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Expenses Paid with PPP Loan Proceeds Reduce Other Adjustment Accounts, According to Draft Instructions for S-Corporation Returns (Form 1120-S)

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Expenses Paid with PPP Loan Proceeds Reduce Other Adjustment Accounts, According to Draft Instructions for S-Corporation Returns (Form 1120-S)

Background. The Coronavirus Aid, Relief, and Economic Security (CARES) Act did not specify whether expenses paid using funds  received from a Paycheck Protection Program (PPP) loan would be deductible for federal income tax purposes.  Congress subsequently passed the Economic Aid to Hard-Hit Small Businesses, Nonprofits, and Venues Act (the “Economic Aid Act”), which provided such expenses would be deductible (overriding IRS Notice 2020-32).

Issue. The Economic Aid Act did not resolve a potential issue for S-corporations which have accumulated earnings and profits (E&P): how would such expenses affect the computation of the accumulated adjustments account (AAA), if at all?

The AAA is a special account that is used to track earnings of an S corporation that were taxed to the shareholders as passthrough income but not distributed.  The AAA is only required to be maintained for S corporations which have accumulated E&P left over from its prior C-corporation status.  Since the AAA account includes previously taxed earnings, distributions from the AAA are tax-free to the shareholders.  Given that distributions from AAA are tax-free, how expenses paid using PPP loan funds affected the AAA was significant.

The issue arose during the 2021 filing season, when taxpayers went to compute their AAA on Schedule M-2 of Form 1120-S.  I.R.C. §1368(e)(1)(A) (the Internal Revenue Code section defining AAA) and the Economic Aid Act provide a taxpayer’s basis would be increased by the PPP loan forgiveness, but the S-corporation’s AAA would not be increased as the income was exempt from tax.  Accordingly, the 2020 instructions directed taxpayers to omit tax-exempt income from the calculation of AAA.

However, I.R.C. §1368(e)(1)(A) also provides that “no adjustment shall be made for income (and related expenses) which is exempt from tax under this title…” (emphasis added).  Despite this, the 2020 instructions provided AAA was to be reduced by all deductible expenses (including expenses paid by PPP loans).  Most tax filing software, following the instructions rather than the Code, would automatically move the tax-exempt income (i.e. forgiven PPP loan proceeds) to the Other Adjustments Account (OAA) column, but would not move the expenses paid with PPP loans out of the AAA and into OAA.

New Guidance. On January 3, 2022, the IRS provided guidance on this issue in the draft instructions for the 2021 Form 1120-S.  They confirm expenses paid with tax-exempt income, such as forgiven PPP loans, do not reduce the AAA.

“An S corporation should include tax-exempt income from the forgiveness of PPP loans on line 3 and report expenses paid with PPP loans that are forgiven on line 5 in column (d) of the Schedule M-2.”

Compliance. Returns prepared using the default treatments provided by most tax software will have understated AAA (i.e., AAA reduced by expenses paid by PPP loans) and overstated OAA (i.e., forgiven PPP loan proceeds) for S-corporations whose PPP loans were forgiven.  Fortunately, revising this calculation will not require filing an amended 2020 return because the amount of AAA at the beginning of 2021 is not required to agree with that shown on the 2020 return.  The Code only requires an S-corporation to use the proper amount of AAA to determine the tax status of any distributions.

However, if distributions in 2020 exceeded AAA for S-corporations with accumulated E&P (given the erroneous reduction to AAA for the expense paid by the PPP loans), the corporation would be required to issue amended Forms 1099-DIV to carry out such excess E&P.  In turn, shareholders receiving such amended Forms 1099-DIV may be required to file amended returns.  Failing to do so could create issues later.  The IRS would likely take the position that these distributions were not dividends, and thus would have reduced the shareholders’ basis in their shares.

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