Due to the unique nature of the Paycheck Protection Program (“PPP”) loan forgiveness, Taxpayers should consider its impact on their qualified research expenses (“QREs”) and the research credit under IRC Sec. 41.
While the deductibility of expenses associated with PPP loan forgiveness was enacted pursuant to the 2021 Consolidated Appropriations Act, the IRS has issued no guidance on how PPP loan forgiveness impacts the research credit. The primary consideration is whether the loan forgiveness should be treated as funding and offset related QREs (primarily wages). The conclusions below are based on our interpretation of tax law.
Is the PPP Loan Funded Research?
IRC Sec. 41(d)(4)(H) provides that qualified research does not include any research to the extent “funded by any grant, contract, or otherwise by another person (or governmental entity).” While that language is very broad, the examples in the regulations illustrate an “agreement” or “contract” involving a negotiation for work to be performed prior to that research and potential ownership of the results. In contrast, PPP loan forgiveness is simply a reimbursement mechanism to keep employees on payroll, utilities working, and rent paid and is not connected to research to be performed for or on behalf of the government. Under the broad “or otherwise” language, however, a PPP loan could be considered funding under IRC Sec. 41.
The regulations governing “funded research” appear in Treas. Reg. Sec. 1.41-4A(d). To determine whether research is “funded,” the regulations direct our focus to the agreement(s) executed by the contracting parties: “All agreements (not only research contracts) entered into between the taxpayer performing the research and other persons shall be considered in determining the extent to which the research is funded.”
The regulations specify two main factors (Risk and Rights) as relevant in ascertaining whether research is “funded.”
Risk – payment that is contingent on the success of the research is not treated as funding, while payment that is made regardless of success are considered funded. Tax courts have historically looked to the following contract clauses to determine which party held financial risk
- Payment procedures,
- Quality and performance standards,
- Termination clauses,
- Warranty and default provisions,
- Right to review and approve design documents,
- Invoice dispute provisions, and
- Revision obligations and covering related costs.
The PPP loan is not considered a payment or grant for research or services because it is a loan issued by a bank that is guaranteed by the SBA. The recipient is obligated to pay back the loan and therefore has financial risk. This financial risk is clearly outlined in the loan application under the Debt Collection Act of 1982 clause which states
“If you receive a loan, and do not make payments as they come due, SBA may: (1) report the status of your loan(s) to credit bureaus, (2) hire a collection agency to collect your loan, (3) offset your income tax refund or other amounts due to you from the Federal Government, (4) suspend or debar you or your company from doing business with the Federal Government, (5) refer your loan to the Department of Justice, or (6) take other action permitted in the loan instruments”
Accordingly, PPP loan forgiveness represents cancellation of that loan due to meeting certain requirements and should not be considered funded research under Sec. 41.
Rights – the regulations provide that a taxpayer is entitled to the credit only if it “retains substantial rights in the research.” Sec. 1.41-4A(d)(3)(i) “If a taxpayer performing research for another person retains no substantial rights in research under the agreement providing for the research, the research is treated as fully funded.”
Tax courts have looked to the following contract details to determine who held substantial rights:
- Restrictions from using the research it performed,
- Cost or license needed to pay for the use of research, and
- If the right to use the research was exclusive to the buyer.
The PPP loan agreement does not assign any rights to the government related to the work performed by the recipient. As the government was the drafter of the loan terms and did not claim exclusive legal rights, it is presumed that the loan recipient retained substantial rights to the work performed.
Legislative Intent
Further support for the position that a forgiven PPP loan does not impact the research credit is found in the 2021 Consolidated Appropriations Act Sec. 276(a)(i)(2), which provides:
“no deduction shall be denied, no tax attribute shall be reduced, and no basis increase shall be denied, by reason of the exclusion from gross income provided by paragraph (1)”
The IRS may interpret this provision as limited to the context of debt forgiveness under IRC Sec. 108 and does not negate the Sec. 41 funding requirement. In other words, PPP loan forgiveness falls within IRC Sec. 108 without the income pickup and without the related reduction of tax attributes that would otherwise occur (NOLs, GBCs, minimum tax credits, capital loss carryovers, debtor basis, passive activity losses and credit carryovers). However, taxpayers are required to treat the forgiveness as funding for purposes of the research credit because that is outside the debt forgiveness rules.
We, however, believe the more appropriate interpretation is that Congress broadly intended for PPP loan forgiveness to not otherwise limit a taxpayer’s ability to claim deductions, credits or other items covered by the forgiven loan. This is consistent with Congress’ clear rebuttal of the prior IRS position that expenses covered by a forgiven PPP loan were not deductible for tax purposes.
Conclusion
Consistent with Congressional intent that taxpayers are not negatively impacted by PPP loan forgiveness and because a PPP loan recipient has financial risk for the loan and retains substantial rights in the work performed any related cancellation of debt should not be considered funding under IRC Sec. 41(d)(4)(H).
For additional assistance or if you have questions contact:
Matt Neuenswander, Tax Manager, Tanner LLC
801-924-5120 | mneuenswander@tannerco.com
Shawn Marchant, Tax Principal, Tanner LLC
801.990.5928 | smarchant@tannerco.com