A Treasury news release makes it clear that the IRS is holding firm to its negative view on deducting expenses paid by forgivable Paycheck Protection loans. Should taxpayers resist? Or would that be futile gesture like dumping tea in the harbor?
This is the season of the year when on-the-ball taxpayers with on-the-ball advisers figure out where they stand. 2020 has been such an easy year that the IRS has decided to give us just a little bit of challenge by issuing Revenue Ruling 2020-27 and Revenue Procedure 2020-51. The Service is doubling down on the tough stance that it adopted on Paycheck Protection Program (PPP) forgiveness. I thought it might be useful to review the bidding as we contemplate how to respond.
Paycheck Protection Program
PPP was enacted as part of the CARES act back in March. The basic idea was that businesses would be able to borrow the lesser of 2.5 months of payroll or $10 million. If the money was spent properly, it did not have to be paid back. I am not going to recount all the drama that followed as many of the nations tax professionals were transfromed into loan processors. Rather, we are focusing here on one aspect of the orginal legislation.
Taxability.—For purposes of the Internal Revenue Code of 1986, any amount which (but for this subsection) would be includible in gross income of the eligible recipient by reason of forgiveness described in subsection (b) shall be excluded from gross income.
So besides help with paying people during the crisis there was a bit of a tax subsidy. On top of that thanks to the CARES Act there are now net operating loss carrybacks. So the losses from this horrible year can recover some of the taxes paid in the good times. If you barely broke even after PPP forgiveness you would still have a loss that you might carry back and recover more funds.
On April 17, I wrote about Greg Bernhardt’s concern that the expenses that are funded by forgivable loans might not be deductible because of Code Section 265 – Expenses and interest relating to tax-exempt income. I was skeptical as was Lu Gauthier of the Boston Tax Institute. If that was so, the part of the act that indicated no gross income for forgiveness seemed kind of pointless.
Then the hammer fell on April 30. IRS issued Notice 2020-32.
“Specifically, this notice clarifies 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 pursuant to section 1106(b) of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act)
Notice 2020-32 relied both on Code Section 265 and “authorities holding that deductions for otherwise deductble expenses are disallowed if the taxpayer receives reimbursement”.
Maybe The IRS Is Wrong
John Anthony Castro certainly thought the IRS was wrong. I published a guest post from him on Your Tax Matters Partner on May 8, 2020.
The U.S. Tax Court has held that “the legislative purpose behind § 265 is to prevent taxpayers from reaping a double tax benefit by using deductions attributable to tax-exempt income to offset taxable income.” However, Congress did not require taxpayers to develop an extrasensory psychic ability to foresee the future and determine the extent to which a loan may or may not be forgiven.
Section 265 was not intended to apply to future contingent events in order to retroactively deny the deductibility of expenses. Such a reading contravenes the unambiguous language in the statute.
Section 265’s use of the phrase “wholly exempt” cannot reasonably include loan proceeds that may only be partially exempt.
And because the IRS’s interpretation of Section 265 could result in a requirement that debt discharged in bankruptcy or claimed as non-taxable by reason of insolvency pursuant to Section 108 give rise to an affirmative requirement to amend prior-year returns, which is beyond unreasonable, IRS Notice 2020-32 is invalid as a matter of law.
Even assuming that Section 265 does apply, there is the question of timing, since the loan forgiveness might not happen till 2021.
Revenue Ruling 20-27 walks us through two examples- Taxpayer A and Taxpayer B. We’ll call them Allie and Bobby. Allie received a PPP loan, paid qualifying expenses and applied for forgiveness in 2020. Allie has not heard back from the bank. Bobby received a PPP loan, paid qualifying expense, but has not yet applied for forgiveness. They both reasonably expect loan forgiveness. Neither Ally nor Bobby can deduct the expenses following the logic of Notice 2020-32.
Revenue Procedure 2020-51 addresses the possibility that Allie or Bobbie are surprised to find that some of their loan is not forgiven. In that case they can amend their 2020 return to claim the deductions. Alternatively they can claim the deduction in the year that the non-forgiveness is clear. In the latter case, they will attach a statement referring to Revenue Procedure 2020-51.
What To Do
John Anthony Castro is holding firm in his view that the IRS is wrong. Meaning no disrespect, but Mr. Castro is a bit on the aggressive and unconventional side.
Lucien Gauthier of the Boston Tax Institute tends to be a bit more moderate. (Disclosure I am on the BTI faculty) He tells me that he is leaning toward taking the deduction and attaching Form 8275 – Disclosure Statement to returns. Having Boston Tax Institute recommend a position requiring Form 8275 disclosure for millions of returns nationally is not quite as extreme as dumping tea in the harbor, but it is extreme. I will be covering the BTI conference Rev. Rul. 2020-27 & Form 8275 Disclosure Statement for PPP Loan Forgiveness on Tuesday.
Lu said that some people object to the notion of deducting expenses funded by a forgiven tax exempt PPP loan as double dipping. He wants to reassure them that when it comes to S Corporations, it is not double dipping. It is actually triple dipping. S Corporation shareholders should be entitled to a basis step-up thanks to the the Gitlitz decision. Congress did react to Gitlitz in 2002, but that might not be relevant as McLaughlin Quinn explains in this post.
Following the Gitlitz decision, Code Section 108 was amended to include “Special Rules for S-Corporations” to close this basis increase loophole. These special rules apply only to discharged debt income excluded under Code Section 108. PPP Loans are forgiven and excluded from income under the CARES Act, not Code Sec. 108. This begs the question, does the Gitlitz rationale still apply? If so, an argument can be made that S-corporation shareholders can increase their stock basis by forgiven PPP Loans. As the Supreme Court stated, discharged debt is an item of income under general federal income tax principles. Therefore, Code Section 1366 and 1367 should still apply as written to provide for an increase in stock basis.
The Gitlitz issue has garnered little attention except amongst the savviest tax practitioners. (Interestingly, this issue was first raised by Walter Abbott, CPA in a conversation with Lucien Gauthier, Esq. of the Boston Tax Institute on behalf of which Attorney Bilodeau presents live video conferences.) For S-corporation shareholders seeking a “free” increase in stock basis, perhaps to permit the pass-through of prior year losses, the Gitlitz strategy warrants consideration.
Senators Chuck Grassley and Ron Wyden issued a very strong statement encouraging Treasury to change its position and offering hope that there might be a legislative fix.
Since the CARES Act, we’ve stressed that our intent was for small businesses receiving Paycheck Protection Program loans to receive the benefit of their deductions for ordinary and necessary business expenses. We explicitly included language in the CARES Act to ensure that PPP loan recipients whose loans are forgiven are not required to treat the loan proceeds as taxable income. As we’ve stated previously, Treasury’s approach in Notice 2020-32 effectively renders that provision meaningless.
Regrettably, Treasury has now doubled down on its position in new guidance that increases the tax burden on small businesses by accelerating their tax liability, all at a time when many businesses continue to struggle and some are again beginning to close. Small businesses need help maintaining their cash flow, not more strains on it.
“While we continue our efforts to clarify in any end-of-year legislation the intended relief in the CARES Act, we have an opportunity to provide meaningful relief to small businesses at this critical time. We encourage Treasury to reconsider its position on the deductibility of these expenses, and the timing of those deductions, to provide relief to the small businesses that need it most.
There is a bill in the Senate (S.3612 – Small Business Expense Protection Act of 2020) that would solve the problem.
Run Good Numbers
There is a tendency in doing planning to make a simplifying assumption about the effect of a deduction based on marginal tax rate. This violates Reilly’s Sixth Law of Tax Planning – Don’t do the math in your head. There are numerous phase-outs, thresholds and limitations. So you won’t be able to judge the effect that the deduction will have on you without running pro-forma returns. That includes pro-formas for the carryback year or years, which may have collateral effects on other returns.
You will need to consider AMT, 199A, 469 and limitations on itemized deductions. And don’t forget state income taxes, which can have some oddities particularly in states that deviate a lot from federal AGI. If you use good software a lot of that should flow, but only if all the correct information is in. Net operating loss deductions for individuals are particularly tricky. People making planning decisions for S corporations will need to figure out the effect that they are having on the individual returns of the shareholders.
Revenue Ruling 20-27 to the contrary notwithstanding, I think it is best to defer forgiveness application to 2021. Plan on putting your 2020 return on extension to give as much possible time for things to work themselves out. Consider whether there is actually anything you might do differently before December 31 – accelerating income recognition, deferring income, accelerating deduction, deferring deductions. If there is not that takes the immediate pressure off.
If decisions need to be made run good proformas so that you know the effect of the different possibilities – deduction denial in 2020, income pickup in 2021 or full deductibility with no income pickup with any NOLs, if any either carried back or forward.
The conservative approach is to assume that you are denied deductions for the amount of your PPP loan that will be forgiven, but you don’t have to resign yourself to that until late next summer.
Sally Schreiber has IRS doubles down on nondeductibility of PPP-funded expenses on the Journal of Accountancy. It is a basic summary of the notices.
Michael Cohn has IRS clarifies deductibility of PPP loan expenses, as AICPA criticizes forgiveness questionnaire on accountingtoday.
Robert W Wood has IRS Denies PPP Tax Deductions Even If Loan Might Be Forgiven In Future on Forbes.com.
Laura Davison and David Hood has Congress Blasts IRS for Limits on Forgiven PPP Loan Tax Breaks on Bloomberg. They quote Joe Kristan.
“I think most of them are, at least for now, resigned” to not getting the write-offs, Joe Kristan, a partner at the accounting firm Eide Bailly LLP in Des Moines, Iowa. “They’d certainly like to be allowed by Congress to step in and allow their deductions, but they’re not counting on it.”
David Mercado has Business owners expecting paycheck protection loan forgiveness can’t deduct expenses on CNBC.
Tony Nitti has IRS Crushes Hopes Of Deducting PPP-Paid Expenses Before Forgiveness Approval; But Questions Remain on Forbes.com.
Tony’s opening paragraph is a sign that he should tread carefully will not make him real popular with most devotees of the Boston Tax Institue:
I’m not proud to admit it, but I hate a lot of things. I don’t mean that certain things annoy me or I have a general distaste for them; I mean I hate them. I hate country music. I hate Newark Airport. I hate Tom Brady and jean shorts and the Full House reboot.
Tony then proceeds to raise another unresolved disturbing issue.
Now I confess, these connections are not perfectly clear, and the result I’m reaching is contrary to the intent of the Section 199A W-2 limit, which was to incentivize businesses to hire people and pay wages. Nondeductibliity of those wages, one would think, should have no bearing on whether they are included in the W-2 limit; after all, the wages were paid, and someone is paying tax on them. But a literal reading of the regulations may cause the IRS to conclude that any wages that are nondeductible are not taken into account in computing QBI, and thus are not included in the W-2 limit.
Mike Greenwald of Friedman LLP has Latest IRS Guidance Dashes Hopes of Deducting Expenses Paid with PPP Loans.
What does this mean for you? It is still possible that Congress will pass legislation making the expenses deductible. It is highly unlikely that will happen in the lame duck session that is about to begin but is possible by the end of January in the new Congress. On the other hand, the IRS release may spur action in Congress. Sen. John Cornyn’s bill has significant bi-partisan support and advocacy by the AICPA, among other organizations.
With that in mind, we continue to generally recommend you wait to file a forgiveness application. You should, however, review your particular circumstances with your advisors to determine the best course of action. Most borrowers still are well within the forgiveness application window – 10 months from the end of the covered period of the loan. If Congress hasn’t acted by the tax filing deadlines in March and April, we will likely recommend requesting an extension of time to file returns in the hope that the proposed legislation will pass before the extended due date.