KPMG Requests Additional CARES Act Guidance

May 20, 2020

Krishna Vallabhaneni
Tax Legislative Counsel
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

John Moriarty
Associate Chief Counsel (Income Tax & Accounting)
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Re: Suggested Guidance Relating to Federal Tax Provisions in the CARES Act

Gentlemen:

On March 27, 2020, President Trump signed the Coronavirus Aid, Relief, and Economic Security Act, P.L. 116-136 (the “CARES Act” or the “Act”) passed by Congress. The CARES Act is intended to provide fast and direct economic assistance for American workers, families, and small businesses, and preserve jobs for American industries. We are submitting this letter to make you aware of certain federal tax issues that we anticipate will be faced by passthrough entities resulting from certain provisions in the Act.

Please note that we have not been engaged by a client to submit the recommendations discussed herein. However, we anticipate that we will have many clients affected by the CARES Act and the resolution of the issues described. Rather, we are writing to the IRS and Treasury to request consideration of the issues described herein in the interest of sound federal tax administration.

Among other provisions, the CARES Act contains the Paycheck Protection Program (the “PPP”) to be administered by the Small Business Administration (“SBA”) and designed to provide small businesses with funds to pay certain payroll and overhead costs associated with the business for a period of time (the “PPP Expenses”). The funds are provided in the form of loans (the “PPP Loans”), with no collateral or personal guarantees required. If used to fund PPP Expenses, a PPP Loan generally will be fully forgiven, provided that at least 75 percent of the forgiven amount was used for payroll.

PPP Loans no doubt will provide significant relief to small businesses during a time of uncertainty. However, we believe the interaction of certain federal tax provisions with the PPP Loans and the potential forgiveness of the loans raises significant issues that should be addressed by the Internal Revenue Service (“IRS”) and the Department of Treasury (“Treasury”) to provide guidance to small businesses. We include in the discussion below certain of these issues, as well as suggestions for guidance to be issued.

In light of the current demands on your time, we have attempted to keep the discussion of most of the issues as brief as necessary to convey the issue and provide our recommendation. However, we discuss one issue more thoroughly to express our disagreement with the position taken by the IRS and Treasury in the recently issued Notice 2020-32. We can participate in a more robust discussion of any of the issues described at your request.

BACKGROUND

As described above, the CARES Act contains a program designed to provide funds to small businesses in the form of PPP Loans. A complete discussion of the CARES Act and the PPP Loans program is beyond the scope of this letter. Instead, we limit our discussion to certain federal tax provisions in the Act that are likely to present significant federal tax issues for recipients of PPP Loans.

Section 1106 of the Act provides that an eligible recipient of a PPP Loan generally is eligible for forgiveness of some or all of the PPP Loan if certain requirements with respect to the use of funds are satisfied and certain employment standards and salaries are maintained. Section 1106(i) of the Act provides a rule describing the federal tax treatment of the forgiveness of the loan, providing that “any amount which (but for this subsection) would be includible in gross income of the eligible recipient by reason of [the forgiveness] shall be excluded from gross income” (the “Exclusion Rule”).

The Exclusion Rule was a valuable addition to the CARES Act. Without it, there would have been significant uncertainty regarding whether and to what extent the recipient of a PPP Loan would incur a federal tax liability if and when its PPP Loan is forgiven. Thus, we applaud Congress and the Administration for including that provision in the Act.

Unfortunately, the provisions in the Act do not go far enough to eliminate uncertainty that may arise from their application. We describe below certain issues that we anticipate will be faced by passthrough entities and thus should be addressed by the IRS and Treasury to provide tax certainty with regard to PPP Loans. We also include suggestions for resolving these issues in a manner consistent with the CARES Act's purpose of providing fast and direct economic assistance to small businesses and preserving jobs in American industries

SUGGESTED CLARIFICATIONS

As noted above, we have identified certain issues with respect to the federal tax consequences relating to PPP Loans entered into by passthrough entities that are in need of clarification. These issues are as follows: 

DISCUSSION OF SUGGESTIONS

Treatment of PPP Loans as Debt for Federal Tax Purposes

Section 4003(h)(1) of the CARES Act provides that certain loans made or guaranteed by Treasury under the CARES Act are treated as indebtedness for purposes of the Code issued for their stated principal amount (the “Debt Characterization Rule”); unfortunately, that section does not apply to PPP Loans. The failure to provide for the federal tax characterization of a PPP Loan raises questions about how the “loan” should be treated for federal tax purposes. In our view, a PPP Loan should be characterized as debt for federal tax purposes. However, clarification of that treatment by the IRS and Treasury would remove uncertainty.

It is possible that the federal tax characterization of a PPP Loan would be made under a general debt vs. equity analysis.² Although a full description of a debt vs. equity analysis is beyond the scope of this letter, one important factor in the analysis is whether there is a written unconditional promise to pay a sum certain at a fixed time and with a fixed rate of interest. In the case of many — though not all — PPP Loans, the expectation at the time the loans are entered into is that some portion of the loans ultimately will be forgiven. Clearly, this raises a question of whether the loan should be characterized as debt for federal tax purposes. If a PPP Loan is not characterized as debt for federal tax purposes, then it may be characterized as either an equity interest in the borrower or a grant received by the entity from someone that does not own an equity interest in the entity.

Treatment of a PPP Loan as equity for federal tax issues could raise a variety of issues in certain situations. For example, if a PPP Loan entered into by an S corporation is characterized as equity for federal tax purposes, it raises a question as to whether that equity should be characterized as a second class of stock or stock owned by an ineligible shareholder — either of which would terminate the S election of the borrower.³ If a PPP Loan entered in to by a partnership is characterized as equity for federal tax purposes, then any deductions funded by the PPP Loan (such as rent or compensation) likely would be allocated by the partnership to the lender — rather than the partners — for federal tax purposes. Given the Act's purpose of providing relief to small businesses, this seems unlikely to be the intended result. Moreover, it could result in significant complexity for small businesses in determining whether and to what extent they are required to issue a Schedule K-1 to the lender (or possibly even the federal government).

Treating a PPP Loan as a grant also raises issues. Section 118 addresses the treatment of a grant made to a corporation, providing that gross income does not include certain contributions to the capital of the taxpayer. However, §118 (as amended in 2017) does not apply to any contribution by a governmental entity, which a PPP Loan arguably could be considered.⁴ Thus, receipt of a PPP Loan treated as a grant presumably should give rise to taxable income at the time of receipt for the recipient partnership or S corporation; that income would flow through to the owners in the entity. Such treatment would seem to violate the purpose of the Act and, as noted above, seems inconsistent with the Exclusion Rule.⁵

In contrast to the above, characterizing a PPP Loan as debt for federal tax purposes would eliminate certain of these issues. In our view, in many cases debt characterization better reflects the possibility that, at the time the taxpayer enters into a PPP Loan, there is significant uncertainty as to whether and to what extent it actually will be forgiven. Moreover, debt characterization is consistent with the language of the Act as well as its purposes. Specifically, the Exclusion Rule appears to directly contemplate debt treatment by acknowledging that forgiveness of a PPP Loan might otherwise give rise to income to the borrower. If the intent was to treat the a PPP Loan as equity or a grant, then any realization event would have arisen at the time the loan was made — not when it was forgiven.

Further, treatment of the PPP Loan as debt for federal tax purposes would prevent the issues arising if it is characterized as an equity interest or a grant. Finally, treating a PPP Loan as debt may provide sufficient tax basis to the partners in a partnership that enters into a loan to report any deductions funded by it.⁶ Specifically, if a PPP Loan is characterized as a § 752 liability of the partnership, then each partner in the partnership should increase its outside basis in its partnership interest by its allocable share of the debt. Thus, provided that the debt is allocated among the partners in the same manner as the expenses funded by the PPP Loan, this should provide each partner with a basis in its partnership interest that at least equals its allocable share of the loss.⁷ Accordingly, if the expenses funded by the PPP Loan are deductible, the partner should be permitted to report its share of the deduction (provided it is not limited under § 465 or § 469).

Based on the above discussion, we request that the IRS and Treasury issue guidance confirming that a PPP Loan will be characterized as debt issued by the recipient of a loan for federal tax purposes. Our remaining comments are based on the assumption that debt characterization applies.

Deductibility of PPP Expenses by the Relevant Business

PPP Expenses include items such as wages, rent, and utilities that generally are deductible for federal tax purposes under § 162 as ordinary and necessary expenses when incurred in connection with a trade or business. Prior to the release of Notice 2020-32, certain practitioners raised questions about whether a taxpayer should be entitled to a deduction for those expenses if and to the extent they are funded by a PPP Loan that ultimately is forgiven. Essentially, these questions raise the question of whether § 265 (which generally provides that no deduction is allowed with respect to a class of income an expense allocable to income wholly exempt from federal tax) or other federal tax principles should apply to disallow the deduction, given that the funds used to pay the PPP Expenses ultimately may be received without federal income tax consequences.

In Notice 2020-32, the IRS and Treasury addressed the question of whether PPP Expenses are deductible by the taxpayer that incurs them. The notice purports to “clarify” that:

no deduction is allowed under the Internal Revenue Code (Code) for an expense that is otherwise deductible if the payment of the expense results in forgiveness of a covered loan pursuant to section 1106(b) of [Act] and the income associated with the forgiveness is excluded from gross income for purposes of the Code pursuant to section 1106(i) of the CARES Act.

We fundamentally disagree with this characterization as both a technical matter and in terms of public policy. Thus, we encourage the IRS and Treasury to reconsider this conclusion for the reasons discussed below.

First (and as noted above), all aspects of the PPP (most notably the Exclusion Rule) convey an intent to treat a PPP Loan as debt — not as a reimbursement for expenses actually incurred by the taxpayer. In other words, Congress could easily have chosen to draft legislation that provided small businesses with a reimbursement mechanism under which small businesses could recoup PPP Expenses in much the same way that it did with respect to the educational expense described above. However, it did not choose to do so, but rather appears to intend that a PPP Loan be characterized in the same manner as an actual loan. This — in conjunction with the possibility that, at the time it is entered into, a PPP Loan may not be forgiven — means that the PPP expenses differ significantly from expenses eligible for direct reimbursement from a former or current employer. Instead, they are more analogous to expenses funded by debt that ultimately is forgiven;⁸ thus, they should be treated similarly.

In the case of a loan other than a PPP Loan, there would be no question as to whether the PPP Expenses funded by the loan proceeds would be deductible. If — as happens in many cases — a debt ultimately is forgiven in whole or in part, a borrower is not required to retroactively treat the debt funded expenses as non-deductible. Rather, the borrower must either include the forgiven amount in income as cancellation of indebtedness (“COD”) income or, if an exception to income inclusion applies under § 108, reduce certain of its federal tax attributes under § 108(b). Thus, exclusion under § 108 often results in a timing benefit, rather than a permanent impact on the taxpayer.

In our view, § 1106(i) of the Act appears designed to “turn off” the application of § 108 (and thus its accompanying attribute reduction) to the forgiveness of a PPP Loan. As discussed above, this indicates that Congress intended that a PPP Loan should be characterized as debt for federal tax purposes. However, it also indicates that Congress understood that any amount forgiven would (in the absence of § 1106(i) of the Act) be included as cancellation of indebtedness (“COD” income), but did not want the forgiven amounts to be subject to the normal attribute reduction rules of § 108(b). In other words, it appears that Congress intended to provide for income exclusion regardless of whether an exception under § 108 otherwise would apply and without the requirement of attribute reduction under § 108(b). Thus, it appears that Congress intended to provide a permanent economic benefit to borrowers of a PPP Loan.

The position taken by the IRS and Treasury in Notice 2020-32 effectively eliminates the benefit that Congress (seemingly intentionally) gave taxpayers by excluding the forgiveness of debt from income without regard to whether § 108 would otherwise do so and without requiring attribute reduction. In fact, Notice 2020-32 may leave certain taxpayers in a worse position than if § 108 applied because of the timing benefit derived from a federal tax deduction in 2020 with forgiveness in a later year. This seems directly contrary to congressional intent.

In our view, COD income excluded by § 108 is not a “class of income wholly exempt from tax” within the meaning of § 265(a)(1), precisely because of the requirement in § 108(b) to reduce tax attributes. In fact, to the extent the potentially disallowed expense contributes to an NOL, the attribute reduction process under § 108(b) is equivalent, in effect, to the application of § 265. To apply § 265 on top of § 108(b) attribute reduction would impose a double detriment upon taxpayers, a result that cannot be intended by the Code.⁹ Accordingly, in our view, the PPP Expenses should be deductible as expenses funded with loan proceeds; the fact that Congress chose to treat any forgiveness of the debt that subsequently occurs as excludable from income should not result in denial of a deduction.

Second, in Notice 2020-32, the IRS and Treasury describe the conclusion with regard to PPP Expenses as consistent with its treatment of expenses in Revenue Ruling 83-3.¹⁰ We disagree.

As relevant here, in Revenue Ruling 83-3, a military veteran received tax-exempt monthly payments from the Veterans' Administration to pay educational tuition, fees, supplies, books, equipment, and other educational costs. The taxpayer incurred expenses for tuition, fees, books, and other expenses in connection with three courses required by his employer as a condition of continued employment; those expenses generally were deductible as ordinary and necessary business expenses under § 162 to a taxpayer that itemized deductions.

When analyzing the potential deductibility of the expenses incurred by the taxpayer, the IRS noted:

The purpose of section 265 of the Code is to prevent a double tax benefit. In United States v. Skelly Oil Co., 394 U.S. 678 (1969), 1969-1 C.B. 204, the Supreme Court of the United States said that the Internal Revenue Code should not be interpreted to allow the practical equivalence of double deductions absent clear declaration of intent by Congress. Section 265(1) applies to otherwise deductible expenses incurred for the purpose of earning or otherwise producing tax-exempt income. It also applies where tax exempt income is earmarked for a specific purpose and deductions are incurred in carrying out that purpose. In such event, it is proper to conclude that some or all of the deductions are allocable to the tax exempt income.

Based on these authorities, the IRS concludes in Revenue Ruling 83-3 that the amount of the itemized deductions for tuition, books and other expenses connected with further education must be decreased to the extent the expense is allocable to the amounts received for such expenses from the Veterans' Administration.¹¹

We disagree with the conclusion in Notice 2020-32 that the PPP Expenses are analogous to the educational expenses described in the revenue ruling for a number of reasons. First, we note that, at the time the expenses in the revenue ruling were incurred, it was clear that the taxpayer's outlay for the expenses would be reimbursed by the government in accordance with the applicable statute. In other words, there was never a time when the reimbursement was uncertain. In contrast, for many borrowers there was no certainty at the time a PPP Loan was entered into that the entire amount borrowed ultimately will be forgiven. Indeed, many businesses have publicly stated or privately indicated that they do not expect to apply for forgiveness of their PPP Loans because the employment standards required for forgiveness will not be achievable while businesses remain subject to full or partial closures. Thus, at the time most PPP Loans are entered into, it will beunclear whether the PPP Expenses ultimately wil be funded with tax-exempt income; they may in fact simply be funded by a loan that will be repaid.

Third, it could be argued that the types of expenses in Revenue Ruling 83-3 and other authorities appear to effectively be reimbursements of those expenses by the government as compensation for current or prior service; reimbursement arises as a result of a voluntary choice by the former government employee to pay certain types of fees. Indeed, this appears to be the conclusion of the Court of Appeals for the Ninth Circuit in Mannochio v. Commissioner.¹² The Tax Court's decision in Mannochio is cited in Notice 2020-32 as support for the proposition that § 265(a)(1) applied to deny a deduction for expenses similar to the educational expenses described in Revenue Ruling 83-3. Noticeably absent, however, is any mention of the Ninth Circuit's decision on appeal. A review of that decision reveals that, although the court affirmed the Tax Court's decision, the Ninth Circuit court did not rely on § 265. Instead, the Ninth Circuit found that the educational training allowance the taxpayer received was a direct reimbursement for the educational expenses he sought to deduct because — (i) the amount of the benefit was tied directly to the expense; and (ii) not only was there a fixed right to the reimbursement at the time of the expenditure, the reimbursement was actually made at that time.¹³ Because the cost was reimbursed, the court concluded that no deduction was available under the well-established principle that § 162 denies a deduction for a reimbursed expense. Thus, the court did not address the IRS's argument that § 265(a)(1) applied.

In contrast to the expenses in Revenue Ruling 83-3 and Mannochio, any forgiveness of PPP Loans should not be viewed as a reimbursement for PPP Expenses incurred by a loan recipient. With regard to the educational expenses described in the authorities discussed, the taxpayer knew (or had the ability to know) prior to the time when it incurred the expenses that the reimbursement amounts would be excluded from income.¹⁴ That will not be the case for a PPP Loan recipient, as the recipient cannot and will not know until certain requirements are met whether and to what extent the loan will be forgiven. Indeed, as of the date of this letter, borrowers were still waiting on guidance regarding forgiveness from the SBA; in the absence of such guidance it will be difficult for any borrower to predict its potential forgiveness amount with any certainty. In light of the uncertainty with regard to forgiveness and the impetus for the government's guarantee of the loans, it could instead be argued that the PPP Loans are more in the nature of a type of subsidy to induce desired behavior.

Finally, it seems wholly inconsistent with a policy of assisting small businesses to deny deductions for the PPP Expenses, given that they are the very type of expenses the government intended to incentivize the businesses to continue to incur to increase the likelihood the government's goal of the businesses' survival would be met. Indeed, if the intent of the law is to provide relief to small businesses, one way to do that would be to permit a deduction to reduce the 2020 tax income of the business (and, if an net operating loss arises, to carry the loss back to offset 2019 income). This seems to be very reason that Congress, elsewhere in the CARES Act, revised the Code to enhance the use of net operating losses in response to the COVID-19 pandemic.

In this regard, we want to point out that the ability to deduct the PPP Expenses has in our view been characterized incorrectly by some commentators as a “double benefit”¹⁵ We disagree with this characterization. In our view, there is just one benefit provided by the Act, and that is the exclusion of PPP Loan forgiveness from income. To understand why, consider the following hypotheticals in the case of a borrowing sole proprietor that compares the results under what might have been the law with the results under the CARES Act as written.¹⁶

If a PPP Loan for $100 was properly characterized as debt for federal tax purposes but the Exclusion Rule was not included in the Act, then a sole proprietor that entered into a PPP Loan would recognize no income on receipt of the $100 of borrowed funds. In the absence of the Exclusion Rule, there would be no question regarding the deductibility of the PPP Expenses. Thus, the borrower would be entitled to deduct $100 of PPP Expenses. If the PPP Loan was later forgiven and the forgiveness was included in income, the borrower would have $100 of income. So, the $100 expense deduction and the $100 of COD income essentially offset one another, with the borrower left with no net federal tax impact.

In contrast, if a PPP Loan is not characterized as debt, then it (or at least its forgiveness) might be treated as a grant from the government. In that case, the sole proprietor would have $100 of income on receipt of the funds. Again, there would be no question regarding the deductibility of the $100 in PPP Expenses. When the PPP Loan was later forgiven, there would be no COD income because the PPP Loan was never treated as debt for federal tax purposes. So, the deduction and the income essentially offset each other and again there would be no net federal tax impact for the borrower.

Now consider what happens under the Act if a PPP Loan is characterized as debt. In that case, there is no income to a recipient at the time the loan proceeds are received. If the PPP Expenses are deductible, then the recipient would be entitled to a $100 deduction. If and when the debt subsequently is forgiven, what would be COD income is excluded from income. In this case, on a net basis the taxpayer has $100 of deductions that it otherwise would not have had. However, this is just one net federal tax benefit and that benefit derives solely from the Exclusion Rule drafted by Congress. In fact, as mentioned above, denying a deduction for PPP Expenses arguably negates what seems to be the clearly intended benefit of treating a PPP Loan as debt and then applying the Exclusion Rule to its forgiveness, because denying the $100 deduction puts the taxpayer effectively in the same net position from a federal tax perspective as it would have been in if the deduction had been allowed, but the COD income resulted in taxable income.

It is apparent to us that the benefit derived from the Exclusion Rule was intended to be a benefit in addition to any tax benefit derived from deducting what clearly are ordinary business expenses. When “scoring” the Exclusion Rule for purposes of revenue estimates, the amount of reduced revenue anticipated as a result of the rule was the full amount of loans expected to be made. If Congress intended that no deduction would be available with regard to the PPP Expenses, the full amount of loans would have been reduced by the revenue effect of the denied deductions. Thus, it is apparent that the federal tax benefit was intended, likely as yet another mechanism for assisting small businesses. As further support for this, Senator Chuck Grassley, the chairman of the Senate Finance Committee in which the language of the law originated, has already publicly indicated his disappointment with the conclusion in Notice 2020-32. Specifically, he has issued a statement noting that “[t]he intent of the law was to maximize small business' ability to maintain liquidity, retain their employees and recover from this health crisis as quickly as possible. This notice is contrary to that intent." That statement was followed by a letter addressed to Secretary Mnuchin describing similar intent and signed by Chairman Grassley, as well as the Ranking Member of the Senate Finance Committee and the Chairman of the House Ways and Means Committee.

This indication of contrary Congressional intent — especially in the context of an issue that is adverse to the interests of many small businesses — may result in significant public scrutiny of Notice 2020-32. This also could put the IRS and Treasury in a situation similar to one in which a court concluded that a perceived “double benefit” should be respected when legislation failed to prohibit a deduction.

Specifically, during the savings and loans crisis in the 1980s and 1990s, Congress enacted laws intended to incentivize solvent banks to take over insolvent banks. To do so, the government provided “make-whole” type payments to the solvent banks. Under the statue, the make-whole payments did not give rise to taxable income. However, nothing in the legislation indicated whether the healthy banks could deduct losses that arose when they disposed of or wrote down the assets acquired from the insolvent banks. Thus, under the legislation, a taxpayer received payments from the government to incentivize desired behavior, but nothing denied the taxpayer the right to take a deduction (when otherwise entitled) with respect to the assets acquired. Indeed, government agencies other than the IRS had advertised the ability to take deductions as an inducement to solvent banks. At some point after many acquisitions of insolvent banks had occurred, Congress discovered that the legislation did not deny a taxpayer a deduction for losses with respect to assets acquired with government provided funds. Because in that case it did not intend to provide deductions in addition to the other payments, Congress enacted an amendment to “clarify” that no deduction would be allowed.

In Centex Corporation v. United States — which is not a tax case — the Federal Circuit addressed the question of whether the government was required to effectively compensate the taxpayer for the tax benefit it should have derived from deducting losses funded by the government, given that at the time of an acquisition of an insolvent bank those deductions appeared to be (and were represented by a government agency as) available.¹⁷ Ultimately, the court concluded that the government had breached its contract with the plaintiff. In doing so, the court noted that:

[I]t was reasonably well settled that such a deduction for built-in losses on covered assets was available to acquiring institutions under sections 165, 166, and 593, even when the acquiring institutions were receiving FSLIC assistance payments in the amount of the built-in losses. Making a deduction available in that situation may have been poor tax policy, in that it provided acquiring institutions a double benefit for the same loss while giving them an incentive to minimize the recovery of assets carrying built-in losses. Notwithstanding the legitimate arguments that such a deduction was unwise, however, it is clear that the availability of the deduction was unchallenged as of late 1988 . . .

In our view, even if Congress did not intend to allow for deductibility of PPP Expenses (which, as noted above, does not appear to be the case in this situation), any perceived “extra” benefit available to taxpayers that deduct PPP Expenses could be similarly viewed, particularly for taxpayers that receive a PPP Loan prior to any change in the law denying deduction of the PPP Expenses — especially given the more sympathetic case presented here by small business owners in uncertain economic times.

Based on the above discussion, we strongly encourage the IRS and Treasury to withdraw Notice 2020-32 and issue guidance confirming that PPP Expenses will be deductible by the trade or business that incurs and pays them. Our remaining comments are based on the assumption that — (i) a PPP Loan is characterized as debt for federal tax purposes; and (ii) PPP Expenses are deductible by the trade or business that incurs them in calculating its federal tax income. We believe that the IRS and Treasury have sufficient authority to interpret § 1106(i) of the Act to provide that income realized by a borrower from the forgiveness of a PPP Loan is COD income that is subject to neither § 61 nor § 108. Consistent with this interpretation, the IRS and Treasury also may conclude that § 265 does not apply to amounts forgiven under section 1106(i), just as it would not apply to the same borrower if section 1106(i) did not exist. We believe this interpretation is consistent with congressional intent, and furthers Congress's objective in providing immediate and permanent economic relief to businesses adversely affected by the pandemic. As such, the interpretation is well within the IRS and Treasury's authority to administer the tax laws.

Deductibility of Expenses by an S Corporation Shareholder

As noted above, if a PPP Loan entered into by a partnership is characterized as debt for federal tax purposes, each partner generally should have a basis in its partnership interest that at least equals its allocable share of the loss (i.e., the losses should not be limited under § 704(d)). That same result does not follow in the S corporation context.

Section 1366(d) provides that the aggregate amount of loss and deductions taken into account by a shareholder under § 1366 for any taxable year may not exceed the sum of the shareholder's basis in its S corporation stock and the shareholder's adjusted basis in any debt owed to the shareholder by the S corporation. This section generally defers a shareholder's ability to use a loss recognized and allowed by an S corporation if the amount of the loss exceeds the shareholder's basis in its stock.

Notwithstanding the above, § 1367(b)(1) provides that, if the losses and deductions allocable to an S corporation shareholder exceed the shareholder's basis in its stock, then the excess will be applied against the shareholder's basis in any debt of the S corporation to the shareholder. However, both the statutory language and case law make it clear that the only debt that will allow a shareholder to take losses in excess of its stock basis is debt owed by the S corporation directly to the shareholder. Thus, unlike a partner in a partnership, an S corporation shareholder generally gets no basis benefit from a loan owed by the S corporation to anyone other than the shareholder — including a bank.

Under the provisions described above, a shareholder in an S corporation that has no basis in its S corporation stock prior to the corporation entering into a PPP Loan will also have no basis in its stock after the loan is incurred. Thus, any deductible expense of the S corporation funded by a PPP Loan and allocated to an S corporation shareholder will be suspended under § 1366(d).

Regardless of whether one believes it is good tax policy for expenses funded by a PPP Loan to be deductible, the discussion above illustrates that this appears to be the intended result under the Act. If that is the case, then it seems unreasonable to deny those deductions to the owner of a small business simply because it was formed as an S corporation, when those deductions will be allowed to a partner in a partnership or a sole proprietor.

Although it is true that there is always a difference in the treatment of debt borrowed by an S corporation, well-advised or experienced S corporation shareholders are well aware that there is “self-help” available. Thus, those shareholders will take steps to ensure that any borrowing occurs at the shareholder level, with the shareholder then contributing or loaning the borrowed funds to the S corporation. Thus, the shareholder obtains the desired basis increase and thus the debt funded expenses are not suspended under § 1366(d).

In the case of PPP Loans, it is entirely possible (and likely common) that some of the S corporations obtaining the loans have never borrowed money to meet operating expenses or, if they did, they did so at a time when there was sufficient income attributable to the business to provide the basis necessary to report the expenses involved in operating the business. For these small business S corporations that have now experienced income interruptions as a result of both the ongoing crisis and associated governmental orders, the shareholders' ability to report the deductions has been distorted.

In light of this, a shareholder of an S corporation may not have been aware of the potential issue and certainly may not have been aware that there could be a dramatically different result if the shareholders had borrowed a PPP Loan directly (assuming that would have been permitted) and contributed the borrowed funds to the S corporation. To remedy this trap for the unwary, we recommend that the IRS and Treasury issue guidance that allows an S corporation shareholder to treat a its pro rata share of a PPP Loan made directly to the S corporation as a loan made proportionately to the shareholders of the S corporation, followed by a deemed contribution of the borrowed funds by the shareholders to the S corporation.

At-risk Basis for a PPP Loan

Even if a partner in a partnership or a shareholder in an S corporation has sufficient basis in its interest in the entity to prevent the suspension of a loss under § 704(d) or § 1366(d), the partner or shareholder must also satisfy the rules of § 465 before reporting that loss on its own return.¹⁸ Under § 465(a), an individual engaged in certain activities is allowed to take a loss from the activity only to the extent of the aggregate amount with respect to which the taxpayer is “at risk” with respect to the activity at the close of the tax year. A taxpayer is considered at risk for an activity in an amount equal to the basis of money or other property contributed to the partnership, as well as certain amounts borrowed with respect to the activity. However, amounts borrowed for use in an activity only provide an at risk amount to the extent that the taxpayer is personally liable for the repayment of the amounts or has pledged property (other than property used in the activity) as security for the borrowed amount.

The nonrecourse nature of the PPP Loans (as well as the potential forgiveness of those loans) raises concerns as to whether a partner or S corporation shareholder should be considered at risk with regard to a PPP Loan. If the partner or S corporation shareholder is not at risk, then deductions relating to the PPP Loans will not be allowed in the year incurred. As was the case with regard to the basis in the S corporation stock, this may be an unexpected result for partners or shareholders in entities that have previously not borrowed money or otherwise had no reason to consider the at risk rules.

Our recommendation for guidance with regard to the at risk rules in the S corporation context is similar to our recommendation with regard to the S corporation basis rules in the immediately preceding section. Specifically, we recommend that the IRS and Treasury issue guidance that allows a shareholder in an S corporation that enters into a PPP Loan to be treated as being at risk with regard to its pro rata share of the borrowed funds and then treating the shareholder as having contributed the borrowed funds to the S corporation. In the case of a partner in a partnership or a sole proprietor, the recommendation is merely that a partner be treated as being at risk with regard to its § 752 share of the PPP Loan borrowed by the partnership and that a sole proprietor is treated as being at risk with regard to the PPP Loan, notwithstanding the nonrecourse nature of the loan.

Consistent Treatment of PPP Loan Forgiveness

As noted above, § 1106(i) of the Act describes the federal tax treatment of the forgiveness of PPP loans, providing that “any amount which (but for this subsection) would be includible in gross income of the eligible recipient by reason of [the forgiveness] shall be excluded from gross income.” We focus here on the fact that the Exclusion Rule is drafted in such a way that implies it only applies to exclude the forgiveness from gross income in the event it otherwise would have been includible. This raises questions as to whether this rule applies only after it is has already been determined that the forgiveness would not be excluded from gross income under another provision of the Code.

Other provisions of the Code could apply to exclude the forgiveness of a PPP Loan from income, but those provisions would come with collateral consequences. For example, assume that an S corporation or a sole proprietor entered into a PPP Loan. If that loan is later forgiven at a time when the S corporation or sole proprietor is insolvent or in bankruptcy, then § 108 may apply to exclude some or all of the debt forgiveness from the borrower's gross income. If so, then presumably § 1106(i) of the Act would not apply to the forgiveness of the PPP Loan. However, this could lead to a potentially bizarre result. If COD income is excluded under § 108, the taxpayer pays a price in the form of attribute reduction under § 108(b). In contrast, exclusion from income under § 1106(i) of the Act appears to come without consequences. It would be an odd result to apply § 108 and the required attribute reduction under § 108(b) to an insolvent taxpayer solely because § 108 applies, when a solvent taxpayer could exclude the same income without consequences.

In our view, this disparate result likely was not intended by Congress when drafting § 1106(i) of the Act. Rather, the language of § 1106(i) of the Act likely indicates nothing other than an intent that no recipient of a PPP Loan should ultimately suffer adverse federal tax consequences solely as a result of the forgiveness of the PPP Loan. In light of the above, we recommend that the IRS and Treasury issue guidance indicating that the amount of any PPP Loan forgiven will not result in gross income to the recipient under § 1106(i), regardless of whether the forgiveness would otherwise be excluded under another provision of the Code.

We note that neither of the examples described above would seem to apply in the context of a partnership. In the partnership context, COD income is always includible in income by a partnership and only eligible for exclusion under § 108 at the partner level. Thus, in the partnership context, the income would be includible in gross income of the eligible recipient (i.e., the partnership) absent application of § 1106(i) of the Act and thus § 1106(i) should apply in full. Similarly, as noted above, the IRS's position is that neither § 118 nor similar principles apply to a contribution to the capital of a partnership. Thus, § 118 will not apply in that context. To the extent that other provisions of the Code might prevent

§ 1106(i) from applying to some or all of the cancellation of a PPP Loan entered into by a partnership, we make the same recommendation as made with regard to an S corporation.

Basis Increase for PPR Loan Forgiveness in the Case of a Partnership

As noted above, in our view a PPP Loan entered into by a partnership should be characterized as debt of the partnership for federal tax purposes. As such, the PPP Loan should be treated as a § 752 liability of the partnership; thus, each partner in the partnership should be entitled to increase its basis in its partnership in any amount equal to the amount of its allocable share of the liability (as determined under the § 752 regulations).¹⁹ That increased basis will then be decreased by the partner's share of a PPP Expenses (either because it is deductible consistent with our discussion above or because it is a nondeductible, noncapitalizable expense of the partnership). If the partner's share of the debt and the partner's share of the expenses are the same, the increase and decrease will be identical and thus result in a net zero change in the partner's basis in the partnership.²⁰ This raises a significant concern for partners if and to the extent the PPP Loan ultimately is forgiven. To illustrate the problem, consider the following example.

Assume that PRS, an entity classified as a partnership for federal tax purposes, has two equal partners (A and B), each of which has a $0 basis in its PRS interest. PRS enters into a PPP Loan of $100; that loan is allocated equally between A and B. In such case, both A and B should increase its basis in its PPP interest by $50. Thus, after the borrowing, each partner in PRS should have a $50 basis in its PRS interest. Now assume that each partner is allocated $50 of PPP Expenses, which decreases each partner's basis in its PRS interest to $0. However, that $0 basis “includes” a $50 share of the PPP Loan. If the PPP Loan is later forgiven in full, both A and B will have a deemed distribution of $50 under § 752(b).

In the absence of any other increase to basis, the deemed distribution of $50 to each partner will result in a gain of $50 for each partner. In our view, however, that should not be the case. Instead, we believe the IRS and Treasury should issue guidance indicating that the forgiveness of the PPP Loan gives rise to tax-exempt income for PRS under § 705(a)(1)(B). If so, that income is then allocated equally to A and B, which results in a $50 increase in each partner's basis in its partnership interest. Under § 1.752-1(f), the increase in basis resulting from treating the loan forgiveness as tax-exempt income and the decrease in basis resulting from the forgiveness of that debt should be netted. Thus, if this recommendation is followed, no gain should be recognized by a partner as a result of the forgiveness of the PPP Loan.

In the example described, we assumed a $0 basis in the partnership interest to illustrate the issue in the most dramatic scenario. We do note, however, that even if each partner in the example had sufficient basis in its PRS interest to absorb the reduction for its share of PPP Expenses without relying on basis attributable to the PPP Loan, this merely delays the impact of the debt forgiveness. Thus, not treating the forgiveness of the PPP Loan as giving rise to tax-exempt income effectively results in treatment that is inconsistent with the Exclusion Rule, because it ultimately will result in increased income or gain (or reduced loss) to a partner in the amount of its share of the PPP Loan at some point in time.²¹ Note that a similar issue arises in the S corporation context if the S corporation is treated as the borrower with respect to the PPP Loan. However, no issue would arise under our proposed treatment of PPP Loan incurred by an S corporation described above.

CONCLUSION

We appreciate your consideration of our views and recommendations with regard to these federal tax issues arising from the CARES Act. We are aware that, in each case, our recommendation likely results in treatment favorable to most taxpayers. Given the policy behind the CARES Act, we feel those recommendations are most likely to produce the result intended by Congress (or the result that Congress likely would have intended if it was aware of the issue). Given the uncertainty derived from the language of the Act itself and congressional statements with regard to its intent, we believe the IRS should have the authority to issue the desired guidance perhaps in the form of a revenue procedure that effectively establishes a “safe harbor” that describes fact patterns and results that the IRS agrees not to challenge on audit.²²

Again, we have attempted to keep our discussion as brief as possible, as we are aware of the significant demands on your time. If you have any questions or would like to discuss any items in this letter further, please do not hesitate to contact either of us at the numbers listed below.

Respectfully submitted,

Tom West
Principal
KPMG LLP
(202) 533-3212

Deanna Walton Harris
Senior Manager
KPMG LLP
(202) 533-4156