In tribute to Alex Trebek, I couldn’t resist the title in announcing the federal government's final answer regarding the ability to take deductions for expenses paid with PPP debt ultimately forgiven. The COVID-19 relief package, passed by Congress on Monday, December 21, and signed by the President on December 27, 2020, finally put the debate to rest. Under Section 276, the underlying Congressional intent was written into law, and made clear to the Internal Revenue Service, that federal tax deductions should be allowed for expenses paid with PPP funding that is ultimately forgiven.
While the CARES Act passed on March 27, 2020, specifically stated that loan forgiveness is excluded from gross income under Section 1106, the IRS subsequently issued Notice 2020-32 and Revenue Ruling 2020-27 that consistently reiterated the IRS position that the expenses paid with PPP debt that were ultimately forgiven would not be deductible for federal income tax purposes. In response, Congress issued bi-partisan letters showing that it was not Congress’ intent to deny these deductions after each IRS communication.
This left many tax professionals and business owners scratching their heads, asking a variety of questions, and pondering what to do for purposes of satisfying their 2020 estimated income tax payments, after all, they are paid throughout the year and not just on the due date of the tax return. In addition, this unknown surrounding the deductibility of expenses was drastically changing year-end planning strategies centered around optimizing CARES Act net operating loss (“NOL”) carry-back opportunities that expire in 2020. One can only imagine the millions of hours spent by business owners and tax professionals on this exact topic, pontificating whether there was a realistic possibility of success for a contrary IRS position and the need for tax return disclosures under Form 8275. But alas, the answer we all thought was the true intention of Congress was provided: the forgiveness of PPP debt will not be included as cancellation of debt income AND the expenses paid with PPP debt ultimately forgiven will be deductible for federal income tax purposes. Additionally, the new COVID-19 relief package was drafted with sufficient foresight to include specifically that, for purposes of calculating tax basis under Section 705 and Section 1376, (i.e., for partners’ interests in partnerships and shareholders’ stock of S Corporations, respectively), the forgiven PPP Loan amount is an increase to the holder’s tax basis. This eliminates the potential that the forgiven PPP Loan amount would indirectly be taxed as capital gain upon a future disposition of the holder’s partnership interest or S corporation stock.
But What About the New York State Impact of PPP Debt Forgiveness?
Now, this is where it gets more complicated, and we are only going to highlight the challenges in New York State. Essentially, as part of New York State’s budget package on April 3, 2020, New York State and New York City became a fixed conformity state for Article 22 taxpayers, including individuals and individual partners in a partnership.
New York Tax Law 607(a):… Provided, however, for taxable years beginning before January first, two thousand twenty-two, any amendments made to the Internal Revenue Code of hundred eighty-six after March first, two thousand twenty shall not apply to this article.
Therefore, regardless of what the Federal government has stated in the CARES Act or this latest stimulus package, New York State will be ignoring those laws for purposes of individuals and individual partners in a partnership. In other words, provided individuals or partnerships are cash basis taxpayers the cancellation of indebtedness in relation to PPP debt forgiveness will be treated as income when the cash was received, and the expenses will be deducted when cash is paid. For accrual-based taxpayers, the debt forgiveness will be included in NYS the earlier of when the all-events test has been met or when recorded in the Applicable Financial Statements. The expenses paid with the PPP loan will be deducted when the all-events test has been met and economic performance has occurred.
The takeaway? Just because you do not have to recognize the cancellation of indebtedness income for Federal purposes, doesn’t mean you don’t have to for state income tax purposes.
Lastly, you did properly notice that the above discussion does not include C Corporations. That is because, for C Corporations, New York State has decided to follow the CARES Act and the most recent stimulus bill (at least as of today) in relation to PPP debt forgiveness. Therefore, if a C Corporation receives PPP debt forgiveness, for both Federal and New York State income tax purposes, the cancellation of debt will not be income, but the expenses paid with PPP debt ultimately forgiven will be deductible. Fair? I think not, but we are trying our best to work with New York State legislators to highlight the inequity.
Have a headache yet? You should. This is only one state and there are 50 out there with their own spin on whether to conform, conform with decoupling from specific laws, or select fixed conformity. Overall, properly navigating each state's response is going to take time.
Why Does Everyone Keep Talking About Basis?
Remember that partnerships and S Corporations generally are not income tax paying entities. The ability for partners and S Corporation shareholders to avoid paying taxes on distributions and absorb losses is not only connected to a partner or S Corporation shareholder outside tax basis, but also their at-risk basis. At-risk basis is the cumulative result of a taxpayer's:
- Contributions and distributions of cash and the adjusted basis of property contributed.
- Borrowings to the extent the taxpayer is liable for repayment or has pledged property, other than property used in the activity, as security for the borrowed amounts (recourse debts).
- Borrowings in connection with holding real property if no person is liable for repayment (qualified nonrecourse debts).
- The excess of passthrough items of income over deductions from the activity.
Therefore, the latest stimulus package clarifying that the cancellation of debt income related to PPP debt forgiveness will be treated as tax-exempt income for partnership and S Corporations is beneficial as it allows the at-risk basis to increase for flow-through entities, in order to ensure distributions and losses allocated.
While this latest stimulus bill clarified that the cancellation of debt income related to PPP Loan forgiveness will be treated as tax-exempt income for partnerships and S Corporations, and is an increase to basis, the timing of recognition of the tax-exempt income and corresponding basis increase is not specified. The timing of when the PPP Loan forgiveness is considered tax-exempt income, thereby increasing basis, may become extremely important if at-risk basis from the PPP Loan forgiveness income is required to support a partner’s or S corporation shareholder’s current non-taxable distributions and/or the current use of flow-through losses and deductions.
For example, let’s assume a partner in a cash basis partnership has an outside basis of $10,000 at the beginning of 2020. During 2020, the partner's allocable share of PPP loan was $500,000, and expenses paid were $500,000. In addition, the partnership did not apply and receive PPP debt forgiveness until 2021. Under the cash basis principal, this would mean that the cash was not deemed income until 2021, but the partner would want to deduct the expenses in 2020 as they were paid.
Using our example, the 2020 basis calculation to determine loss limitations would be as follows:
Why aren’t you including the partner's allocable $500,000 share of the PPP loan in the partner's basis, you ask? Remember that an at-risk basis only includes recourse loans, and the PPP loan is non-recourse.
While the $490,000 loss most likely will be allowed in 2021 when the tax-exempt income is recognized, there is a loss of benefit from delaying the loss from 2020 to 2021 (see below).
The takeaway? If you generally have a small basis in a flow-through entity at the beginning of 2020, it is important to examine the timing of when the PPP debt forgiveness will be considered tax-exempt income for purposes of calculating basis.
Why is it so Important to Push a Net Operating Loss into 2020, as Opposed to 2021?
Net operating losses created in 2018, 2019, and 2020 are generally more valuable than losses created in 2021 and beyond due to the CARES Act modifications that allow a net operating loss created in those respective years to be carried back five years and carried forward indefinitely with no taxable income limitation. Conversely, if a net operating loss is created in 2021 or afterwards, there is no carryback period (it can only be carried forward) and it can only offset 80% of taxable income.
See the difference in generating a $490,000 loss in 2020 versus 2021 in the below example:
While some might argue it is merely a timing difference, the carryback and ability to offset 100% of taxable income greatly increases the ability to receive cash sooner, and there is also the element related to the time value of money. If the net operating loss is not generated until 2022, the ability to receive cash refunds will take longer, most likely a cash outlay will have to be made in 2022 and beyond due to the net operating loss being limited to 80% of taxable income, and it must be guaranteed that taxable income will be generated going forward to utilize the net operating loss. Lastly, one of the most important factors, is that $1 being carried back prior to 2018 will most likely be offsetting a higher effective tax rate than $1 being utilized in 2018 going forward. The TCJA included some of the most extreme rate reductions. For C Corporations, the tax rate dropped from 35% to 21%, and for individuals, the top marginal tax rate for flow-through business income qualifying for Section 199 treatment was reduced from 39.6% to 29.6%.
Therefore, all discretionary expenses, included those paid with PPP funding that are ultimately forgiven, should be accelerated into 2020, if practical. In addition, potential changes in methods of accounting, inventory write-offs, and cost segregations studies should be seriously considered to maximize 2020 net operating losses.
While the most recent stimulus bill does seem to be taxpayer friendly, it does little to change the increasing complexity surrounding federal funding that is being provided to businesses to survive the economic damage resulting from the nation’s response to the COVID-19 virus. It will take careful navigation of the new laws and appropriate timing to ensure the maximization of these benefits. Please reach out to your Bonadio advisor or our PPP Consulting Team to navigate these recent law changes.
The information and advice we are providing for this matter relates to COVID-19 legislative relief measures. Because legislative efforts are still ongoing, we expect that there may be additional guidance and clarification from regulators that could modify some of the advice and information provided to you, after the conclusion of our engagement. We, therefore, make no warranties, expressed or implied, on the services provided hereunder.