Treasury Secretary Steven Mnuchin. Photo by Andrea Hanks, courtesy The White House.
When Congress cooked up a plan to help businesses weather the pandemic, money was the main ingredient. Then the Treasury Department tossed some handcuffs into the pot, and now the Internal Revenue Service has added a heaping spoonful of uncertainty.
There are way too many chefs in this legislative kitchen.
The original recipe for the Paycheck Protection Program called for forgivable 10-year loans of up to $10 million for almost any U.S. business with 500 employees or less, at an interest rate of no more than 4%. Borrowers could use the money for most business purposes, but to the extent they used the loan for payroll, rent, utilities and mortgage interest, it could be forgiven. The forgiven debt would be free of income tax.
The Treasury Department had the usual authority to write rules implementing the program. This made sense, mainly because the government bears the ultimate cost of forgiving the loans via a 100% guarantee that the federal Small Business Administration provided to the private lenders issuing them.
But Treasury Secretary Steven Mnuchin has his own ideas about how the program should work. His department is behaving as though its regulatory authority gives Mnuchin the last word, even on matters decided by Congress. On the eve of the program’s launch, the Treasury Department issued guidance limiting loan forgiveness to businesses that spend at least 75% of the loan on payroll – within eight weeks of receipt. Amid broad lockdowns and shelter-in-place limits, this standard is unachievable for many businesses. Such short-term payroll spending is pointless for many others that have few customers right now. The businesses that do not clear the forgiveness hurdle must repay the loans in two years (with payments deferred for six months), not the 10 years Congress authorized.
In a show of goodwill (albeit the sort of goodwill displayed by the banker Mr. Potter in the classic film “It’s a Wonderful Life”), the Treasury Department capped interest rates on PPP loans at 1% rather than the authorized ceiling of 4%. But even that generosity comes out of the lenders’ pockets, not the Treasury’s.
Mnuchin wasn’t finished. The initial $349 billion tranche of PPP funding was exhausted in less than two weeks, with perhaps millions of small businesses left unserved. Critics accused larger firms – a relative handful of them publicly traded – of siphoning funds allegedly meant for mom-and-pop shops. Mnuchin piled on at a press conference. His department followed up with pronouncements that public companies that do not return the money by May 7 will be presumed not to have acted in good faith in certifying that they needed the funds to address the pandemic’s economic uncertainties. All PPP loans of $2 million or more will be subject to “full audits,” whatever that means.
The law already demands significant documentation from applicants about their pre-pandemic payroll and other business details, as well as about how they spend the proceeds. The promise of an audit for any loan of a certain size, regardless of whether there is any sign of misuse, amounts to little more than a pledge to harass anyone with the nerve to take the government up on its offer of support.
Now the IRS – which is an arm of the Treasury – has joined the fray. Last week, the Service declared that the tax-free forgiveness of PPP loans will not really be tax-free after all. According to the agency, businesses that get their loans forgiven will have to surrender an equal amount in tax deductions, such as wages paid to employees out of PPP funds. This takes away the benefit Congress thought it conferred.
There are some tax experts who think this is the correct legal result. The IRS acted after at least one of them, a tax attorney and former Treasury official now teaching tax law at Cornell, pointed this out. I think they are wrong. But unless Congress later overrules the IRS in a new law, or unless the Service quickly reverses itself, a lot of small businesses will forgo a tax break that would have meant a lot to them. Larger and more sophisticated taxpayers, or those that use professional tax advisers accustomed to challenging tax authorities when we believe the law is misapplied, may decide to claim the deduction anyway and fight back if the IRS pursues the issue.
Why do I think the IRS is wrong? Because the section of the law that it is citing, Section 265 of the Internal Revenue Code, does not (in my opinion) apply to the PPP loan forgiveness. This is not only a matter of discerning what Congress intended; the law clearly intended to confer a tax benefit. Congress thought it did. I think it did, too. The IRS thinks it didn’t.
So let’s look at the law. Section 1106(i) of the CARES Act – the law that established the PPP – states:
(i) TAXABILITY.—For purposes of the Internal Revenue Code of 1986, any amount which (but for this subsection) would be includible in gross income of the eligible recipient by reason of forgiveness described in subsection (b) shall be excluded from gross income.
Pay close attention to the phrasing “excluded from gross income.” Section 108(e)(1) of the Internal Revenue Code is the section that provides the general rule that income is recognized when a debt is discharged except under certain specified circumstances, such as bankruptcy. While the taxability provision in the PPP legislation did not mention this section, or any section, of the tax law, it is clear that it produces another exception, just as if it had originally appeared among the exceptions in Section 108.
To support its hard line disallowing deductions for PPP spending to the extent of loan forgiveness, the IRS is relying on Section 265 of the tax code. Section 265(a)(1) disallows deductions for expenses “allocable to one or more classes of income ... wholly exempt from taxes under this subtitle.”
In tax-speak, the term “gross income” is the broadest definition of income that could conceivably be taxed under the income tax law, absent special provisions to the contrary. If a client hands me money for preparing a tax return, that’s gross income. If that client tells her neighbor what a brilliant tax adviser and wonderful human being I happen to be, that’s not gross income, even though it might someday produce income if the neighbor hires me.
Remember, the law that established the PPP stated that PPP loan forgiveness is not part of gross income. If it isn’t gross income, it cannot be tax-exempt income. And if it is not tax-exempt income, then the expenses paid out of PPP loan proceeds cannot be allocable to tax-exempt income, and thus cannot be disallowed under Section 265.
If Congress wanted to achieve the result the IRS demands, it would have simply left out the entire subsection about taxability. Then Section 108(e)(1) would have made the debt forgiveness taxable income, while payroll and other business expenses paid from the PPP proceeds would be deductible. The net effect would be zero.
Why do I conclude that the IRS is misreading the law when other tax mavens do not? I give their opinions due respect, but I don’t subordinate my independent professional judgment to theirs. The ultimate umpires, even when the IRS issues a pronouncement about what the tax law means, are the courts. In capably contested and well-argued cases, the courts overrule the IRS fairly often.
Some of these experts, like the ones The Wall Street Journal cited when it reported the IRS announcement, have backgrounds in tax policy and enforcement. In that corner of our profession, there is an ancient concept known as “protecting the fisc.” The Treasury’s tax hawks know they need to follow congressional mandates. At the same time, they believe they are charged with collecting the government’s lawful share of the nation’s bounty. When they see a gray area, they are apt to interpret it in ways favorable to the government. Sometimes they do it in areas that are not very gray at all.
The IRS position boils down to “Congress didn’t realize what it was doing, and thus did not do what it meant to do.” My alternative construction is that Congress understood exactly what it meant to do and did it. I cannot say the courts won’t buy the IRS interpretation, but this outcome hardly seems like a sure thing to me.
Ideally, the IRS will change its position or Congress will change the law before anyone needs to file 2020 tax returns. Otherwise, practitioners who agree with me will probably explain to their clients that the IRS is taking what we think is an overly aggressive position, and that taxpayers are free to take a contrary position on tax returns unless courts rule otherwise. In some situations, taxpayers may need to explicitly disclose that contrary position. Doing so may invite an IRS examination, and potentially an expensive administrative appeal or litigation. Penalties may apply too, though taxpayers can usually avoid such penalties (but not interest) if they rely on written advice from qualified professionals who are duly informed of the facts.
Or the IRS may simply choose to take the money from taxpayers who concede the issue and leave the others alone, to avoid the risk of losing in court. The outcome is unpredictable. Some clients will want to take their chances; others will not.
It is hard enough to manage a business through a deadly global pandemic and an unprecedented economic shutdown. It is not helpful when the bureaucracy bends and curtails an economic support measure to fit the circumstances it thinks Congress should have prioritized. It is even less helpful when the government takes a statute that seems to clearly say what Congress meant to say, and declares that it says something else. We have quite enough uncertainty in our lives right now without the Treasury and its IRS affiliate adding to the pile.