The IRS released on April 30th Notice 2020-32 wherein the IRS interprets general tax law principles to deny business deductions (under Internal Revenue Code Section 162) for the wage and related expenses when the business takes advantage of the SBA’s PPP loan forgiveness.
The IRS Notice is a wrong interpretation of how CARES Section 1106 (see below) and by implication, Internal Revenue Code Section 108 (discharge of indebtedness), works, as well as how Congress intends CARES to work. Congress clearly intends CARES’ SBA loan proceeds to ameliorate Covid-19s damage to small business’ earnings (and thus mitigate the Covid-19 economic recession) by pushing cash flow into, and through, small business.
The IRS is approaching this issue from a perspective that exempting from income the discharge of debt of small businesses and also allowing a deduction for the wage expenses is a ‘double benefit’ and double benefits are not allowed. Yet, this is exactly what many tax credits allow – a double benefit created from deducting the expenses that generate the tax credit. A small business that uses the maximum Sick Leave tax credit of $5,110 (Families First Act) and the $5,000 employee retention tax credit for CARES (these two tax credits may be combined) will receive the $10,110 refundable tax credit excluded from gross income AND ALSO a deduction from the small business owner’s gross income (albeit this deduction is reduced by $5,000 to reflect the Employee Retention credit amount yet no reduction is required for the Families First tax credits) which is worth the small business owner’s tax rate – federally either 37% or 29.6%. with the extra Section 199A 20% deduction for business income (see some of Robert and my Tax Facts Intelligence articles on 199A and Covid-19 at ThinkAdvisor). In New York or California, states with high personal income tax rates, the business expenses deduction is worth more than say, Texas or Florida that do not tax personal income.
So the IRS Notice creates discrimination for many small businesses in favor of the $10,110 refundable tax credits of Families First and CARES in relation to the SBA PPP Loans. Most of the House and Senate certainly did not intend to ‘give with one hand and take back with the other’ regarding the SBA Loans. Had Notice 2020-32 been published before the additional SBA funding, Congress would have been forced to take a stance on what it intended. Now we must wait until the next relief bill for Congress to confront this issue.
The IRS cites IRC Section 265 for its argument to deny the deduction for the CARES Act’s SBA PPP forgiven amount. The IRS contends that the CARES Act Section 1106 creates a “class of exempt income”. Section 265 denies business income deductions under Section 162 when the income in question falls into a class of exempt income. But if CARES creates a class of income, then that class is of ‘debt income’ and debt is excludable from gross income. The IRS’ erroneous interpretation can be stretched that all business deductions should be denied by Section 265 when those expenses are funded by debt income. Even the interest payments on the SBA loans should not be deductible based on this approach.
CARES Act Section 1106‘s Loan Forgiveness exclusion from income is in the same vein as Section 108’s exclusion from income for discharged debt. Section 108 does not create a class of income for purposes of Section 265. Administratively it would be very burdensome for the IRS to reach back to open tax years and clawback deductions for expenses funded by the discharged debt. Congress knows how to deny tax allowances when it intends to do so because Congress included denying certain allowance items in Section 108, but not a denial of tax deductions. Congress included proportional reduction of net operating loss, of general business tax credits (under Section 38), among other items, relative to the amount of loan forgiveness to overall income that generated the tax allowances.
CARES ACT Section 1106 states “(i) 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.”
Section 108 states “(a) Exclusion from gross income (1) In general Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if …”.
Statutorily speaking, why did Congress specifically include that the SBA loan forgiveness is exempt from gross income if Congress intended that the deductions would be disallowed? Based on the IRS’ logic, if Congress had not included the exclusion then the expenditure for wages would be deductible and would offset the discharged debt, a washout. So Congress did not need to do anything to achieve the result that the IRS claims that Congress intended by doing something.
Take an example of a New York business.* Should a New York business choose SBA loan forgiveness or the sick leave plus employee retention tax credits? (Note New York’s decoupling whereby New York has chosen to deny some of the relief of the CARES Act may impact the analysis but I am leaving that aside). For a business with, by example, 100 employees, a combined $10,000 credit (rounding down) per employee is worth $1,000,000 of tax-exempt tax credit. To generate the $10,000 of tax credit, the business had to pay at least $15,000 in wages, so $1.5 million in wages for the 100 employees. At the combined federal rate of 37% and New York highest rate of 8.82%, the wage expense generates a deduction of $458,200 (because the wage deduction must be reduced for the $5,000 of Employee Retention tax). But the employer also paid 06.2% social security tax and 01.45% medicare tax, a combined 07.65% which provides an additional $76,500 deduction (again excluding the Employee Retention tax credit portion). The deduction probably exaggerates the Covid-19 loss for the year that may, pursuant to the new NOL provision for CARES, be clawed back from the previous tax years because the Tax Cuts and Jobs Act is suspended for 2020 losses. Combined benefit of $1,534,700 for the business.
An SBA PPP loan forgiveness for the wage amount of $1.5 million is worth exactly that, $1.5 million. Wage deduction lost. Thus, in this scenario, the tax credits may generate more net benefit than the SBA Loan. And if the IRS argument for Section 265 is carried out, then the interest expense on the SBA loan must be denied, which I estimate will be in the neighborhood of $52,500 until forgiven (maybe the interest will be returned vt the SBA to mitigate the disparity caused by the IRS – I am unclear if the SBA can forgive the interest as well).
What if a small business is insolvent which is just an accounting definition of debt exceeding asset? Generally, a small business with the SBA loan is going to be insolvent. Cash flow is king so the issue of asset book insolvency is not actually relevant to running the business. But for Section 108 it allows exemption from gross income the amount of canceled debt as well as the deduction for the expenses financed by the canceled debt. Perhaps then, any small business seeking the SBA loan forgiveness needs to obtain an accountant’s letter of business insolvency to trump Notice 2020-32 then file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness?
Insolvency calculation:
Total liabilities immediately before the discharge – FMV of total assets* before the discharge = Extent to which the taxpayer is insolvent
(Assets includes bankruptcy exempt assets e.g. retirement account and interest in a pension plan).
And because the tax credits can be captured from the Employer’s Social Security portion of the payroll tax, while the cash flowing of the payroll is still an issue, it is less of an issue, albeit the payroll tax on the $1.5 million is just under $80,000 so not significant. However, the business may request an advance refund of the tax credits as the business spends the wages (Form 7200, Advance Payment of Employer Credits Due to COVID-19). Thus, with the advance tax credit refund, the cash flow challenge is addressed. Regardless, the small business may obtain the CARES Act SBA Small Business Interruption Loan – just not the loan forgiveness that eliminates the deductions according to the IRS.
While tax credits are difficult for taxpayers but the SBA loan process is certainly not straight forward and neither is the forgiveness process, for those businesses that managed to obtain the SBA PPP loans. Depending on the size of the loan and the business’ 2020 wages, the SBA loan may not be more beneficial than the tax credits, or at least, not substantially more.
Thank goodness that the calculations necessary to determine which path is better for the small business will require expensive advice from a tax advisor. Congress certainly intended that CARES is to ameliorate (the temporarily) lost tax advisory fees resulting from the push back of the tax filing season, right?
May 1 at 3:00 pm CARES Act Webinar – Small Business Incentives – Register w/ the Tarrant County Bar Association
William Byrnes and Neal Newman, Texas A&M School of Law
– SBA PPP, Obtaining Loan, Tax-Free Forgiveness, Tax Deduction Expenses?
– Employee Retention Tax Credit and Payroll Tax Deferral?
On May 1st my esteemed colleague, Low Income Tax Clinic Director Professor Bob Probasco, a 30-year tax litigator veteran, responded as follows: You have a valid argument. But from the perspective of a tax litigator, rather than an academic – predicting what will happen rather than what the result should be – I’m not sure it’s that clear.
The analogy to § 108 discharge of indebtedness is not exact and could be distinguished by a court. The link between the § 108 and the specific deductions that were “funded” by the indebtedness is not as clear as the link between CARES § 1106 and the specific expenditures required to qualify for the discharge. Most discharges of indebtedness, outside CARES, are not motivated by the specific use made of the loaned funds, are they?
Similarly, the analogy to tax credits allowed based on the same expenditures that are deducted does not involve exempt income. In addition, those examples were more clearly intended by Congress. You can argue that Congress intended to allow the deductions leading to a § 1106 discharge – but it’s an inference, not as clear as Congress explicitly specifying deduction A and credit B, or credit X and credit Y. The primary purpose of the CARES Act program, and the main benefit to be derived, was the loan foregiveness itself – pre-tax, rather than tax benefit. Concluding that the income from the foregiveness would not be taxable gives some support for an inference that they intended to allow the deductions as well, but they didn’t actually say that.
The arguments from a policy perspective are stronger, but I’m not sure that would overcome the language of the statute. Courts tend to interpret the language of the Code literally, and deviate with judicial doctrines like substance over form and economic substance that benefit the government rather than the taxpayer.
As a practitioner, I could have very comfortably argued either side of the question prior to the Notice. The Notice is going to make the argument for deduction slightly harder. It could easily go either way in court, but my guess is that a court is at least slightly more likely to agree with the Notice than to allow deduction of those expenses.
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