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Byrnes & Bloink’s Covid-19 TaxFacts Weekly of April 30, 2020 (Special Notice – IRS Just Issued Notice Denying Deductions for PPP Loan Forgiveness and Its Dead Wrong)

Posted by William Byrnes on April 30, 2020


           Prof. William H. Byrnes

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?

* I’m simplifying the numbers, factors, and how tax is determined to represent the broader point. One factor is by example the potential Section 199A deduction of 20% of qualifying business income.  This factor may impact the outcome of the calculation if, by example, a business would generate positive qualfied business income instead of a loss because of the SBA PPP loan forgiveness exemption from income without corresponding deductions. In such a case, the additional 20% deduction would need to be added to the business’ benefit column.  However, I think that most businesses will suffer a 2020 loss year with or without SBA loan forgiveness because of loss of revenues from late February through the 3rd quarter.

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.

           Prof. William H. Byrnes
        Robert Bloink, J.D., LL.M.
Legislation that is drafted quickly often ends up needing a lot of regulatory and administrative interpretation to help taxpayers adopt the changes in the new rules, and the COVID tax changes are no different.We continue to see actions from the IRS and DOL to clarify the new provisions in COVID-19 legislation. This week those updates include new info on how to enact FFCRA leave (including what to do when employers have concurrent leave policies), the opportunity for partnerships to file amended returns to take advantage of the CARES Act Bonus depreciation fix, and additional flexibility for companies wrestling with the business interest expense deduction under the CARES Act.
 

DOL FAQ Clarify Concurrent Use of FFCRA Leave

The FFCRA implemented a new paid sick leave law and expanded FMLA leave options for employees impacted by COVID-19. Many employers have independent policies in place that provide employees with leave options, and the DOL regulations raised questions about when the employer can require the employee to use that leave prior to, or concurrently with, FFCRA leave. Employers cannot require employees to concurrently use leave during the first two weeks of paid sick leave for non-childcare related reasons. Employers can, under some circumstances, require use of employee leave concurrently with expanded FMLA leave for childcare reasons. Employers are only eligible for tax credits with respect to leave paid out under the new law. If the employer requires the employee to use otherwise available employer-paid leave, the tax credit is unavailable with respect to that portion of the employee’s pay. For more information, visit Tax Facts Online. Read More

Employee Rights After FFCRA Leave

Employers are generally prohibited from retaliating against employees to take paid sick leave or expanded FMLA leave under the FFCRA. However, the law does not protect employees from layoffs or furloughs undertaken for other reasons, such as the general economic downturn. Exceptions exist for key employees and very small employers with fewer than 25 employees. For more information on the exceptions to the FFCRA rules, visit Tax Facts Online. Read More

CARES Act Bonus Depreciation Fix: Amended Returns for Partnerships

The CARES Act provided retroactive relief to partnerships on multiple fronts, including by fixing the so-called “retail glitch” to allow businesses to take advantage of 100% bonus depreciation on qualified improvement property through 2022. Existing law may have prevented partnerships from filing amended Forms 1065 and Schedules K-1. Instead, partnerships would have been required to file an administrative adjustment request, so that partners would not have received relief until filing returns for the current tax year. Revenue Procedure 2020-23 allows partnerships to file amended returns and issue revised Schedules K-1 for 2018 and 2019 to take advantage of retroactive CARES Act relief (and, absent further guidance, even if they are not taking advantage of CARES Act relief). For more information, visit Tax Facts Online. Read More

IRS Guidance on CARES Act Business Interest Elections

The IRS gives businesses substantial flexibility in making and revoking elections related to business interest expense deduction under the CARES Act. For more information about the choices that are available related to the business interest expense deduction, visit Tax Facts Online. Read More

2020’s Tax Facts Offers a Complete Web, App-Based, and Print Experience

Reducing complicated tax questions to understandable answers that can be immediately put into real-life practice, Tax Facts works when and where you need it….on your desktop, at home on your laptop, and on the go through your tablet or smartphone.  Questions? Contact customer service: TaxFactsHelp@alm.com800-543-0874

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