Last month the IRS answered some lingering questions about Paycheck Protection Program loans.
Unfortunately, they left open an important issue of which equity account is adjusted when an S corporation is the borrower.
Nevertheless, let’s stay positive. Most small business in the U.S. is operated through a passthrough entity form. This can include a partnership or an S corporation.
PPP loans were eligible for forgiveness if the proceeds were used for a statutorily allowed purpose. The allowed expenses were usually the type that are currently deductible if paid with the taxpayer’s own funds.
The law as originally enacted made it clear that no income would result to the borrower if a PPP loan were forgiven. It said little else about the tax treatment of these loans.
Throughout most of 2020, IRS claimed that no deduction could be claimed for PPP-funded expenses. This was for various reasons (IRS offered three), but the IRS approach seemed hard to square with the benefit Congress was trying to confer.
Late in 2020, Congress corrected the law to make it clear that PPP-funded expenses could be deducted. It also said that the exempt income from forgiveness would increase the borrower’s basis in a passthrough entity.
The tax basis adjustment may be needed to deduct the expenses in the year paid. Questions arose about the treatment when the expenses were paid in one year and the loan was forgiven in the next.
“Normal” tax law would not allow the basis increase until the next year (the actual forgiveness year). This could cause the year one deductions to be suspended due to a lack of basis.
In Revenue Procedure 2021-48, IRS said that the tax-exempt income that increases the basis would be allowed at one of three times. The taxpayer may pick.
First, when the qualifying expenses are paid or accrued. Second, when the borrower applies for loan forgiveness. Third, when loan forgiveness is received.
For those taxpayers who filed return before the new guidance, IRS will allow adjustments on amended returns. This includes amendments to partnership filings, which are typically burdensome.
If your business received a PPP loan in 2020 and at least applied for forgiveness in 2020, your tax preparer may be contacting you about a possible amended filing. Some preparers followed the IRS approach even before it was announced.
Partnerships are generally allowed to allocate items of income and deduction by the partners’ agreement. S corporations do not have this flexibility.
To be respected, partnership allocations must have “economic effect.” Treasury regulations have qualifying language that may be included in the partnership agreement and ensure the IRS will respect the allocation.
If the regulatory language is absent, the allocation must follow each “partner’s interest in the partnership.” This is called “PIP” and is based on factors. The result can be subjective.
The “inside baseball” explanation of partnership allocations is that there is only one test. That is, if the regulatory language is in the agreement, it just means the allocation follows the PIP.
There is not one test if you meet the language and another (PIP) if you do not. This is pretty well settled among partnership tax experts, although the regulations do not make the point explicit.
In Revenue Procedure 2021-49, the IRS said PPP-funded expenses in a partnership must be allocated using the PIP test. This statement does not explicitly recognize the ability to rely on the right language in the agreement.
Nonetheless, unless the agreement has been drafted to engage in tomfoolery, the language of the agreement should track the PIP. The tax-exempt income, and basis adjustment, is allocated in the same ratios as the deduction for the expenses.
In limited cases all or a portion of the PPP-funded expenses may need to be capitalized for tax purposes. This means there would be no current deduction.
Without a current deduction, there is no linchpin to connect the allocation of the tax-exempt income to a prior deduction. Therefore, the IRS procedural rule is to assume a “hypothetical” deduction for the capitalized items.
The allocation of the exempt income, and the basis adjustment, then follows the hypothetical allocation of the deduction for the capital expenditures.
Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at email@example.com.