which implies that the legislature was ignorant of the meaning of the language it employed."Montclair v. Ramsdell
It is also worth noting that people could apply for PPP funds as Schedule C, based on their profits. In their case — since there are no expenses to reduce, they would have NO tax impact from the current IRS Regs. This creates an obvious double standard and there is nothing in the law to support that Congress intended for self-employed people and people with W-2 payroll to be treated differently as a result of their law. That would be another argument against the IRS interpretation. It also creates a side argument that that IRS Regs create a "two-tier standard" which is a discriminatory in nature.
I'll file returns how you want them filed. It is your return, but I do believe in looking out for my clients and I want everyone to understand that you don't have to do things just because "The IRS said so". It is not a dictatorship, but it is a large entity with lots of power. And, at the risk of sounding OVERLY dramatic, sometimes standing up for what is right, as opposed to easy, has consequences. If you feel compelled to do so, I'll be happy to stand by you while doing it.
I encourage you to send this out other business owners who might be in the same position.