Professor Questions Double Benefit, Plus Expense Deduction for PPP Loans
DATED JAN. 1, 1899
Tax Analysts received this letter from the author.]
Author note: Professor Reinhold gratefully acknowledges the substantial research and editorial assistance of Brady Plastaras, Cornell Law School class of 2020, in the preparation of this letter.
Dear Mr. Van Hove:
Congress is currently considering expansion of the CARES Act Payroll Protection Program. For the reasons set forth below, I strongly suggest that the tax treatment of expenses funded with PPP loans be addressed in the legislation. Whether such amounts should be tax-deductible is a policy question that I express no view on. However, if the intention is to afford a deduction for these amounts, I believe that needs to be written in the legislation. Otherwise, as discussed below, existing law would disallow these deductions due to the tax-free nature of the loan forgiveness income under the PPP.
As part of the federal response to the COVID-19 pandemic, Congress enacted the CARES Act, which was signed into law on March 27. Title I of Division A of the Act authorizes a major loan program — labelled the "Paycheck Protection Program" — for small businesses and certain non-profit and other organizations. Under the program, loans are made available to fund eligible participants' payroll, mortgage interest expense, rents and utilities during the period February 15 - June 30, 2020 (it is possible to read the Act as referring to a somewhat longer period, but I don't think it changes the analysis so I'll disregard that possibility). Sec. 1106 of the Act provides for forgiveness of such loans, generally subject to a requirement that the employer not reduce employee headcount or overall employee compensation below prescribed thresholds during the covered period. Sec. 1106(i) of the Act states that income deemed to arise from the debt forgiveness is excluded from gross income for purposes of the Internal Revenue Code of 1986, as amended.
In virtually all cases, the covered expenses funded by the PPP loan program would be deductible as business expenses or interest under IRC secs. 162 and 163. The question then arises whether the tax-exempt nature of the loan forgiveness under the PPP functions to deny these deductions. I think the answer is clearly yes, under longstanding common law doctrines as well as IRC sec. 265(a)(1). 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. In other words the loan provides the taxpayer not only with liquidity to fund expenses but also a tax subsidy. In a similar context the U.S. Supreme Court stated, "[w]e cannot believe that Congress intended to give taxpayers a deduction for refunding money that was not taxed when received." Skelly Oil v. U.S., 394 U.S. 678, 685 (1969); IRC provisions also reflect this principle — see, e.g., sec. 597(b)(3), relating to bank financial assistance: "No regulations prescribed under this section shall permit the utilization of any deduction (or other tax benefit) if such amount was in effect reimbursed by nontaxable Federal financial assistance." The balance of this email provides a brief summary of the common law and IRC sec. 265(a)(1) precedents bearing on this question. Before proceeding, however, I want to make clear that nothing in the CARES Act provides any assistance in discerning a congressional view as to deductibility of expenses funded with PPP loans. Given the Act's objective to provide very substantial assistance to taxpayers it is entirely possible that Congress intended the double benefit of income excludability plus a full expense deduction. But in the absence of any indication of Congress' intention in the statute — there being no legislative history — the analysis that follows necessarily proceeds on the assumption that the Congressional silence on the topic reflected an intention not to disturb the prior law limitations on the deductions at issue.
Turning then to the authorities, case law has long denied a deduction for an expense in the situation in which the taxpayer possessed a fixed right to reimbursement of the expense. See, e.g., Wolfers v. Comm'r, 69 T.C. 975 (1968); Charles Baloian Co. v. Comm'r, 68 T.C. 620 (1977). Both cases involved a federal program to reimburse moving expenses of a business required to relocate by the federal government; under the statute the reimbursement amounts were expressly made non-taxable. PPP loans are extended for the purpose of funding covered expenses (wages, etc.) during the covered period (February 15 - June 30)(CARES Act sec.1102(a)(2)), and are forgiven based on certification that the covered expenses were paid during the covered period (CARES Act sec. 1106(b)). It is difficult to see how the expenses can be viewed as other than having been reimbursed through the loan forgiveness mechanism, and on that basis would be non-deductible. The Court in Wolfers noted that the fact that the reimbursement amounts were non-taxable represented a potential independent grounds for denial of the expense deduction under IRC sec. 265 but found it unnecessary to address that in light of its holding regarding the reimbursement.
IRC sec. 265(a)(1) states that, "No deduction shall be allowed for . . . [a]ny amount otherwise allowable as a deduction which is allocable to one or more classes of income other than interest (whether or not any amount of income of that class or classes is received or accrued) wholly exempt from the taxes imposed by this subtitle . . .". Rev. Rul. 83-3 explained that the purpose of sec, 265 "is to prevent a double tax benefit," by denying deductibility where expenses are "incurred for the purpose of earning or otherwise producing tax-exempt income . . . [or] where tax-exempt income is earmarked for a specific purpose and deductions are incurred in carrying out that purpose." For example, Manocchio v. Comm'r, 78 T.C. 989 (1982), aff'd, 710 F.2d 1400 (9th Cir. 1983), involved an airplane pilot who paid for flight instruction, with the expenses being 90% reimbursed under a federal program administered by the Veterans Administration; the statute provided that the reimbursed amounts were not subject to tax. The Tax Court held the reimbursed expenses non-deductible under then IRC sec. 265(1). The Court of Appeals affirmed, but on the separate ground that the expenses were non-deductible due to the VA reimbursement, citing among other authorities Wolfers and Baloian; it therefore found it unnecessary to address the IRC sec. 265 issue. To the same effect is the later decision in Becker v. Comm'r, 85 T.C. 989 (1982).
Income is regarded as "wholly exempt" from tax under the statute if tax thereon is permanently eliminated, rather than simply deferred. Donald B. Jones v. Comm'r, 25 T.C. 4 (1955), aff'd, 231 F.2d 655 (3d Cir. 1956)(excludable life insurance proceeds); Nat'l Engraving Co. v. Comm'r, 3 T.C. 178 (1944)(same); FSA 200135005 (8/31/01)(DISC income excludable from gross income). In determining whether amounts are "allocable to" tax-exempt income, the requisite tracing has been applied on a but for basis. See Treas. Reg. sec. 1.265-1(c)("Expenses and amounts otherwise allowable which are directly allocable to any class or classes of exempt income shall be allocated thereto . . .".); PLR 8506050 (1/1/85)("The language employed by the statute, 'allocable to' is broad enough to embrace situations which but for the expenditure there would have been no exempt income. See Manocchio [citation omitted]."). Thus, in Rev. Rul. 83-3, the IRS held non-deductible under then IRC sec. 265(1) 1) the cost of tuition, books and other expenses of a student to the extent allocable to tax-exempt amounts received from the VA or as a scholarship and 2) real property taxes and mortgage interest incurred by a minister who received a housing allowance excludable under IRC sec. 107. Holding 2) was overridden by adoption of what is now sec. 265(a)(6)(B). See also Induni v. Comm'r, 98 T.C. 618 618 (1992), aff'd, 990 F.2d 53 (2d Cir. 1993)(holding mortgage interest non-deductible under IRC sec. 265(a)(1) where the taxpayers had received a tax-exempt housing allowance, and imposing a negligence penalty due to the lack of support for claiming the deduction in the circumstance).
For a corporate taxpayer, IRC sec. 362(c)(2) would seem to require a basis reduction where a PPP loan is forgiven. While, as a result of a TCJA change, IRC sec. 118(b)(2) no longer treats a non-shareholder capital contribution by a government entity as excludable, there was no change to IRC sec. 362(c). For clarity I'm assuming 1) the contribution would be deemed to flow from the government by reason of the SBA guarantees of the PPP loans and 2) the contribution would be regarded as a contribution of money. 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.
Finally, Skelly Oil, supra, would provide a sufficient basis for denial of the deduction, if further support were required. In that case, oil receipts included in income under a claim of right were subject to a 27.5% depletion allowance. In a subsequent year the taxpayer refunded the entire amount previously received and deducted the full amount. The Supreme Court held that the equivalent of a double deduction resulted, due to effective exclusion of 27.5% of the income amount, and therefore denied the deduction for repayment to that extent. The double deduction — said by the Court to be equivalent to an exclusion coupled with a deduction — is indistinguishable from the PPP excluded loan forgiveness/business or interest expense deduction scenario. Denial of the deduction under Skelly Oil is obviously fully consistent with the results obtained under the common law reimbursement principle and sec. 265(a)(1).
In sum, there does not appear to be support for deduction of covered expenses incurred by a taxpayer whose PPP loans are forgiven in accordance with CARES Act sec. 1106(i). While this result accords with general tax policy principles, I do not by any means regard it as the only sensible policy outcome given the extraordinary economic dislocation to which the CARES Act is intended to respond. My view, however, is that a statutory change would be needed to effect an outcome other than non-deductibility.
Very truly yours,
Richard L. Reinhold
Visiting Professor of the Practice
Cornell Law School
208 Myron Taylor Hall
Ithaca, NY 14853 (607) 255-5314