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Economic Analysis: Double Standard on Double Dipping at the IRS

Posted on May 5, 2020

In August 2013 an IRS chief counsel memorandum argued that an excise tax credit refunded to blenders of biodiesel fuel was not taxable income. The memo’s conclusion easily applied to other alternative fuel credits, and so it was a nice added benefit on top of the multibillion-dollar tax alternative fuels mixture tax credit loophole for large publicly traded and private paper manufacturers.

Those companies had been producing combustible black liquor, a byproduct of the paper pulping process, since the 1940s. By mixing the black liquor with a bit of diesel, they were eligible for the credit: a pure ex-post windfall for doing nothing productive. The 2013 memo (ILM 201342010) converted the bad single serving of tax candy into an undeserved double tax benefit. 

On April 30, 2020, IRS Notice 2020-32, 2020-21 IRB 1, provided guidance denying deductions of expenses that generated tax-free forgiveness of loans granted under the Paycheck Protection Program (PPP) of the Coronavirus Aid, Relief, and Economic Security (CARES) Act (P.L. 116-136). The forgiveness is total for each dollar of payroll costs paid (plus with limitations, rent, interest, and utilities paid) up to 2½ months of payroll cost before loan origination. In general, loan forgiveness is taxable income. There are exceptions for borrowers that are insolvent or in bankruptcy. Section 1101(i) of the CARES Act explicitly excludes PPP loan forgiveness from taxable income.

Except for the absence of logic — no cliché sarcasm, please — the only way to interpret the specific language in section 1101(i) is that it was the intent of Congress to exempt the PPP loan-program subsidy from federal income taxation — a benefit that, by the way, provided an incentive to (mostly) small and medium-size businesses that kept paying their employees during the COVID-19 pandemic. The IRS guidance contradicts that interpretation. Congress provides exemption for amount X. IRS denies deduction for amount X, which leads to the same tax consequences as treating the subsidy as an item of gross income. That’s Alice in Wonderland lawmaking. 

Making this pathetic situation even more wrenching is that a large percentage of the millions of pandemic-stressed employers hoping for PPP loan forgiveness might have interpreted the tax-preferred status for PPP loan forgiveness as actually enhancing the economic benefit of the relief program. Congress giveth, but the IRS taketh by disallowing business-related deductions.  A layperson unfamiliar with section 265 may not get the joke.

Section 265 denies deductions allocable to tax-exempt income (like deductions for interest on municipal bonds or deductions for premiums on corporate-owned life insurance). It is the legal basis for the IRS notice’s denial of deductions to PPP loan forgiveness. Visiting Cornell Law School professor Richard Reinhold’s case against a reading of the CARES Act as allowing deductions can be found here. Lee Sheppard’s case for allowing deductions can be found here. Both were written before the IRS issued its notice.

The 2013 IRS reasoning for granting a double benefit was flimsy. Besides offering mumbo jumbo about congressional intent — which can always be shrugged off (as the agency itself has done in its 2020 guidance) — the IRS argued that excise tax refunds could technically (certainly not substantively) be considered income tax refunds. Taxation of (federal) income tax refunds is wrong because it creates a nonsensical circularity in the computation of taxable income. Taxation of excise tax refunds, on the other hand, is an entirely different matter. Businesses can deduct excise taxes (usually included in cost of goods sold). As a general rule, refunds of deductible taxes (as with any cost) should be taxable.

At this late point in time, it would have been better if the IRS just acknowledged the obvious congressional intent and, if necessary, studied its Tax Notes and adopted the incisive legal reasoning provided by Sheppard. Why so anti-taxpayer, when, now if ever, leaning in the direction of leniency would make common sense? Why so pro-taxpayer in 2013, when no discernible policy could be conjured and policy demerits were so glaring?

Principles, if Anybody Cares

In the future, it would generally be a good idea for Congress to avoid the debate about whether excluding a government subsidy from gross income while allowing a deduction for subsidized business expenses constitutes double dipping. Arguably, denying a deduction for business expenses that are funded with a government subsidy negates the intended “single” benefit of excluding the subsidy from gross income.

On the other hand, double benefits could come in a variety of forms: a tax credit that does not reduce basis, a tax credit that does not reduce current deductions, a refundable tax credit that is not taxable because it is a deemed overpayment, or loan forgiveness not included in gross income when the borrowed funds are used for an otherwise deductible expense.

To its credit, Congress in the CARES Act did reduce wage deductions by the amount of the employee retention credit (section 2301(e) of the act). If it had done the same with PPP loan forgiveness — which, after all, at least from an economic perspective, is equivalent to a wage credit — we could have avoided all this heartburn. 

No, we are not trying to be stingy and deny benefits to taxpayers. Congressional largesse can be implemented in dozens of ways, most of which simply involve changing the digits on the percentages and dollar amounts in statutory language.

The chairs of the taxwriting committees are making noise about writing legislation to overturn the IRS notice. If there is going to be an increase in relief and reduction of uncertainty, it would be best if it is speedy. Unfortunately, Congress has pretty much returned to its gridlocked, slow-motion pace of lawmaking.

In the meantime, it should not be forgotten that loan forgiveness isn’t just equivalent to a tax credit. It is equivalent to a tax credit for 100 percent of wages. Despite the best of intentions, total subsidization creates an environment where bad incentives start to overwhelm good incentives. Just consider the following small business scenario: lay off a half-dozen low-wage employees for eight weeks (who can collect $900 per week in unemployment insurance benefits) and replace them with a half-dozen no-show relatives.

We don’t need to put gasoline on this fire by giving the employer tax-free loan forgiveness. Congress might want to consider more measured relief than what amounts to tax exemption for a 100 percent wage credit. One possibility could be extending the period of loan forgiveness beyond eight weeks.

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