Although a little late, the IRS issued guidance through updated instructions to the draft 2021 S Return which provides that the expenses paid with PPP loan proceeds will reduce the Other Adjustments Account.
The draft instructions on page 45 now provide that S corporations 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.
The potential problem arose when taxpayers tried to compute their Accumulated Adjustments Account (AAA) on their Forms 1120S. AAA measures the amount that former C corporations that elected S status can distribute to shareholders as a tax-free return of basis without triggering a taxable distribution of accumulated C corporation earnings. S corporations were initially told to omit tax-exempt income like the PPP loan proceeds from the calculation of AAA, but all deductible expenses were taken into account to reduce the AAA. This created a disconnect with the PPP loan forgiveness and the expenses used to create it, reducing the AAA and potentially triggering unexpected tax to S corporation shareholders.
Revising an incorrect calculation of AAA should not require amending the 2020 1120 S return since the 2021 beginning balance does not have to match that stated on the 2020 return. However, if distributions to shareholders exceeded the AAA in 2020 and resulted in the issuance of 1009-DIV forms, then those forms may need to be amended along with the resulting individual 2020 returns for those shareholders. Since it could create issues later for the shareholders with basis adjustments it may be advisable to amend those returns and obtain a refund of any tax paid in error. Always confer with your CPA or Financial Advisor.