Look, I’ve never been a particularly happy guy. But if there’s one thing that really gets me down, it’s everyone else being happy. That, I simply can’t have. It’s why, growing up outside of Philly, I rooted for the Eagles to get smoked every Sunday. It’s why whenever I leave my little ski town for a work trip, I pray it doesn’t snow until I return. And it’s why I’m incapable of going to a wedding and not muttering to whoever will listen, “it’ll never last.” Misery, as they say, loves company, and I don’t intend to ever be alone.
But I promise, that’s not where this is coming from. I don’t MEAN to rain on the parade of small businesses and tax pros alike, who have spent the last 24 hours rejoicing after the House and Senate agreed to override the IRS and make it so that expenses paid with forgiven Paycheck Protection Program loan proceeds will now be fully deductible. I’m happy that you’re happy; I swear it. But it’s my duty to point out that when we stop and consider this recent news within the broader application of the tax law, we may need to tone down the celebration a bit.
Here’s why: say you operate your business as an S corporation. You formed the S corporation a few years ago with a nominal investment, and while you’ve been fortunate to earn steady income over the years, you’ve made a point to always withdraw the income from the corporation, either as salary or distributions. In early 2020, COVID-19 shuttered your doors, leaving you desperate to retain staff and make your rent. The PPP offered a lifeline, and you grabbed it, borrowing $300,000. Over the next few months, you spent the funds in full on eligible expenses, and you intend to apply for full forgiveness early in 2021. Income, however, was scarce; as a result, nearly all of your expenses ended up being paid with PPP funds, and at the end of the year, your business had a loss of $200,000, after deducting a full year salary of $75,000 that you paid yourself.
If Congress had not come through, you would have been facing an allocation of taxable income from the S corporation for 2020 of $100,000 – the net loss of $200,000 increased by $300,000 of nondeductible PPP expenses.
On your individual return, you’d find yourself paying tax on a total of $175,000 of income before deductions – the $100,000 from the S corporation and the $75,000 of salary you paid yourself – despite the fact that your business lost $200,000. Not a great result.
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After yesterday – and assuming the President, despite his bluster, eventually signs the bill — those expenses will become fully deductible. As a result, you can pass through the business loss of $200,000, which will more than offset the $75,000 in wages you paid yourself. In fact, you’ll be able to carry back the $125,000 “net operating loss” for up to five years, and recover any taxes you paid in those years. Right?
Not so fast. Remember, before you can utilize a loss from a partnership or S corporation – so called “flow-through entities,” because they generally do not pay tax at the business level; rather, all income or loss is allocated out to the shareholders, who pay tax at the individual level – the partner or shareholder must have “basis” in the business. Losses are only allowable to the extent of basis; any excess losses are suspended and carried forward to a future year under either Section 704(d) (for partnerships) or Section 1366(d) (for S corporations).
For pass-through businesses, basis must constantly be adjusted to reflect the income, gain, loss, deduction and distributions allocated to the owners of the business. The purpose of these perpetual adjustments is to preserve the single level of taxation that is the hallmark of partnership and S corporation taxation; to illustrate, consider the following example:
Example: A invests $500 into a new S corporation, S Co. Under Section 358 of the Internal Revenue Code, A takes a $500 basis in the stock. In Year 1, S Co. earns $100 of income. The income is not taxed at the S Co. level; rather, the income is allocated to A, who pays tax at the individual level. Assume the value of S Co.’s stock increases from $500 to $600 after earning the $100 of income. Rather than distribute the income, A sells the S Co. stock for its now-value of $600. If A’s basis in the S Co. stock is not increased from $500 to $600, upon the sale for $600, A will recognize $100 of gain ($600 – $500). That ain’t right, because the S corporation only earned $100 during A’s ownership, and A already paid tax on that income once at the individual level. A should NOT pay tax on another $100 of gain upon the sale of the S Co. stock, or else a single level of tax has not been preserved.
To avoid this result, a shareholder in an S corporation is required by Section 1367(a) to INCREASE stock basis each year for the following items:
· Non-separately stated income (Line 1, K-1 income)
· Separately stated income (things like interest income, capital gain, etc…)
· Contributions to capital, and
· Tax-exempt income.
Thus, in our example above, when A is allocated $100 of income from S Co., A’s basis increases from $500 to $600. When he sells the stock for $600, no further gain or loss is recognized, and a single level of tax has been preserved. The system works!
But wait…why the increase for tax-exempt income? If the goal of basis increases is to avoid a double level of tax, and tax-exempt income isn’t taxed the first time around, then why increase basis for tax-exempt income? The answer is that if we DON’T, we would convert what was intended to be tax-exempt income into taxable income upon a sale of the stock. For example, if in the example above, the $100 of income were state and local bond interest that is tax exempt under Section 103, and A did NOT increase her $500 of stock basis to $600, a sale of the stock for $600 would create $100 of gain – in other words, we would have inadvertently converted what was intended to be tax-exempt income into taxable gain. The fix, then, is to have A increase her stock basis from $500 to $600 for the tax-exempt income so that no gain arises upon the sale of the stock for $600.
After basis has been increased, it must then be decreased for certain items passed from corporation to shareholder. Under Reg. Section 1.1367-1(f), basis is first reduced by distributions. Why distributions? Not to repeat a theme, but it is to preserve a single level of taxation. Section 1368 states that, in general, a distribution from an S corporation is only taxable to the shareholder if it exceeds the shareholder’s stock basis. Because of this ordering rule — where a reduction for distributions immediately follows an increase for income — a distribution of income will NEVER be taxable. Think about it: if an S corporation earns $100 and distributes all of it, the shareholder’s basis will first increase by $100, and then immediately get reduced by the same $100; by definition the distribution of income can never exceed basis, because basis was FIRST INCREASED BY THE INCOME.
After basis has been reduced by distributions is it then reduced by nondeductible expenses – for the same reason basis is increased by tax-exempt income: to preserve the nondeductible nature of the expenses – and only THEN reduced by non-separately stated and separately stated losses.
This ordering rule is less than ideal, because as mentioned above, Section 1366 limits a shareholder’s use of losses in a given year to the shareholder’s stock basis (and potentially, debt basis, but that’s a conversation for another day), and stock basis is only reduced for losses after it has been reduced for distributions and nondeductible expenses (though, it should be noted that under Reg. Section 1.1367-1(g), a taxpayer can make an irrevocable election to deduct losses from basis BEFORE nondeductible expenses).
You’ve probably guessed where this is going. Let’s go back to our hypothetical PPP borrower: took out a $300,000 loan, generated a $200,000 loss, and paid the shareholder $75,000 in salary. But more importantly, because the shareholder has always distributed out income in full, stock basis at the beginning of 2020 is zero.
What’s the problem? If basis begins at zero, the only hope the shareholder has of using a loss during the year is if there is some increase to basis during the year. But there’s been no contribution to capital, no income, separately stated or otherwise…what’s the shareholder to do?
Well, what about the increase for tax-exempt income? Get ready for a good news/bad news situation.
First, the good news: Section 276 of Division NN of yesterday’s bill provides that while forgiven PPP funds are not considered taxable income – a departure from the general rule of Section 61(a)(11) which requires a borrower to recognize cancellation of debt income when a debt is forgiven – any amount excluded from income shall be treated as tax-exempt income for purposes of sections 705 and 1366…” It then goes on to add that “no basis increase shall be denied by reason of the exclusion from gross income.” As a result, a shareholder should absolutely increase his or her stock basis by the forgiven PPP proceeds.
But now, the bad news: When? When does the shareholder increase their basis for the forgiven loan? The most logical conclusion is that when the PPP loan is first made, it is just that – a loan. It is only when forgiveness is granted that the loan converts into tax-free cancellation of debt income. And that, of course, means that the basis increase won’t happen until the debt is forgiven, which in many cases, including our hypothetical, won’t happen until 2021.
So let’s put it all together. The shareholder gets allocated a $200,000 loss, but will have zero basis, because basis started at nil for the year, and no increase for tax-exempt income is available in 2020 because forgiveness hasn’t been granted. Thus, the entire loss gets suspended, and carried forward into 2021, at which point a basis increase will arise when the $300,000 loan is forgiven.
But in the meantime, while the shareholder is happy to be allocated a $200,000 loss instead of $100,000 of income, the joy is muted a bit by the realization that the $200,000 loss will effectively be deferred for a year, and the shareholder will be paying tax on the $75,000 salary received during 2020.
Of course, the $200,000 loss will free up in 2021 when A increases his basis by the $300,000 of tax-exempt income, but depending on the other items of income and loss in 2021, A may no longer have a net loss from the S corporation, and may no longer generate a net operating loss that can be carried back up to five years to offset income that may well have been taxed at a higher rate under pre-Tax Cuts and Jobs Act law.
There is one other possibility. In the tax law, just because you call something a “loan” doesn’t mean it’s necessarily so. It can be difficult to differentiate between a loan and income; to wit, over the past century, the courts have established a number of factors that attempt to discern between the two. Most recently, there was a case in 2020 —Novoselsky v. Commissioner, T.C. Memo. 2020-14 — in which a lawyer received “advances” from clients he was defending that he used to pay the expenses of the litigation. He was only obligated to repay the amounts if he won the case, so he called the amounts a loan and didn’t record any income. The IRS had other ideas, arguing that because Novoselsky would only have to repay the amounts if he was successful in court, they represented income instead of loans. The Tax Court sided with the IRS, eschewing the need for a formal factor test and opting for a simpler approach by concluding that for an amount to be a loan, there must be an “unconditional obligation to repay” that is not “contingent on future events.”
Might those same principles apply to a PPP loan? Might the IRS view a PPP advance as less of a loan and more of a conditional, contingent obligation to repay that should be included in income when received with a corresponding increase in basis to the owner of a pass-through business?
If that were the case – – and the borrower were to include the advance as tax-exempt income in the year of receipt — how would the taxpayer be made whole in 2021 if less than full forgiveness is achieved? Would it then be treated as a loan to that extent and a decrease in basis recorded?
And what of those borrowers of less than $150,000? Under the new bill, forgiveness for these small loans is generally rubber stamped. If at the time of receipt it’s virtually impossible to foresee a situation in which the borrower would NOT have those amounts forgiven, how can the advance be treated as a loan, even for a short window of time? In these cases, could an argument be made that under case law, a PPP advance is NOT a loan, but rather immediate income that Congress has determined to be tax-exempt? If so, the basis increase would occur in 2020.
Again, I apologize. While I’m no stranger to schadenfreude, I swear that this time I only set out to talk some tax law, not to bring everyone down. It’s just that it’s REALLY hard to do the former without also doing the latter.