Congress is considering expanding the new loan program aimed at keeping workers employed during the coronavirus pandemic, but analysts warn that legislation on that front needs to address the tax treatment of loan proceeds used for expenses.
The expenses that Paycheck Protection Program (PPP) loan proceeds must cover to be forgivable would normally be deductible in virtually all cases under sections 162 and 163, but it is unclear whether the tax-exempt nature of the loan forgiveness functions to deny those deductions, Cornell University law professor Richard L. Reinhold said in an April 8 letter to Treasury.
“Whether such amounts should be tax-deductible is a policy question that I express no view on,” Reinhold said. “However, if the intention is to afford a deduction for these amounts, I believe that needs to be written in the legislation.”
The Coronavirus Aid, Relief, and Economic Security (CARES) Act (P.L. 116-136), which was signed into law March 27, gave employers options for how to keep paying their workers during the pandemic. Those options include the PPP and an employee retention credit that provides a fully refundable credit against the employer’s portion of payroll taxes, but only $10,000 in wages per employee can be counted for all calendar quarters, and the credit is capped at $5,000 per employee.
Employers must forgo that credit if they want to apply for a PPP loan. The CARES Act modified section 7(a) of the Small Business Act to create the program. Employers must jump through several hoops to qualify for the loan, but if they do qualify and a specific portion of the proceeds are used to fund payroll costs over the eight-week period after receiving the loan, it will be forgiven on a tax-free basis.
But practitioners aren’t sure whether the proceeds used to fund payroll costs and other items such as rent and mortgage interest expenses are deductible.
The issue stems from section 265(a)(1) and common law principles, which operate to deny deductions in specific circumstances, Reinhold pointed out.
“The rationale for these limitations is straightforward: to receive an amount tax-free and then expend the amount in tax-deductible fashion means the taxpayer has no economic cost but rather a tax benefit equal to the product of the tax rate and the amount received and paid,” Reinhold said. “In other words, the loan provides the taxpayer not only with liquidity to fund expenses but also a tax subsidy.”
Edward K. Zollars of Thomas, Zollars & Lynch Ltd. said the issue of deductibility came to mind right out of the gate.
“I've had concerns about section 265 and the potential lack of deductibility of the expenses used to justify the cancellation of a PPP debt since the law passed,” Zollars said.
Zollars noted that the CARES Act didn't create an exclusion under section 108, which deals with the tax treatment of loan forgiveness. Section 108 doesn't deny deductions immediately, but generally reduces carryovers and basis — and thus indirectly denies future deductions to offset the exclusion — for most of the section 108 categories, he said.
“Did [Congress] do that because they wanted to avoid any negative tax consequence of the cancellation due to COVID-19?” Zollars asked. “Or did they do it to expose the expenses to the general rule of section 265?”
Reinhold pointed to Rev. Rul. 83-3, 1983-1 C.B. 72, which states that the purpose of section 265 is to “prevent a double tax benefit,” and also cited Manocchio v. Commissioner, 78 T.C. 989 (1982), which was affirmed by the Ninth Circuit for support, albeit on different grounds. In Manocchio, an airline pilot paid for flight instructions that were 90 percent reimbursed under a federal program, and the reimbursed amounts weren’t subject to tax. According to the Tax Court, those reimbursed expenses weren’t deductible under then section 265(1), Reinhold said.
And for corporate taxpayers, section 362(c)(2) appears to require a basis reduction when a PPP loan is forgiven, Reinhold said. Under the Tax Cuts and Jobs Act, section 118(b)(2) no longer treats a non-shareholder capital contribution by a government entity as excludable, but there was no change to section 362(c), he said.
“For clarity I'm assuming 1) the contribution would be deemed to flow from the government by reason of the [Small Business Act] guarantees of the PPP loans and 2) the contribution would be regarded as a contribution of money,” Reinhold said. “On the basis of those assumptions, it seems appropriate to regard the forgiveness as a non-shareholder contribution in the absence of another plausible characterization, with resulting tax basis reduction.”
Adam Sweet of Eide Bailly LLP said another question is how the PPP loan debt is treated for tax purposes.
“For instance, if a partnership incurs the PPP loan and the loan is forgiven, does that loan represent true tax indebtedness for the period it is on the partnership’s books, which would give rise to tax basis for the partners and allow for a possible deduction?” Sweet asked.
When the partnership incurs the debt, there’s no guarantee that it will be forgiven in whole or in part, so one theory is that the expenses are deductible because the debt basis is a real section 752 liability recognized for tax purposes, Sweet said.
“Of course, at-risk limitations could apply as well due to the nonrecourse nature of the loan,” Sweet added.
But then the question is what happens if and when the debt is forgiven, Sweet said.
“We know there is no cancellation of indebtedness income to recapture previous expenses,” Sweet said. “Does the forgiven loan also jeopardize the previous deductions?”
The language of the CARES Act doesn’t answer those questions.