CARES Act Loan Forgiveness

We trust that you are still keeping yourself, your loved ones, and your community safe from the Coronavirus (“COVID-19”).  This article will discuss the tax issues facing those businesses that received a loan under the CARES Act, Paycheck Protection Program (“PPP loans”) and payments under the Coronavirus Food Assistance Program (CFAP).  

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Editor’s note - For sake of illustration, these issues will be discussed in the context of a cattle ranching operation.  In general, discussion regarding PPP loans is not industry-specific.  CFAP, however, is an agribusiness-specific provision of the CARES Act.    

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The Internal Revenue Service (“IRS”) issued Notice 2020-32 clarifying their current position that no deduction is allowed under the Internal Revenue Code (Code) for an expense that is otherwise deductible if the payment of the expense results in forgiveness of a covered loan.  Simply put the IRS says there is no deduction for an expense that the government reimbursed to the taxpayer via a loan forgiveness. However, even with this notice there is still an issue if the loan is forgiven in a different taxable period then the expense. Ranchers with fiscal years ending mid calendar year have/will have this issue for sure.  Likewise, the CFAP payments will likely be determined to fall under the tax-exempt grant case law and also will reduce tax expenses when they are spent by the rancher. However, rules for the identification of the related expense for the CFAP payment is the other uncertainty.  The IRS position on the non-deductibility of expenses has been heavily criticized.  Several bills have been submitted in Congress to make all qualifying expenses deductible even though the PPP loan forgiveness is not taxable.  None have been passed as of the writing of this article.  The following will explore both of these issues and the possible reversal of the current IRS’s position.

IRS Notice 2020-32

Treasury and the IRS cited Code Section 265(a)(1) to arrive at the position that the expenses that are qualified expenses for the PPP loan forgiveness are not deductible expenses once the loan is forgiven.  The purpose of Code Sec. 265 is to prevent a double tax benefit related to tax-exempt income. The rule applies where tax-exempt income is earmarked for a specific purpose and deductions are incurred in carrying out that purpose. Although it was believed that Congress intended to provide a double benefit for PPP loans (i.e., forgiveness and no tax effect from the forgiveness), the IRS is pointing to existing law to eliminate the expense deduction tax benefit.  Since the CFAP payments are also tax-exempt grants it appears the IRS’s tax-deductible expense disallowance position will also apply to those payments.  However, the identifications of the related tax-deductible expenses are not as apparent as the PPP expenses.

PPP Loans

The PPP loan is forgiven based upon incurring and paying qualified expenses, of which 60% must be payroll costs. Although the loan forgiveness is not taxable, the timing and deductibility of the expenses remains in question. Until the PPP loan is forgiven, it remains a loan. As a loan, it is not tax-exempt income; it isn’t income so related expenses are deductible until loan forgiveness creates tax exempt income.

The Small Business Administration (“SBA”) issued the Loan Forgiveness Application on May 15th that will be used by PPP borrowers to determine and report how much of their PPP loan will be forgiven.  The rancher may apply for forgiveness as late as ten months after the end of the covered period (either eight or 24 weeks).  The lender must issue its decision to the SBA on the loan forgiveness application not later than 60 days after receipt of a complete loan forgiveness application from the rancher.  No later than 90 days after the lender issues its decisions to the SBA, the SBA will remit the appropriate forgiveness amount to the lender. Even if the rancher might be certain of his qualified expenditures on his application for partial or full forgiveness, the loan remains a loan owed to the bank at least until the SBA remits the loan forgiveness amount to the lender. The relationship of rancher-lender continues for the amount to be forgiven until the lender has received payment from the SBA. Tax-exempt income for qualified PPP does not occur until this time.  This could be up to 15 months after the expenses have been paid. Official notice of forgiveness might not be received until after the end of the calendar year. The question is, what and when are PPP qualified expenses deductible or disallowed under the current IRS’s position?  We identified three different scenarios.

1. The loan forgiveness is finalized in the same year as the qualified expenses are incurred. The qualified expenses are reported but offset by the amount forgiven

2. The loan forgiveness is finalized in a latter tax period then the qualified expense occurs. The expenses are reported in the year they occur but income is reported under the current IRS position in the year that the loan forgiveness is finalized under the tax benefit rule. (Caution here, see last month’s article on tax planning)

3. Self-employed Rancher filing a Schedule F with no other employees reports nothing when loan is forgiven in either aforementioned case. As a self-employed rancher, there would be no deduction for his time so the forgiveness income is just exempt.

CFAP payments

There are two CFAP payments:

• CFAP 1 assistance is available to livestock producers through FSA the $34 per head inventory / $128 per head on sales between 1/1/20 and 4/15/20 time period.

•  CFAP 2 assistance to ranchers for owned inventory of eligible beef cattle, excluding breeding stock, on a date selected by the producer from April 16, 2020, through August 31, 2020, multiplied by the payment rate of $55 per head, up to $250,000 or 4,546 head per producer. Multi owned ranch operations can qualify for up to three payment limitations if they provide at least 400 hours of active personal labor, active personal management, or combination thereof with respect to the production of 2020 commodities.

Two payment limits = $500,000 or 9,091 head.

Three payment limits = $750,000 or 13,636 head.

 The question is how these grants are to be reported.  It is currently believed that the IRS position is the same as for the PPP payments.  However, the process of how to identify the expenditures that will become non deductible has not been addressed.  Should the expenses related to the head of cattle on which the payments were calculated be reduced, if so which expenditures? Or, should the grant funds disbursements be tracked?  What happens when the funds are used to reduce debt?  Could cost of land be reduced?   The disallowance of a current deduction is just another way to make the funds taxable which seems to go against Congress’s intentions.

Summary

A significant amount of effort will be required to accomplish good tax planning this year with the Secure Act, the CARES Act and the November election. As with other provisions of the CARES Act, it has created uncertainty in the deductibility of expenses resulting from tax exempt income from CFAP payments and PPP loan forgiveness. The guidance provided by the IRS needs to be followed since, not doing so, could result in unintended tax consequences in the future.  More guidance is expected. Although not expected, Treasury could revoke Notice 2020-32 to allow full deductibility of expenses regardless of PPP forgiveness. Congress could pass legislation to overturn the effects of Notice 2020-32. Any action could be retroactive, and may or may not include flexibility for ranchers who have considered the disallowance of expenses in their tax planning.  Plans in place should be reviewed, given the potential focus on tax increases under a Democratic regime.  Nobody knows when new tax legislation might be enacted and what the new rules may be. Your tax adviser should be able to help you navigate these issues.