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Planning Possibilities for PPP Deductions

Posted on Jan. 4, 2021
Charles Lincoln
Charles Lincoln
Benjamin M. Willis
Benjamin M. Willis

Benjamin M. Willis (@willisweighsin on Twitter; ben.willis@taxanalysts.org) is a contributing editor with Tax Notes. He formerly worked in the mergers and acquisitions and international tax groups at PwC and at the Treasury Office of Tax Policy, the IRS, and the Senate Finance Committee. Before joining Tax Analysts, he was the corporate tax leader in the national office of BDO USA LLP. Charles “Charlie” Lincoln (@cealiv on Twitter; charlesedwardandrewlincolniv@post.harvard.edu) is a PhD student at the University of Groningen in the Netherlands, where he focuses on international tax law. The views expressed here are the authors’.

In this article, Willis and Lincoln emphasize that the Consolidated Appropriations Act, 2021, allows some businesses to deduct expenses paid for with Paycheck Protection Program funds, and they share ways that taxpayers could take advantage of the new rules.

President Trump signed the Consolidated Appropriations Act, 2021 (H.R. 133), into law on December 27, 2020. After the months-long debate about the deductibility of expenses funded by the Paycheck Protection Program established under the Coronavirus Aid, Relief, and Economic Security Act (P.L. 116-136), taxpayers have an answer: They are.

Arguments by lawmakers on what are now valid deductions had given rise to taxpayer expectations,1 yet no such intent had been reflected in the CARES Act, at least not for PPP expenses.2 Congress originally designed the PPP to subsidize employee paychecks in the troubled economy, not to provide businesses with deductions to offset earned income.

Practically speaking, the PPP provides some businesses with free labor costs.3 PPP loans encourage businesses to use those funds to pay wages.4 The goal is to prevent layoffs by funding paychecks that would otherwise come from the businesses’ own earned income.5 In substance, the government paid the employees — indirectly through the businesses — so that the businesses would not lay them off.6

While it appears that the intent to provide deductions to businesses for passing along money to employees materialized after the CARES Act became law, the Consolidated Appropriations Act is evidence that the idea had strong bipartisan support. Now taxpayers don’t have to retroactively look to Congress to embed intent into the CARES Act.

The Paycheck Protection Program

The following diagram illustrates how the PPP works as Congress originally intended7:

Diagram

The government uses businesses as conduits to pay workers compensation. The program protects paychecks.

The businesses get free labor and avoid layoffs, so they are better positioned for an economic recovery. Those PPP loan recipients can even use a portion (originally 25 percent and now 40 percent) of the proceeds to pay rent and utility bills to keep their lights on.

Most PPP funds must go to payroll expenses to qualify the PPP loan for forgiveness.8 The loan amount is based on 2½ times the prior 12-month average payroll of the business.9 The CARES Act requires recipients to certify “that funds will be used to retain workers.”10

The CARES Act operates to exclude all or part of a PPP loan from giving rise to cancellation of debt (COD) income, depending on how much of the loan proceeds are paid out as intended. COD income generally requires an adjustment to prevent a double tax benefit.11 The CARES Act ensured businesses don’t have to fit into an exception to COD income or reduce their tax attributes, which generally results in a timing difference by increasing future tax burdens.

But businesses wanted deductions too, and those benefits would be precedented. In fact, Congress ensured that the CARES Act permitted double benefits, but only in limited circumstances.

CARES Act Solution?

The CARES Act provided for $1,200 economic impact payments, or recovery rebates, that are not income. But the PPP is in effect a loan that can be excluded from gross income if forgiven.12 PPP loans are generally forgiven to the extent that the proceeds are passed on to qualifying sources, including employees and contractors through wages and similar compensation.13 This is not a difference without a distinction.

Regarding COD income for PPP loans, section 1106(i) of the CARES Act provides that “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.” On the other hand, section 6428(b) and CARES Act section 2201 provide that economic impact payments are treated as refundable tax credits, which are treated as returns or advances of tax payments even if the advances do not need to be repaid.14 Congress has also given refundable tax credits as cash grants to businesses.15

One cannot ignore the disparate treatment of forgiven PPP loans and stimulus checks: One results in potentially excludable income and one does not qualify as income at all. In contrast to PPP loans, the $1,200 economic impact payments are refundable tax credits.16 Because the IRC does not consider those payments income to begin with, they are not subject to the section 265 limit on deductions for tax-exempt income.17 As designed in the CARES Act, PPP loans intended to pay off qualified expenses are generally subject to section 265.

The CARES Act’s economic impact payments can give rise to deductions, such as through mortgage payments. As confirmed in Rev. Rul. 2020-27, 2020-50 IRB 1, the tax rules generally don’t treat tax-exempt income that way.18 If Congress wanted to provide more generous treatment to PPP loans, it could have addressed them the same way it addressed economic impact payments for which no double benefit concerns arise.

Again, it’s not a difference without a distinction. Via the CARES Act, Congress provided for a $1,200 subsidy that was not income, but it also chose to create a loan excludable from gross income if forgiven because of the way that the loan proceeds were used. Thus, assuming ambiguity exists, in pari materia, there is no question that economic impact payments can give rise to deductions, a benefit not afforded to businesses that disbursed taxpayer-funded paychecks under the CARES Act.

Lawmakers from both sides have said they intended to provide deductions for expenses paid for with PPP funds. Yet neither the CARES Act nor the rules of statutory construction supported a court reaching that determination.19 Interestingly, the Trump administration and Treasury followed the law in a way that a court must agree with, even going against statements made by Republicans and Democrats in Congress.20 Treasury’s interpretation is certainly correct when such an interpretation would deprive a taxpayer of life, liberty, or property.21 As for matters of legislative grace, Rev. Rul. 2020-27 supports Michael L. Schler’s view that a balanced approach should be taken, particularly since so few will take a stand, and perhaps have standing, on anti-taxpayer interpretations.22

In interpreting a statute, the Supreme Court has written that the plain meaning of the statute should be considered first.23 If the plain meaning is unclear, courts should use other rules of statutory construction in interpreting the text. One of those rules is noscitur a sociis, which would allow for an interpretation that relies on the context supplied by nearby words or similar bill provisions. Likewise, the whole act rule provides that courts may determine the meaning of one section of an act based on the act’s other sections. Under those principles, a court would compare and contrast the PPP with other sections of the CARES Act, such as those on economic impact payments that may give rise to deductions.

Are PPP Expenses Deductible?

Trump signed the CARES Act into law on March 27. Two trillion dollars provided a much-needed economic stimulus, given the devastation caused by COVID-19.24 The PPP was meant to help companies continue to pay their workers. However, the CARES Act indicated that taxpayers could deduct no expenses, including payroll, paid for with forgiven PPP funds.25

In what can most accurately be described as a textualist approach, Treasury interpreted the law on April 30. Notice 2020-32, 2020-21 IRB 837, indicated that the CARES Act contained no provision that allowed for deductions for expenses paid for with PPP funds and that Treasury did not have the authority to grant deductions, which are a matter of legislative grace. Moreover, the statutory canons of interpretation bring one no closer to finding evidence that the deduction should exist. Treasury must have the ability to interpret the words of the text within the context of other words in the statute.

Notice 2020-32 provided that “section 265(a)(1) of the Code disallows any otherwise allowable deduction under any provision of the Code, including sections 162 and 163, for the amount of any payment of an eligible section 1106 expense to the extent of the resulting covered loan forgiveness (up to the aggregate amount forgiven) because such payment is allocable to tax-exempt income.” Although this may have disappointed some people, it seems clear Treasury’s decision is consistent with the explicit text of the statute and would likely be viewed as the most appropriate interpretation of congressional intent based on principles of statutory construction.

Many lawmakers said Congress did not intend to disallow deductions for expenses paid for with PPP funds. For example, Senate Finance Committee Chair Chuck Grassley, R-Iowa, said Treasury incorrectly disallowed those deductions and that Congress intended for the payments to be deductible.26 The CARES Act did not deny deductions for taxpayer paid business expenses; it simply did not authorize deductions for paychecks paid by the government.

Thomas A. Barthold, Joint Committee on Taxation chief of staff, wrote to the Senate on July 27 that the JCT “understood [that] the intent of the legislation was not to deny deductions for qualifying expenses” when calculating the revenue-raising mechanisms of the CARES Act. While that letter may be viewed by some as post-enactment evidence of legislative intent, it provides no textual compulsion for Treasury to provide deductibility.

Among the provisions in the Consolidated Appropriations Act is one for $284 billion in forgivable loans secured through the PPP.27 It will “allow businesses to deduct expenses paid for with PPP loans, expand the employee retention credit, and send checks to qualifying taxpayers.”28 Section 276 of the act provides that no deduction shall be denied by reason of payment of the PPP funds. Thus, the act overrules Treasury’s pronouncement denying deductions, and it enables Treasury to begin allowing deductions of expenses paid for with forgiven PPP amounts. While PPP amounts could have simply been grossed up to provide businesses immediate benefit, the deductions will benefit only those business that survive long enough to monetize them.

Potential for Abuse and Planning

The potential for abuse of PPP funds remains high. In one extreme example, a Florida business owner received $3.9 million in PPP funds only to spend it on one or several Lamborghinis.29 The less extreme cases may involve an individual setting up a limited liability company, backdating checks or simply incurring expenses to a friend or other LLC, and requesting PPP money instantaneously when it becomes available. The IRS would benefit from supplying auditors with a manual outlining potential abuses.

Another example of abuse could occur if small businesses and partnerships change the legal relationships of their partners. All partners but the general partner in a partnership could relinquish their partner status and become independent contractors or employees. Such demotions could occur because of COVID-19-related declines in business.30 But the demotions cause legal relationships, as a matter of agency laws, to change, and that kind of change would make the former partners employees who are eligible to be paid with PPP funds.31 At that point, the funds in the partnership pool that would normally be dispersed could be reused or saved until the employees are promoted back to being partners and when the PPP funds are exhausted. The authors call this maneuver the “Prisoner in the Vatican” because it’s reminiscent of popes from 1870 to 1929 who refused to leave the Vatican to avoid any appearance of concession to the Italian government. Like the popes, the partners may have the right to do this from a legal perspective.

Should a business created after the PPP was first established be able to benefit from it? It helps to remember that only those businesses with gross receipts that have dropped by 25 percent are eligible for PPP funds. But a business measures that drop in gross receipts by comparing them from different quarters. Under the CARES Act, if a business wasn’t operating in 2019 it can compare its gross receipts from the first quarter of 2020 with subsequent quarters to determine whether gross receipts were reduced by at least 25 percent. The Consolidated Appropriations Act modified the definition of “covered period” from “the period beginning on February 15, 2020 and ending on June 30, 2020” to the period “beginning on the date of the origination of a covered loan” and ending “on a date selected by the eligible recipient” eight to 24 weeks after origination. It’s not entirely clear to what extent a reduction in gross receipts must be established under the new covered period definition. Perhaps weeks. Moreover, section 307 of the act allows for a simplified one-page PPP loan application for loans up to $150,000.

The act also provides owners of passthrough entities with a step-up in basis from forgiven PPP loans. This is consistent with congressionally provided double benefits as confirmed by the Supreme Court in Gitlitz.32 Owners may be able to more immediately benefit from that basis step-up by disposing of the equity.

FOOTNOTES

1 Richard Rubin, “PPP Borrowers Stand to Gain Tax Deductions,” The Wall Street Journal, Dec. 23, 2020.

2 Peter Reilly, “IRS Rains on the Paycheck Protection Parade,” Forbes, Apr. 30, 2020.

4 Small Business Administration, “Paycheck Protection Program” (“The Paycheck Protection Program is a loan designed to provide a direct incentive for small businesses to keep their workers on the payroll.”).

5 Cf. Eli Rosenberg, “‘A Band-Aid on a Bullet Wound’: Workers Are Getting Laid Off Anew as PPP Runs Out,” The Washington Post, July 24, 2020.

6 The authors see this as a reasonable interpretation of section 1102 of the CARES Act, amending 15 U.S.C. section 636(a) of the Small Business Act.

7 Thomas Franch and Katie Rogers, “Small Business Rescue Loan Program Hits $349 Billion Limit and Is Now Out of Money,” CNBC, Apr. 16, 2020.

8 SBA, “Interim Final Rule RIN 3245-AH52” (June 23, 2020).

11 See, e.g., section 108(b).

12 See section 1102 of the CARES Act.

13 See section 1106 of the CARES Act.

15 Section 1603 of the American Recovery and Reinvestment Act of 2009, P.L. 111-5, provided a 30 percent cash grant, treated as a refundable tax credit, for energy projects.

16 Alexander Bolton, “Democrats Balk at $1,200 Rebate Checks in Stimulus Plan,” The Hill, Mar. 20, 2020.

17 Notice 2020-32, 2020-21 IRB 837 (“To the extent that section 1106(i) of the CARES Act operates to exclude from gross income the amount of a covered loan forgiven under section 1106(b) of the CARES Act, the application of section 1106(i) results in a ‘class of exempt income’ under section 1.265-1(b)(1) of the Regulations. Accordingly, section 265(a)(1) of the Code disallows any otherwise allowable deduction under any provision of the Code, including sections 162 and 163, for the amount of any payment of an eligible section 1106 expense to the extent of the resulting covered loan forgiveness (up to the aggregate amount forgiven) because such payment is allocable to tax-exempt income. Consistent with the purpose of section 265, this treatment prevents a double tax benefit.”).

18 Rev. Rul. 2020-27, 2020-50 IRB 1552 (“Section 265(a)(1) of the Code also disallows any amount of A’s and B’s eligible expenses otherwise allowable as a deduction under the Code, including section 161, to the extent the payment of such eligible expenses is allocable to tax-exempt income in the form of the reasonably expected covered loan forgiveness.”).

19 William N. Eskridge Jr., “Dynamic Statutory Interpretation” (“The dynamic model, however, views the evolutive perspective as most important when the statutory text is not clear and the original legislative expectations have been overtaken by subsequent changes in society and law. In such cases, the pull of text and history will be slight, and the interpreter will find current policies and societal conditions most important. The hardest cases, obviously, are those in which a clear text or strong historical evidence or both, are inconsistent with compelling current values and policies.”); see also Cass R. Sunstein, “Interpreting Statutes in the Regulatory State,” 103 Harv. L. Rev. (1989).

20 Senate Finance Committee Chair Chuck Grassley, R-Iowa, and ranking member Ron Wyden, D-Ore., released the following joint statement regarding Treasury’s PPP loan expense deductibility guidance: “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.”

21 Benjamin M. Willis, “Executive Overreach Burdens Taxpayers,” Tax Notes Federal, Jan. 28, 2019, p. 407; see also Security Bank Minnesota v. Commissioner, 994 F.2d 432 (8th Cir. 1993) (providing “because the application of section 1281 to these loans is ambiguous, we follow the venerable rule that ‘in the interpretation of statutes levying taxes . . . [courts must not] enlarge their operations so as to embrace matters not specifically pointed out. In case of doubt they are construed most strongly against the Government, and in favor of the citizen.’”).

22 Schler, “Still More on Tax Regulations and the Rule of Law,” Tax Notes Federal, Dec. 7, 2020, p. 1633; Schler, “Tax Regulations and the Rule of Law,” Tax Notes Federal, Feb. 4, 2019, p. 531; and Schler, “More on Tax Regulations and the Rule of Law,” Tax Notes Federal, Aug. 3, 2020, p. 879.

23 Caminetti v. United States, 242 U.S. 470 (1917).

24 Carl Hulse and Emily Cochrane, “As Coronavirus Spread, Largest Stimulus in History United a Polarized Senate,” The New York Times, July 11, 2020.

25 Usually, deductions would occur under section 162 or 163. Section 263 provides corollary rules for specific expenses. Neither section 1106(i) of the CARES Act nor any other provisions provide for deductions.

26 “Congress enacted the PPP to give a financial lifeline to small businesses, not deliver a financial tax liability,” Grassley said in a December 18 Q&A. “The last thing small businesses deserve in 2020 is a lump of coal from the IRS in their stocking.”

27 Luke Broadwater, Jesse Drucker, and Rebecca R. Ruiz, “Buried in Pandemic Relief Aid Bill: Billions to Soothe the Richest,” The New York Times, Dec. 23, 2020.

28 Jad Chamseddine, “Congress Passes Year-End Bill With Full PPP Deductibility,” Tax Notes Federal, Jan. 4, 2021, p. 136.

29 Tom Huddleston Jr., “Florida Business Owner Got $3.9 Million in Coronavirus Relief Money, Allegedly Spent It on a Lamborghini and Luxury Hotels,” CNBC, July 29, 2020 (“Federal prosecutors are accusing a 29-year-old small business owner in Miami of spending some of the nearly $4 million in coronavirus relief aid he received from the government on a six-figure sports car, expensive jewelry and stays at luxury resorts.”).

30 John Walter Jones, Brian D. Steffy, and Douglas Weston Bray, Applying Psychology in Business: The Handbook for Managers and Human Resource Professionals 426 (1991).

31 SBA, supra note 8.

32 Gitlitz v. Commissioner, 531 U.S. 206 (2001) (holding section 108 excluded COD income received by an S corporation could provide a step-up in a shareholder’s basis in its shares under section 1366(a) because the IRC’s plain text allows this “double windfall”).

END FOOTNOTES

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