In a recent memorandum (Number: 202237010), the IRS National Office of the Chief Counsel determined that PPP Loan Application and Forgiveness obtained through omissions and misrepresentation may not be excluded from taxpayers’ gross income.

The guidance confirms that, when a taxpayer’s loan is forgiven based upon misrepresentations or omissions, the taxpayer is not eligible to exclude the forgiveness from income and must include the portion of the loan proceeds that were forgiven based upon misrepresentations or omissions.

In reaching its decision, the Chief Counsel determined that failure to meet specific procedures set forth in the statute and associated regulations means that there is no qualifying forgiveness, and thus the exclusions would not apply to the forgiven PPP loan.

Qualifying Forgiveness:

To receive qualifying forgiveness of a PPP loan:

• A PPP loan recipient must have utilized at least 60 percent of the PPP loan amount for payroll costs, while up to 40 percent of the PPP loan amount may be used for other specified costs.
• The qualifying forgiveness amount may not exceed the sum of specified costs that were incurred and paid during a covered period.
• The specified must costs consist of payroll costs, interest on covered mortgage obligations, covered rent obligations, covered utility payments, covered operations expenditures, covered property damage costs, covered supplier costs, and covered worker protection expenditures.
• The PPP loan recipient must submit the application, including documentation and representations required by the statute and by the SBA.
• Finally, the loan recipient must attest to eligibility for forgiveness, including verifying that the loan proceeds were properly expended on eligible expenses and that the amount applied for forgiveness satisfies all the limitations relating to specified costs, and meet other legal requirements.

Once the lender grants qualifying forgiveness to a PPP loan recipient in compliance with the terms, conditions and processes of the PPP, the lender may treat the amount forgiven as “canceled indebtedness.”

Moreover, the exclusion applies only if the loan recipient is an eligible recipient. Thus, even if the loan forgiveness is otherwise a qualifying forgiveness, the exclusion is inapplicable if the loan recipient is not an eligible recipient.

Eligible Recipient:

An “eligible recipient” is an individual or entity that is eligible to receive a covered loan. A prospective recipient is eligible to receive a covered loan if the recipient:

1. Is a small business concern (as determined by the SBA), independent contractor, eligible self- employed individual, sole proprietor, business concern, or a certain type of tax-exempt organization as specified by the authorizing statutes; and
2. Was in business on February 15, 2020, and either had employees or independent contractors whom the recipient paid for services or was an eligible self-employed individual, sole proprietor, or independent contractor.

Claim of Right Doctrine:

The memorandum goes further to state that taxpayers who inappropriately received forgiveness of their PPP loans retains the PPP loan proceeds in 2020 under a claim of right, notwithstanding the ability of the SBA to pursue repayment in the case of misuse of funds. In justifying its claim of right determination, the Chief Counsel cited United States v. Lewis, 340 U.S. 590 (1951).

In Lewis, a taxpayer reported a $22,000 bonus that he had received in his 1944 income statement. Two years later – in 1946, it came to light that his bonus was improperly computed, so the taxpayer had to return $11,000 of that bonus. The taxpayer tried to recalculate his 1944 taxes to reflect the fact that he had a bonus of only $11,000 that year, but the Supreme Court ruled that he could deduct $11,000 from his 1946 return only, not the 1944 one.

In direct response to the Lewis decision and the perceived inequities resulting therefrom, Congress enacted § 1341, which provides relief to taxpayers who restore a substantial amount of money held under a claim of right. The object of this section is to put the taxpayer in the same position he would have been in had he not included the item as gross income in the first place. Dominion Resources, Inc. v. United States, 219 F.3d 359, 363 (4th Cir.2000).

An illustration may be helpful:

Let’s say that in 2020, Joe Taxpayer claimed $200,000 as income under a claim of right, but two years later, in 2022, it was determined that the income belonged to another party, such that Joe had to return that income.

Further, let’s say that the 30% tax rate in effect in 2020 was reduced to 20% in 2022. In the absence of § 1341, Joe could conceivably claim as a deduction in 2022 the $200,000 loss noted above, which would lower his applicable tax for that year by $40,000.

However, because the Joe paid a higher rate when the income was originally claimed, Joe’s $40,000 in savings in 2022 would not make up for the $60,000 lost when the taxes were originally paid in 2020.

Section 1341 addresses this problem by providing Joe with the option of either

1. taking the deduction based on the amount of the income restored or
2. allowing him credit against his current tax liability the amount previously paid on the restored item.

Thus, in the example above, the Joe could either take the deduction, lowering its tax liability by $40,000, or it could credit the $60,000 it previously paid in taxes against his tax liabilities in 2022.

However, it is important to note that amounts included in income due to fraud or embezzlement presumably would fall outside the provisions of Sec. 1341. This position has been upheld by the courts:

“The law is clear, though, that it cannot be said to appear to an embezzler or fraudster that he has an unrestricted right to his ill-gotten gains (notwithstanding the fact that he is obligated to report those gains in his annual gross income). See Culley v. United States, 222 F.3d 1331, 1335-36 (Fed. Cir. 2000); Kraft v. United States, 991 F.2d 292, 299 (6th Cir. 1993); McKinney v. United States, 574 F.2d 1240, 1243 (5th Cir. 1978).

In short, section 1341(a)’s “unrestricted right” language excludes all income reaped by taxpayers who know at the time of receipt that they have no right to the income. “When a taxpayer knowingly obtains funds as the result of fraudulent action, it simply cannot appear from the facts known to him at the time that he has a legitimate, unrestricted claim to the money.” Culley, 222 F.3d at 1335. It follows inexorably that if the taxpayers acquired the funds at issue by fraud, they could not have thought that they had an unrestricted right to those funds.”

PPP Loan Interest and Maturity Dates:

A PPP loan bears a non-compounding interest rate of one (1) percent. Loans issued prior to June 5, 2020, have a maturity of two years. Loans issued after June 5, 2020, have a maturity of five years. The recipient must generally make the first repayment in 24 weeks after the loan disbursement.

What’s Next?…

According to the IRS, Taxpayers who inappropriately received forgiveness of their PPP loans are encouraged to take steps to come into compliance by, for example, filing amended returns that include forgiven loan proceed amounts in income.

In the words of IRS Commissioner Chuck Rettig:

“This action underscores the Internal Revenue Service’s commitment to ensuring that all taxpayers are paying their fair share of taxes, we want to make sure that those who are abusing such programs are held accountable, and we will be considering all available treatment and penalty streams to address the abuses.”

The IRS also provides direction to the general public to report tax-related illegal activities relating to PPP loans on Form 3949-A, Information Referral. Taxpayers should also report instances of IRS-related phishing attempts and fraud to the Treasury Inspector General for Tax Administration at 800-366-4484.

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