photo of Treasury Secretary Steven Mnuchin by Shealah Craighead, courtesy The White HouseSometimes a legislative clarification is only that; other times, it can amount to a bureaucratic beat down.
Treasury Secretary Steven Mnuchin and his deputies are now sporting some professional shiners. Congress recently “clarified” that the tax-free forgiveness of Paycheck Protection Program loans that it authorized back in March is, in fact, tax-free. Mnuchin’s minions at Treasury and the Internal Revenue Service had tried mightily to negate that treatment by declaring that any business receiving forgiveness, or even having a “reasonable expectation” of forgiveness, must forfeit an equal amount of otherwise deductible expenses on their tax returns. The net effect would be the same as if the loan forgiveness produced taxable income, as it generally does when Congress does not specify otherwise.
Mnuchin insisted that allowing businesses to deduct expenses financed with de facto government grants amounts to a “double dip.” Even if you credit that argument, Congress has the last word on how many dips into the tax-benefit punch bowl a taxpayer may take. Treasury and the IRS are responsible for executing tax law, not making it.
The last word came Sunday night, when President Donald Trump got around to signing the appropriations bill that included the latest, much-anticipated round of pandemic financial relief. Tucked neatly into Section 276 of this legislation, under the heading “Clarification of Tax Treatment of Forgiveness of Covered Loans,” was the legislative kick that knocked Treasury’s legal legs out from under it: “no deduction shall be denied, no tax attribute shall be reduced, and no basis increase shall be denied, by reason of the exclusion from gross income” of PPP loan forgiveness.
It should not have been necessary. In March, when lawmakers established the Paycheck Protection Program as part of the Coronavirus Aid, Relief and Economic Security Act (generally known as the CARES Act), they stipulated that forgiveness of PPP loans would be “excluded from gross income.” The loans could be used for any legitimate business purpose, but would be forgiven only to the extent they were used for payroll, rent, mortgage interest and utilities. Mnuchin’s Treasury added some extra stipulations, one of which was that at least 75% of the loan proceeds be used for payroll. Congress later reduced this to 60%.
Shortly after the CARES Act passed, Mnuchin declared that businesses would lose a corresponding amount of deductions. The IRS backed up his declaration in April with Notice 2020-32, and again in November with a more formal (and, to tax practitioners, intimidating) Revenue Ruling 2020-27. Revenue rulings carry a heavier weight of authority. Taxpayers can still challenge positions the Service takes in them. But if courts disagree with taxpayers and their practitioners that the contrary position has substantial authority, or that it at least has a reasonable basis and is properly disclosed, they may apply penalties.
The IRS based its position on Section 265 of the Internal Revenue Code. This section disallows deductions “allocable to one or more classes of income ... wholly exempt from the taxes imposed by this subtitle.” Since Congress had declared that PPP forgiveness is not income at all – because “gross income” is the broadest definition under the tax code – Sec. 265 on its face would not apply. But the November revenue ruling also cited a long-standing section in the tax regulations that defines tax-exempt income as anything excluded from gross income under the tax code or “any other law.”
This regulation, although broadly written, is rather narrowly applied. Consider a couple of examples. Sophie starts a business, depositing $10,000 into a bank account from which she pays rent, an assistant’s salary and her business utilities. The $10,000 is not income; it is a contribution of capital to her own business. Sophie’s business expenses are fully deductible.
Now consider if Sophie’s parents give her the $10,000 that she uses to start her business. The result is exactly the same, because a gift is not considered income to the recipient. It becomes Sophie’s money to use however she chooses. It makes no difference, either, if Sophie’s parents give her the money to replenish her savings after she spends her own funds in the business. It does not even matter if Sophie's parents initially call their funding a loan and later decide to forgive the repayment. The gift is not income, and the business expenses are deductible in all these cases.
Congress decided to structure the PPP program as, initially, a loan, to be forgiven under certain circumstances. This turns the PPP loan into a contribution to the capital of the business, because Congress has stipulated it is not income. This should have settled the matter, and would have but for Mnuchin’s insistence that it did not. The regulation cited by the IRS in support of Mnuchin’s position might well have been ruled invalid for going beyond what the statute provides, and because it is interpreted so inconsistently between gifts from a taxpayer’s family on the one hand and what amounted to a similar gift from the U.S. Treasury on the other.
It is reasonable to argue that the government had no business contributing capital to businesses under the PPP program. But once Congress said that it would, the issue was decided.
I am not convinced the courts would have ever gotten a chance to rule on Mnuchin’s position. The IRS might have simply used its revenue ruling as a threat to spur taxpayers into surrendering their deductions without a fight. Many would have done so, including some that rely on tax professionals for advice. A lot of my peers are loath to pick fights with the tax authorities. Some actually believe Mnuchin’s position was correct in the first place.
Other taxpayers would probably have claimed the deductions on their tax returns and surrendered them on audit. The most insistent could have positioned themselves to go to court, only to have the IRS concede the issue to avoid an adverse ruling. In this respect, the sort of saber-rattling in which the Treasury engaged is particularly unfair. It treats similar taxpayers differently, solely because they – or their advisers – are more willing to object to an overreaching or incorrect reading of the law.
Even now, the PPP loan forgiveness issue may not be completely gone. Experience has taught me that not all IRS auditors are fully versed in the law – especially laws, like the one signed this week, which are not actually part of the Internal Revenue Code. It will not surprise me if some auditor, somewhere, cites Sec. 265 to disallow deductions they attribute to a PPP loan forgiveness. The position wouldn’t survive a challenge. Yet sometimes taxpayers (especially those who represent themselves) just go along, on the false assumption that the auditor must know the law.
I won’t tell you that Congress reached the “right” conclusion. That is a policy opinion you can decide for yourself. It did, however, restore the treatment of the PPP loans to its intended place, thwarting an effort by the Treasury bureaucracy to hijack the policymaking powers of the representatives we elected.
Posted by Larry M. Elkin, CPA, CFP®
photo of Treasury Secretary Steven Mnuchin by Shealah Craighead, courtesy The White House
Sometimes a legislative clarification is only that; other times, it can amount to a bureaucratic beat down.
Treasury Secretary Steven Mnuchin and his deputies are now sporting some professional shiners. Congress recently “clarified” that the tax-free forgiveness of Paycheck Protection Program loans that it authorized back in March is, in fact, tax-free. Mnuchin’s minions at Treasury and the Internal Revenue Service had tried mightily to negate that treatment by declaring that any business receiving forgiveness, or even having a “reasonable expectation” of forgiveness, must forfeit an equal amount of otherwise deductible expenses on their tax returns. The net effect would be the same as if the loan forgiveness produced taxable income, as it generally does when Congress does not specify otherwise.
Mnuchin insisted that allowing businesses to deduct expenses financed with de facto government grants amounts to a “double dip.” Even if you credit that argument, Congress has the last word on how many dips into the tax-benefit punch bowl a taxpayer may take. Treasury and the IRS are responsible for executing tax law, not making it.
The last word came Sunday night, when President Donald Trump got around to signing the appropriations bill that included the latest, much-anticipated round of pandemic financial relief. Tucked neatly into Section 276 of this legislation, under the heading “Clarification of Tax Treatment of Forgiveness of Covered Loans,” was the legislative kick that knocked Treasury’s legal legs out from under it: “no deduction shall be denied, no tax attribute shall be reduced, and no basis increase shall be denied, by reason of the exclusion from gross income” of PPP loan forgiveness.
It should not have been necessary. In March, when lawmakers established the Paycheck Protection Program as part of the Coronavirus Aid, Relief and Economic Security Act (generally known as the CARES Act), they stipulated that forgiveness of PPP loans would be “excluded from gross income.” The loans could be used for any legitimate business purpose, but would be forgiven only to the extent they were used for payroll, rent, mortgage interest and utilities. Mnuchin’s Treasury added some extra stipulations, one of which was that at least 75% of the loan proceeds be used for payroll. Congress later reduced this to 60%.
Shortly after the CARES Act passed, Mnuchin declared that businesses would lose a corresponding amount of deductions. The IRS backed up his declaration in April with Notice 2020-32, and again in November with a more formal (and, to tax practitioners, intimidating) Revenue Ruling 2020-27. Revenue rulings carry a heavier weight of authority. Taxpayers can still challenge positions the Service takes in them. But if courts disagree with taxpayers and their practitioners that the contrary position has substantial authority, or that it at least has a reasonable basis and is properly disclosed, they may apply penalties.
The IRS based its position on Section 265 of the Internal Revenue Code. This section disallows deductions “allocable to one or more classes of income ... wholly exempt from the taxes imposed by this subtitle.” Since Congress had declared that PPP forgiveness is not income at all – because “gross income” is the broadest definition under the tax code – Sec. 265 on its face would not apply. But the November revenue ruling also cited a long-standing section in the tax regulations that defines tax-exempt income as anything excluded from gross income under the tax code or “any other law.”
This regulation, although broadly written, is rather narrowly applied. Consider a couple of examples. Sophie starts a business, depositing $10,000 into a bank account from which she pays rent, an assistant’s salary and her business utilities. The $10,000 is not income; it is a contribution of capital to her own business. Sophie’s business expenses are fully deductible.
Now consider if Sophie’s parents give her the $10,000 that she uses to start her business. The result is exactly the same, because a gift is not considered income to the recipient. It becomes Sophie’s money to use however she chooses. It makes no difference, either, if Sophie’s parents give her the money to replenish her savings after she spends her own funds in the business. It does not even matter if Sophie's parents initially call their funding a loan and later decide to forgive the repayment. The gift is not income, and the business expenses are deductible in all these cases.
Congress decided to structure the PPP program as, initially, a loan, to be forgiven under certain circumstances. This turns the PPP loan into a contribution to the capital of the business, because Congress has stipulated it is not income. This should have settled the matter, and would have but for Mnuchin’s insistence that it did not. The regulation cited by the IRS in support of Mnuchin’s position might well have been ruled invalid for going beyond what the statute provides, and because it is interpreted so inconsistently between gifts from a taxpayer’s family on the one hand and what amounted to a similar gift from the U.S. Treasury on the other.
It is reasonable to argue that the government had no business contributing capital to businesses under the PPP program. But once Congress said that it would, the issue was decided.
I am not convinced the courts would have ever gotten a chance to rule on Mnuchin’s position. The IRS might have simply used its revenue ruling as a threat to spur taxpayers into surrendering their deductions without a fight. Many would have done so, including some that rely on tax professionals for advice. A lot of my peers are loath to pick fights with the tax authorities. Some actually believe Mnuchin’s position was correct in the first place.
Other taxpayers would probably have claimed the deductions on their tax returns and surrendered them on audit. The most insistent could have positioned themselves to go to court, only to have the IRS concede the issue to avoid an adverse ruling. In this respect, the sort of saber-rattling in which the Treasury engaged is particularly unfair. It treats similar taxpayers differently, solely because they – or their advisers – are more willing to object to an overreaching or incorrect reading of the law.
Even now, the PPP loan forgiveness issue may not be completely gone. Experience has taught me that not all IRS auditors are fully versed in the law – especially laws, like the one signed this week, which are not actually part of the Internal Revenue Code. It will not surprise me if some auditor, somewhere, cites Sec. 265 to disallow deductions they attribute to a PPP loan forgiveness. The position wouldn’t survive a challenge. Yet sometimes taxpayers (especially those who represent themselves) just go along, on the false assumption that the auditor must know the law.
I won’t tell you that Congress reached the “right” conclusion. That is a policy opinion you can decide for yourself. It did, however, restore the treatment of the PPP loans to its intended place, thwarting an effort by the Treasury bureaucracy to hijack the policymaking powers of the representatives we elected.
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