Uptick in Business Divorces?

I’ve read a number of articles over the last few weeks in which marriage counselors have been predicting a wave of divorce filings once the COVID-19 quarantine has been lifted.[i]

That may be – we’ll just have to wait and see.[ii] Query, however, whether “business divorces” will follow suit?

The quarantine and the resulting economic downturn have likely created, highlighted, or aggravated stress points among the owners of many businesses. Disagreements over steps already taken by the business in response to the downturn, or differing opinions on the direction in which to steer the business once it emerges from quarantine,[iii] will probably cause a number of business owners to go their separate ways.

Of course, the mechanics by which such a break-up is effectuated will depend upon a number of factors, including whether the owners are already parties to a shareholders, partnership or operating agreement that specifies the form of buyout. In the absence of such an agreement, each of the owners will seek to optimize their respective after-tax economic consequences. In turn, this will inform their decisions as to the structure of the transaction, the determination of the nature and amount of the consideration to be exchanged, and the timing of such exchange.

A recent decision of the U.S. Tax Court[iv] considered the pre-coronavirus breakup of a joint venture that resulted in litigation, but which was settled for a lump-sum payment to Taxpayer in exchange for Taxpayer’s relinquishing whatever rights it had in the joint venture. Taxpayer and the IRS disagreed as to the tax treatment of this payment.

Although the Court ultimately sided with Taxpayer, the IRS raised some interesting points – although other issues were left untouched – in the context of the cross-purchase buyout[v] of a partner, of which partners and their tax advisers should be aware.

The Joint Venture

Taxpayer was a real estate development and investment firm. It would locate desirable properties to develop, and would then partner with others who would provide the capital needed for such development.

Taxpayer connected with Partner, who was interested in financing the development of certain properties identified by Taxpayer. The parties executed a term sheet which set forth the major terms for a real estate development joint venture.

While Taxpayer and Partner were working on developing these properties – each as a separate venture – conflicts arose between them. The parties struggled to formalize the terms of their deal in a written agreement, but never succeeded in doing so.

Eventually, Partner replaced Taxpayer with another development company.

The Litigation

Partner then filed a complaint against Taxpayer in which Partner claimed that Taxpayer did not have any interest in Partner’s joint ventures,[vi] and Partner sought declaratory relief and damages for conversion, imposition of constructive trust, breach of contract, and breach of fiduciary duty.[vii]

Partner asserted that “[p]ending the execution and delivery of written agreements [Taxpayer and Partner] entered into an oral contract, pursuant to which [Taxpayer] rendered services to and for [Partner].”

Taxpayer filed a cross-complaint alleging that Partner had breached its fiduciary duties to Taxpayer as a joint-venturer. Taxpayer sought declaratory relief and partition of the properties. Taxpayer asserted that its joint venture with Partner was reflected “in many oral and written statements and emails.” It also alleged that the parties had operated according to the above-referenced term sheet, which the parties executed intending to finalize the terms of their joint ventures. Taxpayer claimed that because they were partners in a joint venture, Partner owed Taxpayer fiduciary duties of care and loyalty and had an obligation of good faith and fair dealing, and that repudiating the existence of the joint ventures breached those duties.

A jury was presented with Taxpayer’s claims for breach of fiduciary duty. The trial court instructed the jury that to establish its claim “[Taxpayer] must prove that [Partner was] in a joint venture with Taxpayer and that [Partner] excluded Taxpayer from a joint venture, wrongfully repudiated the existence of the joint venture and converted all of the joint venture assets to [its] own use.”

“Damages”

The Court explained that, under State law, the victim of “repudiation” of a partnership interest could choose among several methods of measuring damages. Taxpayer chose the “conversion measure of damages, which is the value of what was taken on the date of repudiation.”

Taxpayer’s expert determined the value of the repudiated joint venture interests by considering the future fees the joint ventures expected to receive,[viii] as well as other factors.

The jury found that Taxpayer and Partner had a joint venture, and that Partner breached its fiduciary duty to Taxpayer.

The court instructed the jury that “[i]f you find that * * * [Partner] breached [its] fiduciary duty, Taxpayer would be entitled to damages measured by the reasonable value, at the time of the breach, of Taxpayer’s interest in the joint venture(s) of which Taxpayer was deprived.” The jury awarded damages in an amount that matched the estimate provided by Taxpayer’s expert. The jury also found that Partner was liable for punitive damages.

After the judgment was entered, Partner appealed. While the appeal was pending, Taxpayer explored settling the case.

Settlement

Taxpayer understood that the terms of any settlement agreement would affect the net after-tax proceeds. Taxpayer’s tax adviser, CPA, advised Taxpayer that the tax treatment of the settlement proceeds would likely depend on how the settlement agreement characterized the proceeds. CPA believed that if the settlement agreement provided for an exchange of Taxpayer’s joint venture interests for the settlement proceeds, the result would be favorable capital gain treatment for Taxpayer.[ix]

While the appeal was pending, Taxpayer and Partner reached a settlement. The settlement agreement included several relevant provisions; for example, it provided for Taxpayer’s transfer and relinquishment of the joint venture interests, and stated that each party sought legal counsel and advice regarding the agreement, including its tax consequences.

The Court described how the parties worked though several drafts before reaching a final agreement. According to the Court, their negotiations clearly demonstrated what the parties intended to achieve in the settlement agreement: Taxpayer wanted it to reflect “a transfer by [Taxpayer] of its joint venture interest in these projects with Partner, transferring them to Partner as an essential part of this transaction,” while Partner intended for agreement to cause Taxpayer to relinquish any ownership interests it had in the joint ventures.

Tax Return Challenged

The settlement agreement entitled Taxpayer to receive a payment from Partner. Taxpayer reported the payment on its tax return as long-term capital gain from the disposition of a partnership interest.[x]

The IRS challenged this tax treatment and sought to re-characterize the gain reported by Taxpayer as ordinary income. Specifically, the IRS asserted that the settlement proceeds represented lost fees,[xi] taxed as ordinary income.

The IRS argued that the valuations provided by Taxpayer’s expert in the State court proceeding showed that Taxpayer received damages for its interests in the joint ventures in the form of lost fee income.

The Court’s Opinion

The Court observed that the parties did not dispute that Taxpayer may treat amounts received in exchange for the joint venture interests as capital gains. Under the Code, it explained, the sale or exchange of a partnership interest is generally treated as the sale or exchange of a capital asset.[xii] Any amounts received as compensation for lost profits, however, must be treated as ordinary income.[xiii]

Nature of the Claim

The tax treatment of proceeds received in settlement of a claim, the Court continued, is generally guided by the nature of the claim, or the characterization of the claim for which the settlement was paid.[xiv]

The nature of the underlying claim, the Court stated, was a factual determination made by considering the settlement agreement in light of all the facts and circumstances; if the settlement agreement expressly allocated the settlement proceeds to a type of damage, the Court would generally follow that allocation if the agreement was reached by adversarial parties in arm’s-length negotiations and in good faith.

Specific Allocation

The settlement agreement between Taxpayer and Partner provided an express allocation. It provided that Taxpayer was receiving payment in exchange for its interests in the joint ventures – no portion of the payment was allocated elsewhere, and the Court saw no reason to read the agreement as other than expressly written.[xv]

Adverse and At Arm’s Length

The Court also pointed out that parties were adversarial and negotiated at arm’s length and in good faith regarding the nature of the settlement payment. It explained that drafts of the agreement showed that Taxpayer wanted the agreement to reflect both that it had joint venture interests and that it was transferring those interests. In contrast, Partner wanted language that supported its contention that Taxpayer only claimed to have interests. In the final agreement, however, Partner acknowledged that it was paying to acquire whatever interests Taxpayer had.

Moreover, Partner and Taxpayer had adverse tax interests, the Court stated, in the characterization of the payment. If Partner had made the payment to compensate Taxpayer for providing services, Taxpayer would have received ordinary income, taxable at ordinary income rates, while Partner would likely have been able to deduct a payment for services as an ordinary and necessary business expense.[xvi]

But if the payment was made in exchange for joint venture interests, Taxpayer would recognize long term capital gain, taxable at favorable capital gain rates. Partner, however, would have been required to treat any amounts paid for Taxpayer’s interests in the joint ventures as additions to its bases in the joint venture interests.[xvii]

These differing tax consequences of the payment’s characterization supported the conclusion that the parties were adverse for tax purposes.

Moreover, nothing in the facts and circumstances of the negotiation indicated that Taxpayer and Partner approached the settlement agreement other than in good faith and at arm’s length, or that the payment had a different purpose.[xviii] Indeed, the Court noted, the facts and circumstances surrounding the settlement agreement demonstrated that the payment was made in exchange for the joint venture interests.

The Valuation

Finally, the IRS argued that the valuation report prepared by Taxpayer’s expert valued both Taxpayer’s interests in the joint ventures and the lost fee income. Therefore, the IRS argued, the economic reality was that Partner compensated Taxpayer for the latter’s loss of future income. The Court disagreed.

The Court conceded that the expert used lost fee income as a factor in calculating the values of the joint venture interests. The Court explained, however, that it was a common and accepted method for valuing an asset to consider the future economic benefits the asset would bring to its owner.[xix]

Because the settlement agreement expressly allocated the settlement proceeds to payment for Taxpayer’s interests in the joint ventures, and because the settlement agreement, including the allocation provision, was negotiated by adversarial parties at arm’s length and in good faith, the Court concluded that Taxpayer received the settlement proceeds in exchange for its interests in the joint ventures. Thus, the sale proceeds were properly treated as gain from the sale of a capital asset.

There’s More to A Cross-Purchase

Once it was accepted that Taxpayer was a member of a joint venture with Partner, the buyout of its partnership (joint venture) interest, described above, represented a fairly straightforward affair.

Even so, there were a number of points on which the Court touched, and a few that were not discussed at all, that are worthy of further comment.

“Hot Assets”

In general, the Code provides that the gain realized from the sale of a partnership interest is treated as gain from the sale of a capital asset.[xx]

However, if any of the consideration for the transferor’s interest in the partnership is attributable to the value of the partnership’s unrealized receivables[xxi] or inventory items,[xxii] then part of the gain from the sale of the interest will be considered as an amount realized from the sale or exchange of property other than a capital asset;[xxiii] in others words, ordinary income.[xxiv]

Interestingly, neither the IRS nor the Court made any mention of the application of this rule to attribute some of the consideration for Taxpayer’s interest to the properties being developed.[xxv]

“Debt Relief”

It should be noted that the consideration to be paid in exchange for a transferor’s partnership interest includes not only the amount of cash and the fair market value of the property to be transferred by the purchaser to the transferor; it also includes the transferor’s share of partnership liabilities that are allocated away from the transferor as a result of the sale.[xxvi]

Installment Reporting

Moreover, such “ordinary gain” will not qualify for installment reporting; rather, the amount of such gain will be included in the transferor’s gross income for the taxable year of the sale notwithstanding that the payment of the consideration in respect thereof may be deferred to a later taxable year.[xxvii]

Similarly, the amount of the “debt relief” realized by the transferor in the taxable year of the sale will be treated as cash received in such year.

Inside Basis[xxviii] Adjustment

In general, the basis of partnership property is not adjusted as the result of a transfer of an interest in a partnership by sale or exchange unless an election under Section 754 of the Code is in effect with respect to the partnership.[xxix]

Where such an election is in effect, the partnership will increase the adjusted basis of the partnership property by an amount equal to the excess of the basis to the transferee (acquiring) partner of their interest in the partnership[xxx] over their proportionate share of the adjusted basis of the partnership property.[xxxi]

This increase will constitute an adjustment to the basis of partnership property with respect to the transferee partner only.[xxxii] Thus, for purposes of calculating income, deduction, gain, and loss, the transferee will have a special basis for those partnership properties the bases of which are adjusted.[xxxiii] In the case of partnership property that is amortizable or depreciable, the adjustment will be added to the transferee’s share of inside basis in determining their amortization or depreciation deduction and, on the sale of property, the adjustment will be subtracted from the amount of gain allocated to the transferee.[xxxiv]

The Court made no mention of Partner’s ability to recover any of the consideration paid for Taxpayer’s interest. To the extent such cost would have been added to property being developed for sale, it would be recovered at the time of sale by reducing the amount of income realized;[xxxv] if the cost was added to investment property, then Partner would have been looking at a much longer recovery period, depending upon whether the real property was nonresidential or residential rental property.[xxxvi]

Valuation

A long-term capital gain is generated when there is a sale or exchange of a capital asset. A capital asset is generally defined as property held by the taxpayer, whether or not connected to their trade or business, subject to several statutory exceptions.[xxxvii] Long-term capital gain may also be generated on the sale of property used in a trade or business, of a character which is subject to depreciation, or of real property used in a trade or business.[xxxviii]

Against this background, Congress, the IRS and the Courts have, over the years, developed arguments that are intended to defeat attempts by taxpayers to “convert” ordinary income into capital gain. The hot asset rule, described above, represents one statutory attempt in support of this goal.

Another, judicially-developed, argument is embodied in the “substitute for ordinary income” doctrine. In brief, if an amount is received by a taxpayer for an interest in property, but the transaction is recast as a payment in lieu of future ordinary income payments, the amount received will also be treated as ordinary income – the taxpayer is merely converting future income into present income; they are accelerating the receipt of the income.[xxxix]

Taxpayers, on the other hand – like the Court in Taxpayer’s case discussed above – have argued that many assets, including closely held business interests, are valued on the basis of the present value of their future income stream.[xl] Thus, they assert, it is possible to take the “substitute for ordinary income” doctrine too far, and to thereby define the term “capital asset” too narrowly.

Between these two extremes, the courts have stated that they must make case-by-case judgements as to whether the conversion of income rights into a single payment reflects the sale of a capital asset that produces capital gain, or whether it produces ordinary income.[xli]

What’s Next?

Assuming we do experience an increase in business divorces after the COVID-19 quarantine is lifted, business owners who have decided to go their separate ways will have to consider, together with their advisers, a number of transaction-related options, some of which will be more tax efficient than others.

In the case of a partnership, for example, they will have to decide whether a cross-purchase or a liquidation of the interests held by the departing partner(s) represents the best buyout structure.

They will have to consider the proper valuation method for the business and the interest to be acquired in light of the circumstances in which our economy (and probably the business) finds itself.

A related issue will be the financing for such a buyout.[xlii]

The partnership may also want to consider whether an in-kind distribution, whether in the form of a division of the partnership[xliii] or in liquidation of a partner’s interest in the distributing partnership,[xliv] may be the most cost effective and tax efficient means of separating the owners of the business. Of course, this may present its own valuation and other practical challenges. In addition, an in-kind distribution may trigger the disguised sale and mixing bowl rules, thus triggering the taxable event that the owners sought to avoid.[xlv]

Over the course of the following weeks, we will try to review many of these issues. At the end of the day, however, it will be incumbent upon the business owners, the business organization, and their advisers to sift through these factors, and others, as they decide upon the terms of the buyout.

——————————————————————————

[i] Causes? Money pressures: reduced earnings, maybe job loss? Not sharing household and family duties, including homework with the kids and taking care of the newly-acquired pet? (Whose idea was that anyway?) Close proximity to one’s elderly mother-in-law for an extended period of time. (Give me a few more weeks – I’ll get back to you on that.) Finally getting to know one another? (What ever happened to the “Newly Wed Game”? In retrospect, it appears to have been serving an important societal function.)

May we accept this as proof of the converse, that “absence makes the heart grow fonder?” Not necessarily.

[ii] In general, divorce statistics come from the States, the National Center for Health Statistics, and the Census Bureau.

[iii] For example, will they close offices, drop unprofitable lines of business, reduce the number of employees, pay down debt, establish reserves, cut “fat,” etc.?

[iv] NCA Argyle LP, v. Commissioner, T.C. Memo. 2020-56.

[v] Where the remaining partner or partners acquire the departing partner’s equity interest. This is to be contrasted with a liquidation of the departing partner’s interest, in which the partnership itself is the acquiring party.

[vi] Partner alleged that Partner and Taxpayer had negotiated potential terms for real estate development ventures but never entered any written agreement.

[vii] What do you think of “litigation speak?” Do you recall “A Fish Called Wanda?”

Wanda: Archie? Do you speak Italian?

Archie: I am Italian! Sono italiano in spirito. Ma ho sposato una donna che preferisce lavorare in giardino a fare l’amore appassionato. Uno sbaglio grande! But it’s such an ugly language. How about… Russian?

[viii] Which caught the attention of the IRS.

[ix] IRC Sec. 741, Sec. 1221, Sec. 1222, 1(h).

[x] Its interest in the joint venture with Partner.

[xi] As well as punitive damages.

[xii] IRC Sec. 741.

[xiii] Ordinary income is subject to federal income tax at a maximum rate of 37 percent. Amounts received as punitive damages are also taxable as ordinary income to the recipient.

[xiv] The “origin of the claim” doctrine.

[xv] The settlement agreement stated that it represented the entire understanding of the parties, including as to the character of the payment. The Court did not find that the parties’ agreement as to the price for the converted joint venture interests was inconsistent with the economic realities of the case; rather, the Court found that such price was within the reasonable range of value placed on the joint venture interests.

[xvi] IRC Sec. 162.

[xvii] IRC Sec. 1012.

[xviii] When an expressed settlement “is incongruous with the ‘economic realities’ of the taxpayer’s underlying claims,” the Court stated, “we need not accept it.”

[xix] Like distinguishing a share of stock from its dividend history, or a building from its rental income.

[xx] IRC Sec. 741. Of course, in order for the gain from the sale of the partnership interest to be treated as long-term capital gain, the partner must satisfy the “more than one year” holding period requirement. IRC Sec. 1222 and Sec. 1223.

[xxi] IRC Sec. 751(c).

[xxii] IRC Sec. 751(d). Inventory, together with unrealized receivables, are referred as “hot assets.”

[xxiii] IRC Sec. 751. There is no comparable rule for C corporations or S corporations. The so-called “collapsible corporation” rules (IRC Sec. 341), which bore only a passing resemblance to Sec. 751, were repealed in 2003.

[xxiv] For purposes of this rule, the term “unrealized receivables” includes, to the extent not previously includible in income under the method of accounting used by the partnership, any rights to payment for goods delivered, or to be delivered, to the extent the proceeds therefrom would be treated as amounts received from the sale or exchange of property other than a capital asset, or services rendered, or to be rendered.

It also includes several less obvious items; for example, depreciation recapture. IRC Sec. 1245. This is generally described as the amount of depreciation claimed by the taxpayer with respect to depreciable tangible personal property.

[xxv] It may be that these were not held for sale but, rather, for investment; i.e., rental.

[xxvi] IRC Sec. 752(d); Reg. Sec. 1.752-1(h). Of course, this debt may have also been added to the transferor’s basis for their partnership interest. To the extent the transferor-partner was able to claim deductions as a result of this increased basis – see IRC Sec. 704(d) – the inclusion of this debt in the amount realized serves to recapture this benefit.

[xxvii] IRC Sec. 453(b)(2) and 453(i); Mingo v. Comm’r, T.C. Memo 2013-149.

[xxviii] This refers to the partnership’s basis for its assets, whereas “outside basis” refers to a partner’s basis for their partnership interest.

[xxix] IRC Sec. 743(a). Note than such an election is not necessary in the case of a two-person partnership in which one partner purchases the interest of the other. In that case, Rev. Rul. 99-6 treats the partnership as having made a liquidating distribution of its properties and the purchasing partner as having acquired, from the departing partner, the latter’s share of the partnership’s properties.

[xxx] Basically, their cost basis for the partnership interest (IRC Sec. 1012), increased by their allocable share of partnership liabilities (IRC Sec. 752(a) and Sec. 722).

[xxxi] It’s also possible to have a negative adjustment. It’s important to note that, once made, the election is irrevocable without the consent of the IRS.

[xxxii] No adjustment is made to the common basis of partnership property.

[xxxiii] Reg. Sec. 1.743-1(j). IRC Sec. 755 and the regulations thereunder provide for the allocation of the adjustment amount among the partnership’s assets.

[xxxiv] In other words, a positive adjustment may generate increased deductions and reduced gain.

[xxxv] IRC Sec. 263A.

[xxxvi] IRC Sec. 168.

[xxxvii] IRC Sec. 1221.

[xxxviii] IRC Sec. 1231. These properties must not represent inventory or other property held primarily for sale to customers in the ordinary course.

[xxxix] Hort v. Commissioner, 313 U.S. 28 (1941).

[xl] An income approach to valuation; for example, the discounted cash flow and capitalization of cash flow methods.

[xli] Congress has addressed the issue in the case of a distribution in liquidation of a partnership interest where the amount to be distributed is determined with regard to the income of the partnership. IRC Sec. 736(a).

[xlii] And, in the case of acquisition indebtedness, the tax treatment of any related interest expense. IRC Sec. 163.

[xliii] Reg. Sec. 1.708-1(d).

[xliv] IRC Sec. 731 and Sec. 736.

[xlv] IRC Sec. 704(c)(1)(B), Sec. 707, and Sec. 737.

What Did You Do Last Night?

“Friday night, May 15 . . . You didn’t watch the roll call vote in the House? . . . On CSPN . . . The HEROES Act. . . . C’mon, seriously. . . . Really? . . . You had no interest whatsoever? . . . Foregone conclusion? . . . Hmm, probably, but there were a couple of surprises. . . . No, I don’t get a kick out of watching paint dry.”

The House passed the “Health and Economic Recovery Omnibus Emergency Solutions Act,” or the “HEROES Act,”[i] just before 9:30 pm yesterday, by a vote of 208 to 199,[ii] with 23 members not voting.[iii] If enacted, the HEROES Act will represent the fifth piece of major Federal legislation aimed at combatting the domestic health and economic effects of the coronavirus pandemic.[iv]

The bill will now be sent to the Senate, where the Republican majority has already stated that the measure does not stand a chance of being passed in its current form; the majority leader, Senator McConnell, described the proposed legislation[v] as a “liberal wish list,” and the White House has threatened to veto the measure if it somehow gets through the Senate with too many of its “offending” provisions intact.

Truth be told, the scope of the HEROES Act is not limited to dealing with the COVID-19 health crisis and with the economic consequences arising from the government-ordered shutdown of many businesses as part of our effort to contain the spread of the coronavirus.

Indeed, the bill modifies or expands a wide range of other programs and policies, including those regarding Medicare and Medicaid, health insurance, broadband service, immigration, student loans and financial aid, the federal workforce, prisons, veterans’ benefits, consumer protection requirements, the U.S. Postal Service, federal elections, aviation and railroad workers, and pension and retirement plans.[vi]

Glass Half Full?

That being said, the bill also provides payments and other assistance to state and local governments to help them through the financial crisis in which they find themselves as a result of the pandemic; modifies and expands the Paycheck Protection Program (“PPP”),[vii] which provides loans and grants to small businesses and nonprofit organizations;[viii] establishes a fund to award grants for employers to provide pandemic premium pay for essential workers; expands several tax credits and deductions;[ix] allow companies with forgiven PPP loans to defer their payroll tax payments; provides funding and establishes requirements for COVID-19 testing and contact tracing; requires employers to develop and implement infectious disease exposure control plans;[x] and more.

The Act would also suspend the $10,000 cap on the itemized deduction for state and local income taxes for 2020 and 2021.[xi]

In other words, there are enough items in the bill on which both Democrats and Republicans can agree, if they are ready and willing to act reasonably.

Significantly, among these items is a provision that addresses the deductibility of business expenses paid with the proceeds of a PPP loan.

Tax Deductibility of Business Expenses

Under the Code, taxpayers are allowed to deduct any ordinary or necessary trade or business expenses from their gross income.[xii] This would normally include PPP-eligible “covered” expenses like wages or other compensation, paid employee leave and fringe benefits, rent or utility payments associated with a business facility, interest on certain business debt, and state tax payments.

The CARES Act has no language referring to the deductibility of PPP expenses.

This left many tax advisers wondering what Congress intended; specifically, should a business that enjoyed the tax-free forgiveness of its PPP loan[xiii] also be allowed to claim a tax deduction for the expenses paid with the proceeds from the forgiven PPP loan?

Many were troubled by this “double benefit” from a conceptual perspective – it seemed out of balance, as indeed it is. They argued that an express legislative statement would be needed if Congress intended to allow a deduction for covered expenses incurred by a taxpayer whose loan is forgiven under the PPP.

Others pointed out that, if Congress meant to disallow the double benefit, why was the exclusion of the loan forgiveness from gross income explicitly provided in the legislation? If Congress had remained silent, they contended, the forgiveness would have generated cancellation of indebtedness income,[xiv] and the business would have claimed a deduction for the expenses paid with the loan proceeds.

On April 30, 2020, however, the IRS issued Notice 2020-32, setting forth the IRS’s position that recipients of PPP loans cannot claim a deduction for expenses funded from a PPP loan that has been forgiven.[xv] In support of its position, the IRS relied upon that provision of the CARES Act under which forgiven PPP loans are not to be included in the borrower’s gross income and, thus, are not taxable.[xvi]

As explained below, the IRS’s guidance would reduce the economic benefit of PPP loans.[xvii]

Congress Responds?[xviii]

Within one week of the issuance of Notice 2020-32, a bipartisan-sponsored bill was introduced in the Senate – S. 3612, the Small Business Expense Protection Act of 2020[xix] – which would add the following language to the end of Section 1106(i) of the CARES Act (which excludes the forgiven PPP loan from gross income): “and . . . no deduction shall be denied or reduced, no tax attribute shall be reduced, and no basis increase shall be denied, by reason of the exclusion from gross income.”

The HEROES Act, introduced on May 12, and passed by the House on Friday, May 15, includes a similar provision, which reads as follows: “notwithstanding any other provision of law, any deduction and the basis[xx] of any property shall be determined without regard to whether any amount is excluded from gross income under section 20233 of this Act or section 1106(i) of the CARES Act.”[xxi]

Although the Senate has not yet passed its version of this provision, I’d wager that the IRS has heard enough from Congress, generally, to realize that the legislature’s intent was to allow the borrower-business to claim a deduction, for purposes of determining its income tax liability, for the business expenses paid with the PPP loan proceeds, without regard to whether such loan is forgiven or not.

Hopefully, the IRS will act on this realization and immediately withdraw Notice 2020-32. There is no reason to hold the deduction hostage to Congressional negotiations on other items in the HEROES Act bill – businesses deserve at least that degree of certainty as they move into an otherwise uncertain future.[xxii]

Double Benefit =’s Reserves?

Speaking of uncertainty or, more accurately, perhaps one way for a business to prepare for its inevitable arrival, is to utilize the double benefit described above to establish a cash reserve. This, in turn, would address, at least in part, a shortcoming of many businesses, one that both accelerated their economic downturns and aggravated the adverse consequences thereof.

This opportunity afforded by the double benefit may be best conveyed with a simplistic example.

First, assume a business receives a conventional loan of $100. The borrower-business receives the proceeds tax-free; they represent a loan, after all. The business uses the $100 loan to pay certain expenses. The lender forgives the loan, and the business realizes taxable income from the discharge of indebtedness. However, because the expenses paid by the business are deductible for tax purposes, the business has no income tax liability at that point.

If the business later realizes a profit of $100 net of related expenses, it will owe income tax thereon. If the business is a C corporation, its Federal income tax liability will be $21, and it will be left with $79.

Now assume the business receives $100 of PPP loan proceeds. These are received tax-free. The business uses the $100 loan to pay certain expenses, as required under the PPP, and the SBA subsequently forgives the $100 loan. Pursuant to the CARES Act, this debt forgiveness is not treated as taxable income to the business and, under Notice 2020-32, the business is not allowed to deduct the expenses paid for purposes of determining its income tax liability. Because the business does not have any income from the discharge of indebtedness, the absence of a deduction has no impact on its tax liability, which is zero.

However, if the business subsequently earns a profit of $100 net of related expenses, it will owe income tax thereon in the absence of a deduction for its payment of the PPP-related expenses – no tax savings are realized from the payment of the PPP-covered expenses. If the business is a C corporation, its Federal income tax liability will be $21.[xxiii] It may retain the remaining $79 as a reserve, subject to establishing that the amount accumulated does not exceed the reasonable needs of the business.[xxiv]

Now assume that the expenses paid with the PPP loan are deductible by the business. In determining its taxable income for the year, the business excludes the forgiven loan from its gross income, as provided under the CARES Act. However, the business may deduct the $100 of PPP-related expenses against the subsequently earned $100 of profit; as a result, the business has no taxable income, nor does it have positive earnings and profits, for that year.[xxv] Thus, the business does not owe income tax on that $100 – a tax savings of $21 – and it may retain the entire amount as a reserve.

Get Ready

It will be a few weeks before the HEROES Act is negotiated to the point that it will pass muster in both the Senate and the House. In light of the clear Congressional intent, the IRS should not wait for a “final” legislative pronouncement regarding the deductibility of covered expenses that are paid with PPP loans before it withdraws Notice 2020-32 and acknowledges this tax benefit.

For the same reason, businesses that have received PPP loans, which they are reasonably confident will be forgiven by the SBA, should not squander the tax savings to be realized. Although many businesses will need the resulting liquidity to get back on their feet, those that can afford to do so should plan to set those funds aside as a reserve. You may recall the loan amount was determined by reference to 2.5 times the monthly “payroll costs” of the business[xxvi] – that’s not a bad place to start.

If the reserve is coupled with cutting fat and waste from a business, and with securing a line of credit, then the business will have placed itself in a much better position for the next economic downturn, whatever the reasons therefor.[xxvii]


[i] H.R. 6800.

Do you ever wonder what comes first, the statute’s full name or the acronym? CARES. HEROES. A reasonably strong argument can be made that some staff member in the Senate Finance Committee or in the House Ways and Means Committee thought of these emotionally-accented acronyms first – suspend for a moment, please, the definitional chicken and egg issue this presents – then found the words to match them in a reasonably coherent manner.

Have we seen the last of names like TEFRA, TRA, OBRA, EGTRRA, and their kind? Speaking as a traditionalist, I hope not.

[ii] One Republican, New York’s Peter King, voted for the bill, in part, because of its support for state and local governments. Mr. King will be retiring from the Congress shortly, after what will be his 14th term. 14 Democrats voted against the proposed legislation – according to the so-called “experts,” some of these were moderates who face a difficult re-election campaign in November and, so, could not support a measure that many described as “too partisan.” One is the Co-Chair of the Progressive Caucus – Ms. Jayapal thought the bill did not go far enough. https://www.rollcall.com/2020/05/15/house-narrowly-passes-3-trillion-coronavirus-aid-bill/

[iii] 12 Democrats and 11 Republicans. I’m not sure why these folks did not vote; given the number of Democrats who refused to follow the party-line, this had the potential to turn a vote that was already relatively close into a nail-biter.

[iv] The first four being (i) the Coronavirus Preparedness and Response Supplemental Appropriations Act, (ii) the Families First Coronavirus Response Act, (iii) the Coronavirus Aid, Relief and Economic Security Act, and (iv) the Paycheck Protection Program and Health Care Enhancement Act.

[v] Over 1,800 pages.

[vi] https://www.congress.gov/bill/116th-congress/house-bill/6800

[vii] The Coronavirus Aid, Relief, and Economic Security Act (CARES Act; P.L. 116-136) established the PPP to provide short-term economic relief to certain “small” businesses and nonprofits. The initial authorization of $349 billion for PPP loans was exhausted by April 16, 2020. Congress authorized another $310 billion ($659 billion total) for PPP loans in the Paycheck Protection Program and Health Care Enhancement Act (P.L. 116-139).

[viii] Among other things, it would extend the forgiveness period to cover eligible costs incurred over 24 weeks (rather than the current eight weeks, during which most businesses have been, and will likely remain, closed by government order),

[ix] For example, it would retroactively expand the employee retention credit to cover 80% of as much as $15,000 in compensation per calendar quarter, limited to $45,000 for the year.

For more on the CARES Act’s tax credits, see https://www.taxlawforchb.com/2020/05/opting-out-of-the-ppp-there-are-some-tax-benefits-to-consider/.

[x] It also provides additional direct payments of up to $1,200 per individual; expands paid sick days, family and medical leave, unemployment compensation, nutrition and food assistance programs, housing assistance, and payments to farmers; eliminates cost-sharing for COVID-19 treatments; and extends and expands the moratorium on certain evictions and foreclosures.

[xi] As enacted by the 2017 Tax Cuts and Jobs Act (“TCJA”).

Unfortunately – and ironically – the Act would restore and make permanent the “Republican Tax Act’s” (the TCJA) limit on excess loss deductions for pass-through business losses that was suspended for 2018 through 2020 by the CARES Act. In addition, it would eliminate the CARES Act’s changes to the net operating loss deduction, which allows businesses to carry back losses from 2018 through 2020 for five years; the idea here was to enable qualifying businesses to generate liquidity through tax refunds for earlier years. The TCJA had eliminated the two-year carryback provision that was in effect before 2018.

[xii] IRC Sec. 162.

[xiii] Not a foregone conclusion at the inception of the loan.

[xiv] Subject to IRC Sec. 108, and its “offsetting” reduction of tax attributes; for example, the exclusion of COD from income for an insolvent taxpayer.

[xv] Payments on PPP loans are deferred for the first six months of the loan. Before that period is over, a borrower can apply for forgiveness of the loan for eight weeks of expenses as long as the borrower: (1) maintains the same number of full-time equivalent employees during specified time periods and (2) does not decrease salaries by more than 25 percent for employees that make less than $100,000 in annualized compensation. At least 75 percent of the loan must be used for payroll costs.

Late last week, the SBA issued the Paycheck Protection Program Loan Forgiveness Application, with instructions for calculating the loan forgiveness. OMB Control Number 3245-0407.

[xvi] Section 1106(i) of the CARES Act. In general, forgiven debt (“cancellation of debt income”) is included in the gross income of the borrower and is subject to income taxation. IRC Sec. 61(a)(11).

[xvii] With this said, many businesses could still find that the economic benefits of PPP loans outweigh the potential costs. https://www.taxlawforchb.com/2020/05/ppp-loan-forgiveness-and-the-denial-of-deductions-for-covered-expenses-whats-wrong-with-the-irss-position/

[xviii] It ain’t over till the tax lawyers sing.

[xix] https://www.congress.gov/bill/116th-congress/senate-bill/3612

[xx] Both S. 3612 and H.R. 6800 refer to basis in case an otherwise deductible expense paid with PPP loan proceeds has to be capitalized. See, for example, IRC Sec. 263A.

[xxi]  Sec. 20235 of the Act.

[xxii] For many years now, we have been living with temporary measures. The Code is full of expiration dates. That’s no way to legislate. Business needs certainty; tax decisions should not be made primarily because a provision is expiring – they have to make sense from a business perspective. It’s bad enough that we’re in a general election year, with all the posturing which that entails.

[xxiii] IRC Sec. 11.

If the corporation wanted to eliminate its tax liability, it could make a deductible payment to its shareholders – for example, as “reasonable” compensation – but that would not reduce the aggregate tax liability of the corporation and its shareholders; rather, it would merely shift the tax burden to the shareholders. If the shareholders are individuals, the deductible payment would increase the aggregate tax liability because individuals are currently taxed at a higher maximum rate (37%) than the corporation.

[xxiv] The accumulated earnings tax under IRC Sec. 531 et seq. A corporation with no current or accumulated earnings and profits is not subject to this tax; its distribution of the accumulated funds would not be treated as a dividend for tax purposes. IRC Sec. 301, 312 and 316.

[xxv] Which “eliminates” its accumulated earnings tax problem.

[xxvi] Section 1102(a)(2)(E) of the CARES Act.

[xxvii] https://empirereportnewyork.com/louis-vlahos-economic-losses-blame-the-virus-not-entirely/

So Much Promise

I am not embarrassed to say that I was excited at the introduction of the bill that would eventually be enacted as the CARES Act.[i] In particular, I viewed the Paycheck Protection Program[ii] as a practical means of getting funds into the hands of those closely held businesses that needed them to survive the present economic downturn.[iii]

Even as the legislation evolved in Congress, over a short but stressful period, the basic features of the PPP remained the same: billions of dollars in nonrecourse, unsecured, SBA-guaranteed loans to be used by small businesses to satisfy their payroll costs, rental and utility expenses, as well as interest on certain pre-existing indebtedness; significantly, the loans would be forgiven if businesses could demonstrate that the proceeds were used for their intended purpose; and, finally, such forgiveness would not be treated as income from the discharge of indebtedness for purposes of determining taxable income.

Now Comes the Hard Part

The passage of any legislation, however, is only the first step toward accomplishing its goals. It has to be implemented, which is no easy task in the best of circumstances, let alone during the unprecedented shutdown of much of the nation’s economy, and it can be especially challenging for a measure as complex as the CARES Act.

Granted, the implementation of a law involves some degree of interpretation by the agencies charged with making it work. At times, Congress will authorize an agency to fill in the blanks, as it were.[iv] This process takes time.[v]

In the case of the PPP, however, the timeline was necessarily accelerated. The legislation was enacted on March 27 – by which time, 21 States were already in lockdown[vi] – and PPP loans became available on April 3.[vii] By April 16, the $349 billion appropriated by Congress for PPP loans was gone.[viii] The following week, Congress passed the Paycheck Protection Program and Health Care Enhancement Act,[ix] which authorized an additional $321 billion for the PPP.[x]

During a relatively short period, the SBA has issued, revised and updated its “interim final rule” a total of nine times, most recently on May 8.[xi] The SBA has also issued a number of FAQs[xii] to assist businesses with understanding the PPP; these have been updated approximately fourteen times.

“Economic Need”: What Was Intended?

Although most of these revisions and updates would not be described as “game changers” (though the clarification they have provided is certainly welcome), some of them have caused a number of business owners to second-guess their decision to apply for a loan under the PPP.

The principal reason for this change of heart? The addition of “Question & Answer 31” to the PPP’s hit parade of FAQs:

Question: Do businesses owned by large companies with adequate sources of liquidity to support the business’s ongoing operations qualify for a PPP loan?

Answer: . . . [B]orrowers must assess their economic need for a PPP loan . . . at the time of the loan application. . . . [B]orrowers should review carefully the required certification that “[c]urrent economic uncertainty makes this loan request necessary to support the ongoing operations of the Applicant.” Borrowers must make this certification in good faith, taking into account their current business activity and their ability to access other sources of liquidity sufficient to support their ongoing operations in a manner that is not significantly detrimental to the business. . .[xiii]

How does one define a “large” company? The FAQ merely states: “[I]t is unlikely that a public company with substantial market value and access to capital markets will be able to make the required certification in good faith.” No further guidance is provided.

What constitutes an “adequate source of liquidity?” Must the business make a capital call on its owners if they have the wherewithal to invest more in the business? Must it draw down on its available line of credit?[xiv] Must it exhaust its reserves? Must it reassign funds it had already designated for another business-related purpose? Query whether an approach similar to an “accumulated earnings tax” analysis should be applied; basically, has the borrower accumulated earnings beyond the reasonable needs of the business?[xv] Again, no other guidance has been provided.

This uncertainty – coupled with the risk of civil penalties, or criminal liability for “knowingly” making a false statement – has left the owners and officers of many closely held businesses on edge. They are reluctant to certify as to the “economic need” for the PPP loan – or are at least ambivalent about doing so – in the absence of more definitive rules.

Give It Back?

As if sensing this possibility – but probably not appreciating its breadth – the SBA announced a change to its interim final rule pursuant to which any borrower that applied for a PPP loan prior to April 24, 2020, that was concerned about its eligibility in light of FAQ 31, and that repaid the loan in full by May 7, 2020, would be deemed to have made the required certification in good faith.[xvi] Although this option brought peace of mind to many borrowers, the “squid pro row”[xvii] for such relief was significant: withdrawal from the PPP.

Last week, probably after having received what must have been a number of inquiries regarding the foregoing issues, the SBA issued FAQ 43,[xviii] which extended the repayment date from May 7 to May 14, 2020, thus giving businesses more time to consider their options.

In addition, and as if to dangle a carrot, the SBA issued FAQ 45[xix] to clarify that if a business repays its PPP loan by May 14, 2020, it will be treated as though it had never received a PPP loan for purposes of the Employee Retention Credit.[xx] Therefore, the business may qualify for the credit if it is otherwise an eligible employer for purposes of that benefit.[xxi]

Reduced Benefit?

For those businesses that were not concerned about their eligibility for a PPP loan, their participation in the program lost some of its luster when the IRS recently announced[xxii] that a business with such a loan will not be allowed an income tax deduction for the payment of any payroll costs, rent, and utilities – as directed by the PPP – that would otherwise be deductible by the business, if the PPP loan used to pay these expenses is forgiven, and such debt forgiveness is excluded from the gross income of the business for tax purposes.[xxiii]

These deductions, which were to be generated by using the PPP loan proceeds for their intended purpose – not to mention the resulting tax savings and liquidity – were taken for granted by most loan applicants and their advisers.

In fact, last week, members of the Senate Finance Committee and of the House Ways and Means Committee asked that the IRS reconsider its position. A couple of days later, a bipartisan group of Senators introduced a measure to clarify that the PPP does not affect the tax treatment of ordinary business expenses paid with PPP loan proceeds, with the result that such expenses would remain deductible for purposes of determining taxable income.[xxiv]

It remains to be seen whether the IRS will relent, or whether Congress will overturn the IRS’s position.

Meanwhile, the inexorable march toward May 14 continues.

Seventy-Five Percent?

While the CARES Act provides that a business will be eligible for forgiveness of its PPP loan in an amount equal to the sum of payroll costs and any payments of rent, utilities, and interest on certain indebtedness, made during the eight-week period beginning with the receipt of the loan proceeds,[xxv] the SBA determined[xxvi] that the non-payroll portion of the forgivable loan amount should be limited to 25 percent, whereas at least 75 percent of the PPP loan should be expended for payroll costs.[xxvii]

Many businesses that have already received their PPP loan proceeds have not yet spent the money, primarily because they are still shuttered by order of their state governments. The owners of these businesses don’t see how they can possibly apply the funds to pay salaries while their businesses remain closed and their employees remain at home. Their preference would be to wait until the stay-at-home orders are lifted so they can hire back the employees they have furloughed,[xxviii] and start generating revenue; if their businesses have to spend the funds on payroll now, the owners claim, they will not have the liquidity necessary to reopen and, hopefully, jumpstart their businesses later.

Meanwhile, the clock for the eight-week “covered period” during which the loan proceeds are required to be spent is ticking away.

Other businesses are wondering whether they should have waited longer before applying for a PPP loan, perhaps closer to the statutorily prescribed June 30, 2020 loan origination deadline, by which time there would be a greater chance of their being back in business and of satisfying the “75 percent payroll cost expenditure test” during the eight-week covered period.

Still others are confident that they will never satisfy this 75 percent test because their labor costs are not as significant as their rental costs or capital costs.[xxix] They nevertheless applied for the PPP loan because they needed the money to stay afloat.

Last week, in a letter dated May 5, 2020, a bipartisan group of Senators asked that the Treasury and the SBA consider increasing the threshold for non-payroll expenses from 25 percent to 50 percent. It is anyone’s guess what will happen.

How are these businesses going to fare when, after eight weeks, they apply to their lender for forgiveness of their PPP loan? Will they be saddled with indebtedness that will have to be repaid in two years, albeit at a low rate of interest?[xxx] Perhaps worse, will they be charged with not having certified in good faith as to their intended use of the loan proceeds?

Again, the May 14 “guilt-free” repayment date is approaching.

Next Steps?

The foregoing highlighted some of the thorniest issues facing many businesses that have not yet applied for a PPP loan, as well as those businesses that have already received PPP loans and which may be thinking about whether their applications for forgiveness will be well-received.

With respect to the latter, the SBA has extended the repayment date by a mere seven days.

Although the FAQs’ repayment option was drafted to address the issue of those applicants who, in retrospect,[xxxi] have determined they do not need a PPP loan, it is also available, practically speaking, to any other business that chooses to avoid an inquiry down the road – regarding its eligibility under the PPP, or regarding its certification as to the use of the loan – by repaying the loan and dropping out of the program.

In light of the questions raised by Congress over the deductibility of the payroll costs and other statutorily approved expenses paid with the loan proceeds, and over the appropriateness of applying the 75 percent threshold test to all businesses, the SBA and the Treasury should extend the repayment deadline by a meaningful period so as to allow these matters to be resolved.[xxxii]

PPP Dropout

“Baby don’t blow it, Don’t put my good advice to shame! Baby you know it, Even dear Abby’d say the same!”[xxxiii]

What is left for a business that decides to stay away from the PPP, its ever-changing rules, and its seemingly more elusive promise of loan forgiveness?

Plenty. By choosing not to take a PPP loan, a business is free, within the limits of the law, to let go of employees and to reduce the salaries of whatever employees it retains. Even as to those whom it furloughs, the business may choose to continue paying their health care premiums, as many have.

Rather than using PPP loans to make rental and interest payments for which no tax deduction may be available, the business may seek to renegotiate and or defer its obligations, the payments of which will still be deductible for tax purposes.[xxxiv]

Deferring Employment Taxes

Such a business may also qualify for certain tax benefits from which its participation in the PPP would have precluded it.

For example, the CARES Act allows employers to defer the deposit and payment of the employer’s share of social security taxes.[xxxv]

The deferral applies to deposits and payments that would otherwise be required to be made during the period beginning on March 27, 2020, and ending December 31, 2020. The deferred amounts must be deposited by the following dates (the “applicable dates”): (1) On December 31, 2021, 50 percent of the deferred amount; and (2) On December 31, 2022, the remaining amount.

A business that has received a PPP loan, that has not yet been forgiven, may defer the deposit and payment of the employer’s share of social security tax. However, once an employer receives a decision from its lender that its PPP loan is forgiven, the employer is no longer eligible to defer the deposit and payment of the employer’s share of social security tax that is due after that date.

In order to provide a timeframe within which to consider the benefit of this deferral, a PPP borrower applies to its lender for forgiveness of the loan after the eight-week covered period that began with the borrower’s receipt of the loan proceeds. The lender must issue its decision no more than sixty days after its receipt of the application.[xxxvi]

However, the amount of the deposit and payment of the employer’s share of social security tax that was already deferred through the date that the PPP loan is forgiven continues to be deferred and will be due on the applicable dates.[xxxvii]

A qualifying business may want to take advantage of and maximize this deferral opportunity and the increased liquidity that should arise from it.[xxxviii]

Employee Retention Credit[xxxix]

The CARES Act also provides businesses an Employee Retention Credit which may be claimed by eligible employers for wages paid after March 12, 2020, and before Jan. 1, 2021.[xl]

The credit is available to all businesses that have experienced an “economic hardship” due to COVID-19 – except for businesses that receive PPP loans.[xli] For purposes of this credit, a business experiencing an economic hardship includes one that has suspended its operations due to a government order related to COVID-19, or one that has experienced a “significant decline” in gross receipts.[xlii]

A business may have to fully or partially suspend its operations because a government order limits commerce, travel, or group meetings due to COVID-19 in a manner that prevents the business from operating at normal capacity.[xliii]

A significant decline in gross receipts begins in the first calendar quarter in 2020 in which a business’s gross receipts are less than fifty percent of its gross receipts for the same quarter in 2019.[xliv] The decline ends the first calendar quarter in 2020 after the quarter in which the business’s gross receipts are greater than eighty percent of its gross receipts for the same quarter in 2019. The business calculates these measures each calendar quarter.

The amount of the tax credit is fifty percent of up to $10,000 in “qualified wages” paid to an employee by an employer-business for all calendar quarters.[xlv] Thus, the employer’s maximum credit for qualified wages paid to any employee for all calendar quarters is $5,000. Qualified wages include the cost of employer-provided health care.

The wages that qualify for the credit vary based on the average number of the employer’s full-time employees in 2019. If the employer had 100 or fewer employees on average in 2019, the credit is based on the wages paid to all employees, regardless if they worked or not. If the employer had more than 100 employees on average in 2019, then the credit is allowed only for wages paid to employees for time they did not work.[xlvi] In each case, the wages that qualify for purposes of determining the credit are wages paid for a calendar quarter in which the employer experiences an economic hardship.[xlvii]

Beginning with the second calendar quarter of 2020, to claim the credit, employers should report their total qualified wages and the related health insurance costs for each quarter on their quarterly employment tax returns.[xlviii] The credit reduces, on a dollar-for-dollar basis, the employer’s share of social security taxes on the qualified amounts paid.[xlix]

The credit is refundable because if, for any calendar quarter, the amount of the credit to which the employer is entitled exceeds the employer’s share of the social security tax on all wages paid to all employees, then the excess is treated as an overpayment and is refunded to the employer.  Consistent with its treatment as an overpayment, the excess will be applied to offset any remaining tax liability on the employment tax return and the amount of any remaining excess will be reflected as an overpayment on the return.[l]

Neither the portion of the credit that reduces the employer’s applicable employment taxes, nor the refundable portion of the credit, is included in the employer’s gross income. At the same time, though, the employer’s aggregate deductions would be reduced by the amount of the credit.[li]

Latest Developments re the Credit

It should be noted that, last week, a bipartisan group of lawmakers proposed increasing the amount of the tax credit from $5,000 per employee for the remainder of the year to $12,000 per employee per quarter, thereby making the credit a more valuable and more meaningful economic incentive for employers. The bill would also remove some of the limits, based on the number of employees a business must have, in order to make it easier to qualify for the credit. Stay tuned.

In addition, until last week, the IRS had taken the position that an employer could not qualify for the credit by paying the health plan premiums for employees that have been furloughed and are not being paid a salary by the employer-business. However, in response to a letter from the chairs of the Senate Finance Committee and the House Ways and Means Committee, the Treasury revised the FAQs to change its position.[lii]

Now What?

So much to consider. So little time in which to do it.

There is no sugarcoating the circumstances in which so many businesses find themselves. The new rules that were enacted to help businesses through this period are complex, yet decisions have to be made, and sooner rather than later.

The best a closely held business can do is to review the guidance that’s out there with its advisers, consider the condition of the business, run the numbers, and make the choice with which the business and its owners are most comfortable, but remaining alert for possible changes coming out of Washington.

It isn’t ideal, but . . .


[i] The Coronavirus Aid, Relief and Economic Security Act. P.L. 116-136.

[ii] The “PPP” is found in Sections 1101 through 1107 of the CARES Act.

[iii] https://www.farrellfritz.com/sba-7a-loans-under-the-ppp/

[iv] We (meaning tax people, at least in my world) talk about procedural vs. interpretive vs. legislative rules and regulations.

[v] For example, regulations are proposed, comments are solicited, and hearings are held before the regulations are revised (maybe) and finalized. Alternatively, regulations may initially be issued in temporary form when immediate guidance is needed. The temporary regulation is still treated as a proposed regulation and, so, follows the path outlined above before being finalized.

[vi] That number increased to 30 States by March 30, and 42 States by April 6 (three days after the PPP was launched).

[vii] Though many private lenders – including a few of the “too big to fail” variety (remember them?) – were late in participating and, when they did, several favored customers over others, notwithstanding the first-come, first-serve directive from the government. Oh well. Penalties anyone?

[viii] It should be noted that Section 1114 of the CARES Act directed the SBA to issue regulations to carry out the PPP within 15 days after the date of enactment.

[ix] “CARES Act 3.5.” P.L. 116-139.

[x] It was reported last week that over $100 billion remains available.

[xi] https://home.treasury.gov/policy-issues/cares/assistance-for-small-businesses

[xii] Frequently asked questions.

[xiii] As is often the case, a few bad actors take advantage of a situation, the government overreacts, and many of the intended beneficiaries of legislation are either frozen out, or voluntarily “remove” themselves for fear of the consequences of perhaps being found ineligible.

[xiv] Mind you, the CARES Act suspended the ordinary requirement that SBA borrowers demonstrate they are unable to obtain credit elsewhere. Section 1102(a)(2)(I) of the CARES Act.

[xv] See IRC Sec. 531 et seq. This has been my approach.

[xvi] 85 FR 23450 (April 28, 2020). The SBA, “in consultation with the Secretary [of the Treasury], determined that this safe harbor is necessary and appropriate to ensure that borrowers promptly repay PPP loan funds that the borrower obtained based on a misunderstanding or misapplication of the required certification standard.” Misunderstanding? Misapplication? How about poor drafting and fear of the consequences if one’s interpretation is rejected? The PPP application states that knowingly making a false statement is punishable by a fine and/or imprisonment; this includes the certification as to “need.”

[xvii] From Austin Powers in Goldmember. Translated, “quid pro quo.” Cut me some slack, OK. Starting my ninth week of house arrest – with my mother-in-law. (She’s OK, really.)

[xviii] May 5, 2020.

[xix] May 6, 2020.

[xx] Also passed as part of the CARES Act. Section 2301.

[xxi] More on this later.

[xxii] Notice 2020-32 (April 30, 2020).

[xxiii] https://www.taxlawforchb.com/2020/05/ppp-loan-forgiveness-and-the-denial-of-deductions-for-covered-expenses-whats-wrong-with-the-irss-position/

[xxiv] S.3612.

[xxv] Congress probably thought we’d be back to “normal,” or at least approaching something like it, after eight weeks. Turns out that was wishful thinking.

[xxvi] In an early version of its interim final rule. 85 FR 20811 (April 15, 2020). It should be noted that although this version of the interim final rule was issued on April 2, 2020, and although loan applicants were told they could they rely on such rule, the rule did not become effective until April 15, 2020.

I can tell you that many active real estate businesses (and their advisers) waited for the SBA to modify this version of the interim rule by dropping its per se treatment of real estate development and rental businesses as passive and, thus, not eligible for SBA loans, including under the PPP. See 13 CFR 120.110 and described further in SBA’s Standard Operating Procedure (SOP) 50 10, Subpart B, Chapter 2. Inexplicably, that has not happened, though the industry continues to press Congress and the SBA.

[xxvii] To “effectuate the core purpose of the statute and ensure finite program resources are devoted primarily to payroll.”

[xxviii] Meanwhile, these former employees are receiving state unemployment benefits plus an additional federal benefit of $600 per week; in some cases, they are making more than if they had remained employed.

[xxix] Think of restaurants in large cities. Think of manufacturers.

[xxx] One percent. See the interim final rule. 85 FR 20811.

[xxxi] And with the fear of being lumped together with The Lakers, Ruth’s Chris, and Shake Shack.

[xxxii] After all, it is not the borrower’s fault that they may have applied for the PPP loan based on a “misunderstanding” of the rules.

[xxxiii] With apologies to Frankie Avalon who sang the song “Beauty School Dropout” in the 1978 movie Grease.

[xxxiv] https://www.taxlawforchb.com/2020/04/tax-considerations-as-businesses-prepare-to-emerge-from-the-covid-19-shutdown/

[xxxv] Section 2302 of the CARES Act. This tax is imposed on employers at a rate of 6.2 percent of each employee’s wages that do not exceed $137,700 for the 2020 calendar year.

[xxxvi] Section 1106(g) of the CARES Act.

[xxxvii] https://www.farrellfritz.com/deferral-of-employment-tax-deposits-and-payments-through-december-31-2020/

[xxxviii] The IRS has indicated that the Form 941, Employer’s Quarterly Federal Tax Return, will be revised for the second calendar quarter of 2020 (April – June, 2020), and information will be provided to instruct employers how to reflect the deferred deposits and payments otherwise due on or after March 27, 2020 for the first quarter of 2020 (January – March 2020). In no case will employers be required to make a special election to be able to defer deposits and payments of these employment taxes.

[xxxix] The IRS has issued over 90 Frequently Asked Questions regarding this credit. There is no substitute for reviewing these, including the examples, if a business wants to take full advantage of the credit. https://www.irs.gov/newsroom/faqs-employee-retention-credit-under-the-cares-act

[xl] Section 2301 of the CARES Act. The credit is not available for wages paid after December 31, 2020.

[xli] Recall that a business which repays the PPP loan by May 14, 2020 will be treated as having never participated in the PPP for purposes of determining its eligibility for the credit.

[xlii] FAQ 2. The number of employees an employer has does not affect whether it is an eligible employer that may claim the credit. FAQ 16.

[xliii] FAQ 3.

[xliv] FAQs 4 and 39.

[xlv] FAQs 5 and 47.

[xlvi] An aggregation rule applies which treats all entities under common ownership as one employer, including for purposes of determining who is an eligible employer and for the 100 full-time employee threshold.

[xlvii] See FAQs 51 and 52.

[xlviii] Usually, IRS Form 941, Employer’s Quarterly Federal Tax Return.

[xlix] The employer can receive the benefit of the credit even before filing these returns by reducing their federal employment tax deposits by the amount of the credit. The employer will account for the reduction in deposits due to the Employee Retention Credit on the Form 941.

The IRS has posted Frequently Asked Questions about the ability of a business both to reduce deposits for the credit and to defer the deposit of all of the employer’s share of social security tax due before Jan. 1, 2021, as described earlier.

[l] The employer may request an advance payment of the credit from the IRS. This is done by submitting Form 7200, Advance Payment of Employer Credits Due to COVID-19.

[li] Section 2301(e) of the CARES Act; FAQs 85 and 86.

[lii] May 7, 2020 letter from the Treasury to the Chair of the Senate Finance Committee. See FAQ 64, especially Ex. 2.

The Program

The Paycheck Protection Program[i] has been welcomed by many as the cornerstone of the CARES Act.[ii] It was passed by Congress and signed into law by the President shortly after the government-ordered shutdown of businesses and other organizations[iii] throughout the country as part of the effort to contain the spread of the coronavirus, and in the wake of the economic downturn that followed this countermeasure.

The Program offers many small businesses[iv] – both those that are shuttered and those that remain open – the cash liquidity they need to retain much of their workforce at salaries that approach pre-shutdown levels.[v] It also provides these businesses the wherewithal to pay their rent and utilities, as well as certain other pre-existing indebtedness.

The Federal government, working through private lenders,[vi] is making the above-referenced funds[vii] available to an eligible business through a nonrecourse, unsecured, 100 percent government-guaranteed loan.

The first PPP loans were made on April 3 – only one week after enactment of the Program – and will continue to be offered, provided funds are available, until June 30, 2020.[viii]

PPP Loan Forgiveness

A key feature of the Program provides that a business will not be required to repay the principal amount of its PPP loan[ix] if the business uses the loan proceeds for certain statutorily prescribed purposes[x] – specifically, payroll costs, rent, utilities, and certain pre-existing indebtedness – over the eight-week period that begins with its receipt of the proceeds.[xi]

In order to fully enjoy this benefit, the business must be able to adequately substantiate its use of the proceeds.[xii] Moreover, the business must not have reduced its employee workforce or the total salary of any of its employees[xiii] during the eight-week period.[xiv]

These requirements – that the loan be used to retain workers and maintain payroll, to make lease and utility payments[xv] – are basically the same purposes that a business represents on its PPP loan application as its reasons for seeking the loan.[xvi]

Once the loan is forgiven, the SBA will remit to the lender (no later than 90 days after the date on which the amount of the forgiveness is determined) funds equal to the amount forgiven, plus any interest accrued thereon;[xvii] thus, the government will indemnify the lender for its “loss.”

Through this mechanism, a business that fully satisfies its obligations under the Program may effectively be treated as having received a grant of money from the government.[xviii]

Forgiveness: Tax Treatment

According to the legislation, for Federal tax purposes, the amount of any PPP loan which is forgiven, as described above, will be excluded from the gross income of the borrower-business,[xix] notwithstanding that it would otherwise have been includible as income from the discharge of indebtedness.[xx]

In terms that a child would appreciate – yes, I’m a big kid – if forgiveness of the PPP loan was the whipped cream on a sundae, the exclusion of such loan forgiveness from income was the cherry on top.[xxi]

The CARES Act is otherwise silent as to the tax treatment of the cash flows under the Program. It does not address (i) the receipt of the loan proceeds by the business, (ii) the receipt of the salary by the employees of the business, or the receipt of the rent by the business’s landlord, and (iii) the payment of the foregoing expenses by the business.

Moreover, neither the Senate nor the House has contemporaneous legislative history regarding the CARES Act, such as a committee report or technical explanation, which sheds light on these tax issues; and although the Joint Committee on Taxation has prepared a helpful summary of the legislation’s tax provisions, it does nothing more than repeat the language of the forgiveness provision.[xxii]

Borrowed Funds, Generally

If we accept the PPP loan as bona fide indebtedness – i.e., its forgiveness is not a foregone conclusion[xxiii] – then the business’s receipt of the loan proceeds should not be includible in the gross income of the business for purposes of determining its income tax liability. On these facts, as in the case of any other loan, the business has not realized an accretion in value; the loan has to be repaid.

In general, the business’s use of borrowed proceeds does not affect the tax treatment of the expenditures made by the business using such proceeds. Thus, a business that uses loan proceeds to satisfy its ordinary and necessary operating expenses, including, for example, reasonable salaries and rent, may nevertheless deduct the expenses in determining its taxable income.[xxiv] Similarly, if the borrowed sums are used to acquire depreciable property for use in the business, the business may claim depreciation deductions[xxv] in respect of such property.[xxvi] If the loan is used to acquire inventory, the amount so expended is added to cost of goods sold.[xxvii]

The flipside of this favorable tax treatment? The business may not deduct its repayment of the loan principal.[xxviii]

Much the same way that the use of borrowed funds by a business generally does not affect its tax treatment of the business expenditures made using such funds, the tax treatment of the recipient of those payments does not depend upon their origin as loan proceeds. Thus, the employee to whom salary is paid using these proceeds, or the landlord to whom rent is paid using borrowed funds, must include the amount received in its gross income for purposes of determining its tax liability.[xxix]

Application for Forgiveness

Unlike most loans, the Program allows a business to apply for forgiveness of its PPP loan. Such an application may be filed after the end of the eight-week period during which the loan proceeds are supposed to have been used for their legislatively mandated purposes, and must include documentary evidence that demonstrates the business’s use of the loan proceeds and supports its request for forgiveness of the loan.

The lender has 60 days after receipt of the borrower’s application to issue a decision thereon.[xxx] Until the PPP loan is forgiven, it remains a debt of the business.[xxxi]

Reasonable Assumption?

In light of the foregoing, and given the overall emphasis of the CARES Act’s tax provisions on assisting businesses with generating liquidity,[xxxii] – presumably for the period following the forgiveness of the PPP loan, during which businesses will likely not be operating at pre-lockdown levels – many businesses that have applied for PPP loans, and many that have already received them, and have been making payments using the proceeds from such loans, have done so under the assumption that such payments will be deductible for tax purposes.

The IRS Finally Speaks

On April 30, 2020, however, the IRS issued Notice 2020-32 (the “Notice”) – more than one month after the enactment of the Program, and almost four weeks after the submission of the first PPP loan applications.

According to the Notice, it “clarifies” that no deduction will be allowed under the Code for an expense that would otherwise be deductible by a business if the payment of the expense – i.e., the use of the loan proceeds by the business for payroll costs, rent and utilities, in accordance with the terms of the Program – results in forgiveness of a PPP loan pursuant to the CARES Act, and the income associated with such forgiveness is excluded from gross income for tax purposes.[xxxiii]

The CARES Act, the Notice states, provides that, for purposes of the Code, any amount which would otherwise be includible in the gross income of the borrower-business, by reason of the forgiveness of the PPP loan under the Program, “shall be excluded from [the] gross income” of the business. The Notice explains that this includes “any category of income that may arise from loan forgiveness under the Program, regardless of whether such income would be (1) properly characterized as income from the discharge of indebtedness under section 61(a)(11) of the Code, or (2) otherwise includible in gross income under section 61 of the Code.”

Before continuing with our summary of the Notice, query to what other category of income the IRS is referring therein that may arise from loan forgiveness? It is obvious that the relationship between the creditor and the debtor may result in the forgiveness being treated as something other than cancellation of indebtedness income; thus, for example, the forgiveness of a loan may be treated as a gift, a contribution to capital, an adjustment or credit to purchase price, compensation for services or for the use of property, or a distribution. However, with the exception of a “contribution to capital,”[xxxiv] none of these alternative treatments makes any sense in the context of a PPP loan.

The Notice concedes that the CARES Act does not address whether deductions otherwise allowable under the Code for payments of “eligible expenses” by the borrower-business will still be allowed if the PPP loan is subsequently forgiven “as a result of the payment of those expenses.”

As stated earlier, the Code generally provides for a deduction for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. The rent obligations, utility payments, and payroll costs paid comprise typical trade or business expenses for which a deduction under the Code is usually appropriate.

The Notice points out, however, that no deduction is allowed to a taxpayer under the Code for any amount, otherwise allowable as a deduction, that is allocable to one or more classes of income that are wholly exempt from the income tax.[xxxv] The purpose of this rule is to prevent a double tax benefit: the deduction of the payment made with the loan proceeds and the subsequent exclusion of such loan proceeds from gross income notwithstanding the forgiveness of the loan.

This disallowance provision, the Notice explains, applies to otherwise deductible expenses incurred for the purpose of earning or otherwise producing tax-exempt income. It also applies where tax-exempt income is earmarked for a specific purpose and deductions are incurred in carrying out that purpose.[xxxvi]

The Notice explains that, to the extent the CARES Act operates to exclude from gross income the amount of a forgiven PPP loan, it results in a “class of exempt income.” Therefore, the Notice concludes, the Code disallows any otherwise allowable deduction for the amount of any payment of an eligible PPP expense to the extent of the resulting loan forgiveness because such payment is allocable to tax-exempt income. “This treatment,” the Notice observes, “prevents a double tax benefit.”

According to the Notice, this conclusion is consistent with prior guidance of the IRS which provides that, where tax-exempt income is earmarked for a specific purpose, and expenses are incurred in carrying out that purpose, the Code denies the deduction of such expenses because they are allocable to the tax-exempt income. The Notices states that the direct link between (1) the amount of tax-exempt loan forgiveness that a PPP loan recipient receives pursuant to the CARES Act, and (2) an equivalent amount of the otherwise deductible payments made by the recipient for expenses, constitutes a sufficient connection for the Code to disallow deductions for such payments under any provision of the Code, to the extent of the income excluded under the CARES Act.[xxxvii]

How “Strong” is the Notice?

The IRS’s reasoning for denying a deduction to a business that uses its PPP loan proceeds in accordance with the legislative mandate of the CARES Act to retain its employees and to maintain their salaries is somewhat misguided; it also presents a “chicken and egg” problem.

The Notice relies upon the tax treatment of costs (i) that are incurred for the generation of income that is intrinsically tax-exempt, without regard to the actions of the taxpayer, or (ii) that are paid with funds that are intrinsically tax-exempt, without regard to the actions of the taxpayer.

It then tries to equate these situations with the exclusion from gross income for any debt forgiveness that may be granted to a business which uses its PPP loan proceeds to pay the salaries of its employees (among other things); thus, on the one hand, it treats the loan as if it were not a loan but, rather, a tax-exempt grant, and on the other, it treats the forgiveness (and the attendant exclusion from income) as the tax-exempt income to be generated by the expenditure of the funds for the directed purpose.

An Alternative

Fortunately, there is a better alternative, one that is both more in line with the economic goal of the CARES Act, and more defensible from a tax perspective. This alternative is premised on respecting the PPP loan as such.

The cancellation of a taxpayer’s indebtedness is generally treated as ordinary income.[xxxviii] There are circumstances, however, in which the taxpayer is not required to recognize such income.[xxxix] For example, the Code has long provided that the income realized by a taxpayer by reason of the discharge of the taxpayer’s indebtedness will not be included in the taxpayer’s gross income if the discharge occurs in a bankruptcy proceeding[xl] or when the taxpayer is insolvent, to the extent of such insolvency.[xli] Over the years, additional non-recognition situations have been added to the Code for which Congress has determined that recognition of discharge of indebtedness income, and the resulting tax liability, would not serve society well.[xlii]

That is not to say that Congress decided to give taxpayers a free ride under the cancellation of indebtedness rules, having allowed them to spend the borrowed funds, claim deductions therefor, and still avoid the recognition of income upon the discharge of such indebtedness.

Rather, Congress has recognized that such immediate recognition would not be appropriate under the circumstances, when the debtor business was likely in need of liquidity.[xliii] However, in recognition of the accretion in value realized by the debtor, and in order to recapture the tax benefit bestowed upon the debtor by reason of the exclusion of the discharged indebtedness from the gross income of the business, Congress required the business to reduce certain tax attributes[xliv] which, over time, would otherwise have reduced the tax liability of the business. In this way, the business repays the tax benefit over time.[xlv]

Why wouldn’t this approach apply under the current circumstances? It would provide the borrower-business with badly needed liquidity for the post-PPP loan period, while also ensuring that the business, assuming it survives, does not enjoy a double tax benefit.

We are still in the early stages of the Program. The IRS should reverse the position set forth in the Notice. If it unwilling to do so, Congress has time to act before the appropriate tax returns have to be filed.


[i] The “PPP” or the “Program”. See Sections 1101-1107 of the CARES Act.

[ii] The Coronavirus Aid, Relief and Economic Security Act. Pub. L. 116-136.

[iii] Other than those deemed “essential.” The President declared a national state of emergency on March 13, 2020, and the legislation was enacted on March 27, 2020.

As I write this, some states are already taking steps to reopen their economies. I’m certain they mean well, but like Theoden when he led his people to Helm’s Deep, I fear they too are underestimating the threat facing them.

[iv] See Section 1102(a)(2)(D) of the CARES Act. The definition of “small business” has been the subject of much discussion over the last couple of weeks. If I were feeling magnanimous, I’d say that Congress was sloppy. The problem with that, though, is that Congress was pretty specific in the language chosen to describe what it meant by “small.” Because I’m not in a generous mood, I’m inclined to say that Congress got caught. That’s a subject for another day.

[v] Notwithstanding that many of these employees were in no position to work because the employer-businesses were still closed by government order. Indeed, many employees requested to be fired by their employers in order to qualify for state unemployment benefits which, when supplemented by the $600 per week stipend payable by the Federal government under the CARES Act, put them in a better position economically than if they had remained employed. Go figure. I seem to recall some Senators predicting that would happen. Again, that’s another subject for another day.

[vi] Many of whom seem to have forgotten a certain bailout not that long ago.

[vii] The CARES Act appropriated $349 billion for this purpose. On April 16, the Program announced it had run out of money. The following week, Congress passed the “Paycheck Protection Program and Health Care Enhancement Act” (“CARES Act 3.5”), which authorized an additional $321 billion for the Program.

[viii] Section 1102(a)(2) of the CARES Act.

[ix] Section 1106(b) of the CARES Act.

[x] Which were subsequently modified somewhat by the Small Business Administration and the Department of the Treasury. For example, the statute does not specify what portion of the loan proceeds must be applied toward the payment of payroll costs – the SBA, however, has indicated that at least 75 percent of the proceeds must be so used. See Q&A 2.o. in Part III of the interim final rule, Business Loan Program Temporary Changes; Paycheck Protection Program, Docket No. SBA-2020-0015, 85 Fed. Reg. 20811, 20813-20814 (April 15, 2020).

In some cases, this is simply impossible. Take for example, the case of a business, like a restaurant, that typically has relatively low payroll costs and high rent.

[xi] In the case of a loan made on June 30, for example, the eight-week period will end on August 24, 2020.

[xii] Section 1106(e) and (f) of the CARES Act.

[xiii] This applies only to an employee with an annualized salary of not more than $100,000. What’s more, such an employee’s salary may be reduced by up to 25 percent without adverse consequences to the employer. Section 1106(d)(3) of the ARES Act.

[xiv] Section 1106(d) of the CARES Act. However, the statute also affords the business the opportunity to cure these failures no later than June 30, 2020. Section 1106(d)(5).

[xv] See the definitions in Section 1106(a) of the CARES Act.

[xvi] To the extent the business fails to satisfy the above requirements, at least a portion of the loan will remain outstanding; according to the statute, the loan will bear interest at an annual rate not to exceed 4 percent, and will be payable over a term not to exceed ten years.

The SBA has set the interest rate at 1 percent and the term of the loan at 2 years; what’s more, the repayment schedule includes a six-month deferral.

[xvii] Section 1106(c)(3) of the CARES Act.

[xviii] Think of it as a quasi-“substance over form” analysis.

[xix] Section 1106(i) of the CARES Act.

[xx] IRC Sec. 61(a)(11); Reg. Sec. 1.61-12; IRC Sec. 108.

[xxi] The open question, until last week, was whether that sundae also came with sprinkles or peanuts?

What? Were you expecting a reference to celery dipped in hummus, with flax seeds drizzled over it? C’mon.

[xxii] Joint Committee on Taxation, Description of the Tax Provisions of Public Law 116-136, the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act (JCX-12R-20). See page 104.

April 23, 2020.

[xxiii] In light of the uncertainty expressed by many loan recipients over how and when they are to spend the proceeds, the SBA may end up with more debtors than they bargained for.

[xxiv] IRC Sec. 162.

[xxv] Including bonus depreciation.

[xxvi] IRC Sec. 167.

[xxvii] IRC Sec. 263A.

[xxviii] As distinguished from the interest paid by the borrower to the lender in exchange for the use of the lender’s funds. The tax treatment of such interest payments may depend upon the uses to which the funds are put. IRC Sec. 163.

[xxix] IRC Sec. 61.

[xxx] In the case of a PPP loan made on June 30, the eight-week period ends on August 24; if the business applies to the lender for forgiveness on August 25, the lender has 60 days – until October 24, 2020 – to decide whether the business qualifies for forgiveness. Section 1106(g) of the CARES Act.

[xxxi] Albeit one that, by statute, is unsecured, nonrecourse, and guaranteed by the Federal government.

[xxxii] For example, the relaxation of the NOL, excess business loss, and interest deduction rules, and the delay of payment of the employer share of payroll taxes. See Section 2301 through 2308 of the CARES Act. https://www.taxlawforchb.com/2020/04/tax-considerations-as-businesses-prepare-to-emerge-from-the-covid-19-shutdown/

[xxxiii] Section 1106(i) of the CARES Act.

[xxxiv] In the sense of IRC Sec. 118. See the changes made thereto by the Tax Cuts and Jobs Act.

[xxxv] The Notice cites IRC Sec. 265(a)(1) and Reg. Sec. 1.265-1.

The term “class of exempt income” means any class of income that is either wholly excluded from gross income under the Code or wholly exempt from taxes under the provisions of any other law. Reg. Sec. 1.265-1(b)(1).

[xxxvi] In which case, the deductions are treated as allocable to the tax-exempt income.

[xxxvii] Inexplicably, the Notice finishes its discussion by stating that the deductibility of payments is also subject to disallowance where the taxpayer is reimbursed for such payments. This is a corollary to the tax benefit rule under which the gross income for a tax year includes the recovery in that year of an expense deducted in another.

Although the concepts underpinning the rule may be extended to other scenarios, the debt forgiveness in question is not one of them.

[xxxviii] IRC Sec. 61(a)(11).

[xxxix] IRC Sec. 108(a).

[xl] IRC Sec. 108(a)(1)(A).

[xli] IRC Sec. 108(a)(1)(B) and 108(a)(3).

[xlii] For example, IRC Sec. 108(a)(1)(D), which was added in 1993, in response to the housing bust of the early 1990s, when, by reason of a significant and sudden drop in the real estate market, owners found themselves with property that was underwater.

[xliii] There is an exception. Under IRC Sec. 108(e)(2), if an accrual basis taxpayer claimed a deduction for an expense that was later forgiven, the taxpayer would have to recognize the discharged liability as income.

[xliv] In an amount determined by reference to the amount of debt discharged that was excluded from income. IRC Sec. 108(b)(3).

[xlv] IRC Sec. 108(b). Among these tax attributes are NOLs, capital loss carryovers, the basis of property, and various credits.

For a somewhat analogous situation, see also IRC Sec. 118 and Sec. 362. According to Sec. 118 of the Code, prior to its amendment in 2017, gross income did not include any contribution to the capital of a corporation made by persons who are not shareholders of the corporation. This included a contribution from a governmental entity, provided the funds were used for certain capital expenditures and not for operating expenses. Assuming the funds were properly used and capitalized, the taxpayer was required to reduce their basis for the property acquired, thus ensuring the subsequent recognition of the “exempted” contribution.

We’ve Been Better

On March 1, 2020, New York had its first confirmed case of the coronavirus.[i] On March 6, pursuant to the Coronavirus Preparedness and Response Supplemental Appropriations Act[ii], over $8.3 billion in emergency Federal funding was appropriated to combat the spread of the coronavirus. On March 7, Governor Cuomo declared a state of emergency in New York.[iii] On March 13, President Trump declared a national state of emergency.[iv] On March 18, the Families First Coronavirus Response Act[v] became law. On March 20, Governor Cuomo signed the “New York State on Pause” Executive Order,[vi] which resulted in the statewide closure of many so-called “non-essential” businesses, and caused other such businesses to operate “remotely.”

On March 27, the President signed the Coronavirus Aid, Relief and Economic Security (“CARES”) Act[vii] which, among other things, created the $349 billion Paycheck Protection Program (“PPP”) to assist “small businesses” with 100 percent SBA-guaranteed forgivable loans. Last week saw the enactment of yet another coronavirus relief bill, which authorized an additional $321 billion of funding for the PPP.[viii]

Although this massive infusion of cash will certainly help many closely held businesses survive through this difficult period, many others are going to fail regardless of the government’s best intentions.[ix] What’s more, it is reasonable to assume that, even among those that survive, most are not likely to fully recover for many months to come given the state of the economy. For example, as of the end of last week, the estimated number of unemployment claims filed in the U.S. was approximately 26 million; the first quarter GDP is expected to show a decline of more than 3 percent, while the second quarter is expected to register a 25 percent drop in economic growth; other economic indicators are following suit.[x]

Then there are the state and local governments that have thrown their budgets out the proverbial window. Many of these are experiencing severe economic stress as tax revenues have plummeted, in part due to the reduction in economic activity, and in part because of the deferrals granted to taxpayers for the payment of various taxes.[xi] It may not be long before these public employers start to lay off workers and to cut services.

Time to Start Looking Forward?

In light of the foregoing, it may be difficult for a business owner to start thinking about, let alone implementing, a plan for what will likely be an uncertain – perhaps even “hostile” – economic and tax environment for business once the nation re-opens.

Granted, there are many factors beyond the control of any business that may nevertheless have a significant impact upon the well-being of the business; for example, the relaxation of social distancing measures. However, there are other factors that, generally speaking, may be controlled, or at least influenced, by the owner – it is these factors to which the owner should devote their attention so as to prepare themselves and their business to withstand the difficult times ahead.

One goal on which businesses and the Federal government are both focused is the relatively immediate generation of liquidity in the private sector. The CARES Act provided a number of means by which this may be accomplished – it is up to the business and its owners to take advantage of the opportunities presented.

PPP Loan Forgiveness

It seems as though everyone and their brother[xii] has applied for a PPP loan.[xiii] A business which has received the requested loan proceeds has eight weeks from such receipt to expend the funds on permitted expenses, including “payroll costs,”[xiv] rent, utilities, and certain other items.

After the eight-week period, the business may apply to its lender for forgiveness of the loan. In order to secure this benefit, the business will have to provide documentation that demonstrates how it has spent the funds, including proof that at least 75 percent of the funds were applied toward payroll costs.

Any loan that is forgiven in accordance with the terms of the PPP will not be included in the gross income of the borrower-business as income from cancellation of indebtedness.[xv]

At the same time, nothing in the CARES Act denies the borrower-business the ability to claim a deduction for the expenses paid with the loan proceeds in determining the taxable income of the business.[xvi] Thus, the payment of the salaries, rent, etc. for which the PPP loans are intended will be deductible, thereby reducing taxable income or increasing losses.

However, the amount of the loan forgiven may be reduced – meaning that a portion of the loan will have to be repaid[xvii] – if the business has reduced by more than 25 percent the salary of any employee with an annual salary of not more than $100,000. Likewise, the loan forgiveness may be reduced if a business reduces its number of employees.

Notwithstanding that a business may have reduced salaries and/or workforce, it may still qualify for full forgiveness of the PPP loan (as well as any accrued interest) if the business restores salaries and fills “vacant” positions no later than June 30, 2020.[xviii]

It should be noted that there is nothing in the PPP that prevents a business from reducing the salaries of employees whose salaries exceed $100,000. Moreover, the legislation does not prohibit the reduction of salaries or workforce at any level after the end of the eight-week spending period. Thus, a business that survives long enough to spend the PPP loan proceeds in accordance with the statute is not required to maintain salary levels or to retain employees if the business cannot afford to do so.

Building Liquidity: Tax Refunds, Tax Reductions

The PPP will support the continued existence of some closely held businesses that do not lay off their employees and do not cut their salaries, especially those businesses that had few reserves[xix] before they were suddenly shut down. But will it help these businesses to “reboot” after the health crisis passes?

Not necessarily.

Other parts of the CARES Act, however, may assist certain businesses to obtain some badly needed cash relatively quickly, and to thereby mitigate the economic effects of the health crisis.[xx]

I am referring to the few business tax-related provisions in the legislation. Most of these are not “new” tax benefits or incentives; rather, they represent the temporary relaxation of amendments enacted as part of the Tax Cuts and Jobs Act of 2017 (the “TCJA”).[xxi]

In sum, the intended effect of the CARES Act’s tax provisions is to allow businesses that realized losses during prior years (before 2020) to convert those losses into refunds that will be payable (and usable) currently, and to permit business owners to use other losses to offset otherwise taxable income, thereby enabling those tax dollars to be applied elsewhere.

In light if these changes, businesses should review earlier year returns to see if a refund is available. If a business believes it has overpaid tax for 2019, it should file its tax return and claim a refund as soon as possible.

Delay Tax Payments

The due date for filing Federal income tax returns and, more importantly for our purposes, for making Federal income tax payments otherwise due April 15, 2020, was automatically postponed to July 15, 2020.[xxii]

Unless a business is owed a refund for 2019, it should probably take advantage of the deferral.

NOLs

Historically speaking, in the case of a business coming out of an economically challenging period, the ability to carry current losses back to profitable years often provided a ready source of liquidity by generating a refund of monies that the business could use in its operations.

The TCJA eliminated a taxpayer’s ability to carry back its NOLs. It also limited the use of loss carryovers to a taxable year to 80 percent of the taxpayer’s taxable income for such year, though it permitted NOLs to be carried forward indefinitely.[xxiii]

The CARES Act allows a taxpayer that realizes an NOL during a taxable year beginning after December 31, 2017 and before January 1, 2021 to carry such NOL back to each of the five taxable years preceding the year of the loss; for example, a loss arising in 2020 may be carried back to 2015.[xxiv]

The CARES Act also repealed the “80 percent of taxable income” limitation for NOL carryovers arising in taxable years beginning before January 1, 2021.[xxv]

Thus, a taxpayer that realized an NOL during a taxable year beginning in 2018 or in 2019 may carry those NOLs back five years, which may create an opportunity for a refund claim in 2020 with respect to an earlier year for which the taxpayer had an income tax liability.

In addition, an NOL realized in a taxable year beginning in 2018 that is carried to 2019 and 2020, and an NOL realized in a taxable year beginning in 2019 that is carried back to 2018 and forward to 2020, may be utilized without regard to the TCJA’s “80 percent limitation” – the NOLs may be used to offset all of the taxpayer’s taxable income.[xxvi]

Unfortunately for a taxpayer that suffers a loss during a taxable year that begins in 2020, the tax benefit attributable to the carryback of such loss will not be realized until the taxpayer files its return for that year, in 2021, which is still several months away. That is not to say that a refund at that time would not be welcomed – it’s just that the liquidity it may provide would likely be more helpful sooner rather than later.

That being said, the tax benefit attributable to the realization of significant losses in 2020 may be used to facilitate certain strategic transactions during 2020. For example, if a business operated through a corporation wants to dispose of an unwanted asset, the NOLs may be used to offset the gain from such disposition. The same reasoning may apply with respect to the taxable spin-off of a line of business to one or more of the corporation’s shareholders.[xxvii] Similarly, if a corporation with losses incurred during 2020 is planning the sale of its assets, it may want to complete the sale in 2020, before the reinstatement of the 80 percent limitation in 2021.

Non-Corporate Taxpayer Losses

Following the enactment of the TCJA, for taxable years beginning after December 31, 2017 and before January 1, 2026, the “excess business losses” of a taxpayer other than a corporation are not allowed for the taxable year. Instead, such losses are carried forward and treated as part of the taxpayer’s NOL carryforward in subsequent taxable years.[xxviii]

A taxpayer’s excess business loss for a taxable year – which is determined after the application of the passive loss rules – is the excess of the aggregate deductions of the taxpayer attributable to trades or businesses of the taxpayer, over the sum of aggregate gross income or gain of the taxpayer (whether or not related to a trade or business) plus a “threshold amount.”[xxix]

This provision was to be effective for taxable years beginning after December 31, 2017, but the CARES Act defers the effective date (actually, suspends it retroactively) to taxable years beginning after December 31, 2020.

Consequently, an individual taxpayer who realizes a loss from an operating business in a taxable year beginning before January 1, 2021 – whether as a sole proprietor, as a partner in a partnership, or as a shareholder in an S corporation – and who runs the gauntlet of the basis, at risk and passive loss rules,[xxx] will be allowed to apply such losses against their other income for such taxable year, including salary and investment income.

As in the case of NOLs described above, this change will afford some taxpayers an opportunity to claim a refund now with respect to their taxable years beginning in 2018 and 2019, and to use the proceeds therefrom in their business.

Business Interest Deductions

Generally speaking, interest paid or accrued by a business is deductible in the computation of taxable income, subject to a number of limitations. The TCJA further limited the deduction for business interest for a taxable year to an amount equal to 30 percent of the adjusted taxable income[xxxi] of the taxpayer for the taxable year. The amount of any business interest not allowed as a deduction for any taxable year is treated as business interest paid or accrued in the succeeding taxable year, and is carried forward indefinitely, subject to certain restrictions.[xxxii]

The limitation does not apply to taxpayers with average annual gross receipts for the three-taxable year period ending with the prior taxable year that do not exceed $25 million. In addition, at the taxpayer’s election, any real property trade or business is not treated as such for purposes of the limitation, and therefore the limitation does not apply to such a trade or business.

This rule applies to taxable years beginning after December 31, 2017. However, according to the CARES Act, in the case of any taxable year beginning in 2019 or 2020, the Act increases the “interest deduction limitation” from 30 percent to 50 percent of adjusted taxable income.[xxxiii]

In this way, a taxpayer filing their income tax return for 2019 may take advantage of the increased limitation to further reduce their income tax liability and to retain the tax savings in the business.

In addition, for a taxable year beginning in 2020, the Act permits a taxpayer to use their 2019 adjusted taxable income for purposes of determining their “interest deduction limitation” for 2020. Thus, if the taxpayer’s 2019 adjusted taxable income is greater than that for 2020 – which may very well be the case given our circumstances today – the taxpayer may claim a greater interest deduction and, thereby, further reduce their income tax liability, thereby retaining liquidity in the business.

Although the relaxation of the limitation on interest deductions[xxxiv] may entice a taxpayer to borrow funds from commercial lenders during 2020, it is important for the taxpayer to recognize that the TCJA’s 30 percent cap will be reinstated in 2021.

Real Estate

As indicated above, a taxpayer with a real property trade or business may have elected out of the application of the interest limitation rule.[xxxv] In doing so, the electing taxpayer was precluded from claiming bonus depreciation,[xxxvi] and was required to extend the depreciation period for its real properties.[xxxvii]

In recognition of the CARES Act’s increase of the interest limitation from 30 percent to 50 percent of adjusted taxable income, the IRS has issued guidance[xxxviii] that allows a qualifying taxpayer to withdraw their earlier election, and to thereby claim an increased depreciation deduction (including bonus depreciation)[xxxix] for those years to which the election would otherwise have applied.

Thus, a real estate business that reverses its election out of the interest limitation regime may thereby have another opportunity for a refund of taxes paid.

Like Kind Exchanges

Most like kind exchanges are effected as deferred exchanges, with the replacement real property being acquired sometime after the sale of the relinquished real property. Generally speaking, in order for such a transaction to qualify for tax deferral as a like kind exchange,[xl] the replacement property must be identified no later than 45 days after the date of the sale of the relinquished property (the “identification period”),[xli] and it must be acquired no later than 180 days after the date of such sale (the “exchange period).[xlii]

The above-described dates are prescribed by statute and, generally, cannot be changed by the IRS. However, because the President declared a national emergency,[xliii] the IRS was authorized to postpone the time for taxpayers to perform specified “time-sensitive actions,”[xliv] including the identification of a replacement property, and the acquisition of such replacement property, in connection with a transaction intended to qualify as a like kind exchange.

Specifically, the IRS has determined that identification and exchange period deadlines occurring between April 1 and July 15, 2020 (the “relief period”) are extended to July 15, 2020. Any such period that does not end within the relief period is not affected.

Thus, a taxpayer that began an exchange before or during the relief period may want to take advantage of the extended identification or replacement period in order to avoid a taxable event and the resulting outflow of cash to pay the tax liability.

Deferring Employment Taxes

The CARES Act allows employers to defer the deposit and payment of the employer’s share of social security taxes.[xlv]

The deferral applies to deposits and payments that would otherwise be required to be made during the period beginning on March 27, 2020, and ending December 31, 2020. The deferred amounts must be deposited by the following dates (the “applicable dates”): (1) On December 31, 2021, 50 percent of the deferred amount; and (2) On December 31, 2022, the remaining amount.

Employers who have received a PPP loan, that has not yet been forgiven, may defer deposit and payment of the employer’s share of social security tax. Once an employer receives a decision from its lender that its PPP loan is forgiven, the employer is no longer eligible to defer the deposit and payment of the employer’s share of social security tax that is due after that date. However, the amount of the deposit and payment of the employer’s share of social security tax that was already deferred through the date that the PPP loan is forgiven continues to be deferred and will be due on the applicable dates.[xlvi]

A qualifying employer may want to take advantage of this deferral opportunity and the increased liquidity that should arise from it.[xlvii]

Executive Compensation

Thus far, we have been considering how opportunities afforded by the CARES Act, including IRS actions related thereto, may assist a taxpayer in generating liquidity to replace the revenues lost as a result of the shutdown and the resulting economic downturn.

Of course, a business may also try to save money by reducing the salaries of highly compensated employees. As indicated below, this may be easier said than done; nonetheless, a business should consider all of its options, being mindful, however, of the tax and other potentially adverse consequences thereof.

For example, a reduction in salary may give an executive the right to terminate their employment “for good reason,” thereby triggering an immediate obligation for the employer to make severance payments under an employment agreement.[xlviii]

Similarly, a termination of employment, or a reduction in work hours, may trigger the payment of deferred compensation under the terms of a nonqualified deferred compensation agreement.[xlix]

A business may also consider the suspension of contributions toward an executive’s future deferred compensation benefit provided their agreement allows such a suspension or the employee agrees to it.[l]

The business may also seek to suspend or defer payments to be made to an executive pursuant to a nonqualified deferred compensation plan. However, such a deferral may violate Section 409A of the Code – thereby triggering imposition of a 20 percent excise tax on the executive – unless it can be demonstrated that the current payment would “jeopardize” the business as a going concern.[li]

If the plan allows the participating executive an election to delay a payment or to change the form of a payment, such an election may not take effect until at least 12 months after the date on which the election is made,[lii] and the payment with respect to which the election is made must be deferred for a period of at least 5 years from the date such payment would otherwise have been made.[liii]

Alternatively, a business make also seek to terminate such a plan; however, such a termination will likely violate Section 409A because it is being made in connection with the “downturn” in the health of the employer’s business.[liv] Instead, the executive and the business may negotiate a reduction in the benefits to be provided to the executive without violating Section 409A, provided they do not agree to substitute another, “replacement” benefit.[lv]

Incentive Compensation

When cash pipeline is constricted, a business may have difficulty in paying executive bonuses or raising executive salaries. In that case, in order to keep its executives incentivized, the business may want to consider some form of equity-based compensation arrangement.

Where the actual issuance of equity is not “required,”[lvi] an arrangement similar to a so-called “phantom stock” plan may be advisable. Such a plan may try to mimic the economics of actual ownership (for example, by paying compensation to an executive) when the business makes distributions to its owners, or it may simply provide for a payment upon the sale of the business, with the amount thereof being based upon a percentage of the net proceeds.

Moreover, the phantom equity plan may be structured to defer income recognition, and the resulting tax liability, until the occurrence of a liquidity event.

Renegotiating Debt

Many businesses will emerge from the shutdown still owing whatever long-term debt they had previously incurred.[lvii] Some of these same businesses may have to borrow additional sums in order to replenish inventories and supplies, to pay amounts owing to vendors, or perhaps to “disinfect” their place of business.[lviii]

The business may ask its existing lender to consider a modification of the terms of the indebtedness owed by the business so as to accommodate what is likely to be a reduced flow of revenue into the business. The existing lender will probably require some consideration for any concessions given to the business.

For example, the business may have to transfer appreciated property to the lender in satisfaction of a portion of its indebtedness. If the amount deemed satisfied by such transfer exceeds the fair market value of the property, the business will realize both gain from the deemed sale of the property, and cancellation of indebtedness (“COD”) income to the extent the debt forgiven exceeds the value of the property.[lix]

As for the modifications requested by the business, these may include a reduction in the interest rate, a forgiveness of accrued but unpaid interest, perhaps a partial forgiveness of the outstanding principal of the loan, an extension of the maturity date, a relaxation of financial covenants, or some other change in payments terms.

If principal is forgiven, the amount forgiven will be included in the gross income of the business as ordinary income.[lx]

Similarly, the combined effect of several agreed-upon changes – for example, to the interest rate, the maturity date, and the payment schedule – may rise to the level of a so-called “significant modification” of the loan.[lxi] In that case, the “old” debt will be treated as having been exchanged for the “new debt;” if the issue price of the new debt given by the business in exchange for the old debt held by the lender is less than the issue price for the old debt, then the business will realize COD income. If the business is a pass-through entity for tax purposes, such as a partnership or S corporation, the income will be included by the owners on their tax returns.[lxii]

Of course, there are certain exceptions to the recognition of COD income. For example, if the taxpayer is insolvent,[lxiii] the COD income will be excluded from the taxpayer’s gross income provided the debt cancelation does not cause the taxpayer to become solvent.[lxiv]

A business that takes advantage of one of these exceptions, will be required to reduce certain tax attributes; for example, NOLs, certain tax credits, and the adjusted basis of its property.[lxv]

Renegotiating Leases

As in the case of a debt obligation, a business is likely to enter the re-opened market with a lease obligation related to the space out of which the business operates. The rent payable by the business is likely a fixed base amount that may be periodically adjusted according to some commercial index.

In any case, if the business is expecting a reduction in revenue for the foreseeable future, it may want to ask its landlord to consider a change in the terms of its lease, especially with respect to the amount and timing of the rent payable thereunder. For example, the business may ask for a reduction in the rent payable, or it may ask that payment of the rent be deferred, for some period of time.

Unfortunately, these seemingly reasonable and straightforward requests, if accepted and implemented, may risk the application of some very complex tax avoidance rules that are directed at the timing of the landlord’s inclusion of the rental in their gross income, on the one hand, and at the timing of the tenant’s deduction of such rental, on the other.[lxvi]

Thankfully, there are various safe harbors which, if satisfied, will prevent the application of these rules and will permit the parties to report the rent in accordance with their normal method of accounting.[lxvii] Among these, for example, is a rent holiday, the duration of which is reasonable (determined by reference to commercial practice in the locality where the property is located), and which does not exceed the lesser of 24 months or 10 percent of the lease term.

Bad Debts

Although a business may be indebted to a commercial lender, it is also possible for the business to stand in the shoes of a creditor. In the event a bona fide debt owing to the business becomes worthless during a taxable year, the business is allowed a bad debt deduction in determining its income tax liability for such tax year.[lxviii] “Business bad debts” are deductible against the ordinary income of the business.

Generally, a business bad debt is a loss from the worthlessness of a debt that was either created or acquired in a trade or business of the lender, or was closely related to the lender’s trade or business when it became worthless.[lxix] A debt is closely related to the lender’s trade or business if the lender’s primary motive for making the loan was business-related.

In order to claim the deduction, the business must be able to establish that debt became worthless in the year for which the deduction is being claimed, and not in an earlier year.

Gift and Estate Planning

Another option for business owners to consider is whether it makes sense for them to, and whether they can, “rescind” gifts of business interests made in earlier periods.

It is a basic precept of estate and gift tax planning for the owner of a business to transfer interests in the business to a trust for the benefit of the owner’s family before such interests have appreciated in value. The goal of such a transfer is to use as little of one’s exemption amount as possible in order to remove the future value of the business interest from the transferor’s gross estate.

Of course, in retrospect, the business owner may regret having made such a transfer where the economy subsequently takes a turn for the worse. In that case, the owner may wish that they still had the benefit of all of the cash flow from the business, especially if their non-business assets, including retirement assets, have been adversely affected by the economic downturn.

What is the owner to do in these circumstances?

Well, if the owner had retained the right, in a non-fiduciary capacity, to reacquire the gifted property from the trust in exchange for fair market value consideration,[lxx] not only may the owner exercise such right, but they may do so without causing to trust to recognize any taxable gain.[lxxi]

The owner-transferor is thereby able to reacquire the business interest without adverse income tax consequences because the owner’s retained right causes the trust to be treated as a so-called “grantor trust” for purposes of the income tax.[lxxii] In other words, the transferor is treated for tax purposes as owning all of the assets and income of the trust; because one cannot sell property to oneself, the reacquisition of the interest is disregarded for income tax purposes.[lxxiii]

If the business owner has not yet made any gifts of interests in their business, they may want to wait at least until after the November elections.[lxxiv]

A Whole New World[lxxv]

We’re still in lockdown, and the economy is still in a downturn. When the lockdown is lifted, the economy will still be in a downturn, and will likely remain so for some not insignificant period of time – at least that is what I am assuming.

I am certain that many business owners share this assumption, which will, in turn, inform many of their decisions for several months to come.

In light of these circumstances, and all other things being equal, the goal from a tax perspective should be not only to transact business in as tax efficient a manner as possible, but also to build up as much liquidity in the business as possible. This will enable the business and its owners to ride out the downturn, and should put them in a position to expand once the economy finds its new equilibrium.

However, if the Federal government decides to increase tax rates or to eliminate various tax incentives – after all, someone has to pay for the money being distributed through the CARES Act and other programs – the arrival of this new equilibrium may be postponed.

——————————————————————————

[i] The first death attributed to the coronavirus in N.Y. was on March 14, 2020.

[ii] P.L. 116-123.

[iii] https://www.governor.ny.gov/news/novel-coronavirus-briefing-governor-cuomo-declares-state-emergency-contain-spread-virus

[iv] https://www.whitehouse.gov/presidential-actions/proclamation-declaring-national-emergency-concerning-novel-coronavirus-disease-covid-19-outbreak/

[v] P.L. 116-127. The Act requires certain employers to provide their employees with paid sick leave or expanded family and medical leave for specified reasons related to COVID-19

[vi] https://www.governor.ny.gov/news/governor-cuomo-issues-guidance-essential-services-under-new-york-state-pause-executive-order

[vii] P.L. 116-136. The Act provided more than $2.2 trillion of Federal relief funds to counter the economic effects of the state-mandated closures and social distancing policies that were implemented to limit the spread of the virus.

[viii] Known as CARES Act 3.5. (The CARES Act being the third round of coronavirus-related Federal legislation.) The total relief package amounted to approximately $484 billion.

[ix] Call it a “natural law,” though the phrase – more accurately, its underpinnings – is out of favor in many circles.

[x] Pick your source – they’re all reporting the same thing. Durable goods orders, manufacturing, auto sales, consumer confidence – the news isn’t good. Banks are increasing their loss reserves. Other economic reports are expected this week, and the Fed is meeting in a couple of days.

“What about the stock markets?” you may ask. To which I would respond, “The equity market is not the economy.”

[xi] The next round of Federal stimulus legislation may include fiscal assistance for the states and for local jurisdictions. Thus far, Republicans and Democrats are not seeing eye-to-eye on this issue.

[xii] I think I nailed that idiom.

But seriously, I wonder how many businesses have decided against participating in the PPP. Such a business may have cash reserves and/or a line of credit sufficient to withstand a reduction in revenues. It may also be more willing to cut salaries and/or employees than to accept money from the government with strings attached.

[xiii] You may recall that the “sense of the Senate,” set forth in the Senate version of the bill that eventually became the CARES Act, indicated that the SBA “should issue guidance to lenders and agents to ensure that the processing and disbursement of covered loans prioritizes small business concerns and entities in underserved and rural markets, including veterans and members of the military community, small business concerns owned and controlled by socially and economically disadvantaged individuals . . . , women, and businesses in operation for less than 2 years.”

The CARES Act, however, seems to have ignored this. CARES 3.5 tries to redress the oversight.

[xiv] Which include wages, retirement benefits, health insurance, and certain other items paid by the business.

[xv] Section 1106(i) of the CARES Act. IRC Sec. 108.

[xvi] IRC Sec. 162. An oversight or a “gimme?” Definitely the latter.

[xvii] The CARES Act sets a 2-year term for the satisfaction of the loan; interest will be imposed at an annual rate of one percent; the business will have six months before it has to begin making payments under the loan.

[xviii] https://www.farrellfritz.com/sba-7a-loans-under-the-ppp/

[xix] See my Op Ed piece in The Empire Report: https://www.taxlawforchb.com/2020/03/lou-vlahos-op-ed-economic-losses-blame-the-virus-not-entirely-published-in-the-empire-report/

[xx] In addition to the provisions described below, the CARES Act includes the Employee Retention Tax Credit, which is designed to encourage businesses to keep employees on their payroll. The credit is available to eligible employers whose business has been adversely impacted by the coronavirus emergency. However, businesses taking advantage of the PPP are not allowed to claim the credit. The amount of the credit is equal to 50 percent of qualifying wages paid; however, such wages are capped at $10,000 in total per employee.

[xxi] P.L. 115-97. These amendments were intended to compensate for lost tax revenue attributable to the replacement of a graduated rate regime (with a maximum rate of 35 percent) with a flat corporate income tax rate of 21 percent.

[xxii] Notice 2020-18.

[xxiii] These changes were effective for NOLs arising in taxable years beginning after December 31, 2017. For example, NOLs for taxable years ending on December 31, 2018, or on December 31, 2019 (for calendar year taxpayers) could not be carried back. The same applied for any taxable year beginning on or after February 1, 2018 and ending on or after January 31, 2019 (for fiscal year taxpayers); thus, in the case of an NOL realized during the taxable year starting June 1, 2019 and ending May 31, 2020, the NOL could not be carried back to an earlier year.

It should be noted that a taxpayer may waive the carryback if they believe it will be more useful to carry the losses forward, notwithstanding the reinstatement of the 80 percent limitation after 2020. Notice 2020-24.

[xxiv] Section 2303(b) of the Act. Thus, these changes have retroactive effect.

A slightly modified version of the 80% limitation remains in effect for taxable years beginning after 2020.

[xxv] Section 2303(a) of the Act.

[xxvi] The 80 percent limitation is reinstated for taxable years beginning after December 31, 2020.

[xxvii] See IRC Sec. 311(b), Sec. 336, Sec. 355.

[xxviii] IRC Sec. 461(l). In the case of a partnership or an S corporation, the provision applies at the partner or shareholder level.

[xxix] The threshold amount for a taxable year is $250,000 per taxpayer, or $500,000 in the case of a joint return. The threshold amount is indexed for inflation.

[xxx] IRC Sec. 1366(d)/704(d), 465, and 469.

[xxxi] For purposes of this limitation, “adjusted taxable income” generally means the taxable income of the taxpayer computed without regard to any item of income, gain, deduction, or loss which is not properly allocable to a trade or business; certain other adjustments are also made.

[xxxii] IRC Sec. 163(j).

[xxxiii] Sec. 2306 of the Act.

[xxxiv] That, plus the low interest rate environment in which we find ourselves.

[xxxv] IRC Sec. 163(j)(7)(B).

[xxxvi] IRC Sec. 168(k)(2)(D).

[xxxvii] IRC Sec. 168(g)(8).

[xxxviii] Rev. Proc. 2020-22. Among other things, this guidance requires the filing of an election withdrawal statement that should be titled, “Revenue Procedure 2020-22 Section 163(j)(7) Election Withdrawal.”

[xxxix] The Act also corrected an error in the TCJA which prevented “qualified improvement property” from qualifying for bonus depreciation.

[xl] IRC Sec. 1031.

[xli] Reg. Sec. 1.1031(k)-1(c)(4) provides special rules for the identification of alternative or multiple replacement properties.

[xlii] Or, if earlier, by the tax return due date, determined with extensions, for the year of the sale. IRC Sec. 1031(a)(3).

[xliii] IRC Sec. 7508A. Rev. Proc. 2018-58.

[xliv] Notice 2020-23.

[xlv] Section 2302 of the CARES Act. This tax is imposed on employers at a rate of 6.2 percent of each employee’s wages that do not exceed $137,700 for the 2020 calendar year.

[xlvi] https://www.farrellfritz.com/deferral-of-employment-tax-deposits-and-payments-through-december-31-2020/

[xlvii] The IRS has indicated that the Form 941, Employer’s Quarterly Federal Tax Return, will be revised for the second calendar quarter of 2020 (April – June, 2020), and information will be provided to instruct employers how to reflect the deferred deposits and payments otherwise due on or after March 27, 2020 for the first quarter of 2020 (January – March 2020). In no case will Employers be required to make a special election to be able to defer deposits and payments of these employment taxes.

[xlviii] A constructive termination.

[xlix] The key is the definition of “separation from service” under IRC Sec. 409A.

[l] Such a plan is unsecured, and the executive is treated as a general unsecured creditor. What if the plan requires the employer to periodically set funds aside in a rabbi trust so as to provide the employer with a source from which to satisfy its payment obligations under the deferred compensation plan?

[li] Reg. Sec. 1.409A-3(d).

[lii] Query whether this 12-month waiting period makes this option impractical from the perspective of the business?

[liii] IRC Sec. 409A(a)(4)(C).

[liv] Reg. Sec. 1.409A-3(j)(4)(ix)(C).

[lv] Reg. Sec. 1.409A-3(f).

[lvi] It’s all a matter of negotiation and leverage. However, it is often dependent upon the executive’s desire or ability to pay for equity, their aversion toward incurring an income tax liability upon the receipt of equity, and their reluctance to assume any of the responsibilities of actual ownership (for example, personally guaranteeing leases and loans).

[lvii] Hopefully, the business’s PPP loan will be forgiven.

[lviii] I’ve heard stories about how expensive a “deep” clean can be.

[lix] Reg. Sec. 1.1001-2.

[lx] IRC Sec. 108(a).

[lxi] Reg. Sec. 1.1001-3; IRC Sec. 108(e)(10). Basically, a change in yield on the debt, or a change in timing of debt payments.

It should be noted that the so-called “Cottage Savings” regulations include safe harbors for certain modifications to the terms of a debt obligation.

[lxii] IRC Sec. 702 and Sec. 1366. https://www.taxlawforchb.com/2017/12/revoking-s-corp-status-a-fraudulent-conveyance/

[lxiii] IRC Sec. 108(d)(3). The excess of its liabilities over the fair market value of its assets (including intangibles, like goodwill).

[lxiv] IRC Sec. 108(a)(1)(B) and Sec. 108(a)(3). It should be noted that the insolvency exception applies differently to C corporations, S corporations and partnerships. In the case of an S corporation, the insolvency is tested at the corporate level – if the corporation is insolvent, its shareholders will not recognize COD income. By contrast, in the case of a partnership, the exception is applied at the partner level – thus, a partner who is insolvent make benefit from the exception, while a solvent partner will have to include their share of the partnership’s COD in their gross income. IRC Sec. 108(d)(6) and (7).

[lxv] IRC Sec. 108(b), Sec. 1017.

[lxvi] IRC Sec. 467.

[lxvii] Reg. Sec. 1.467-3(c)(3).

[lxviii] IRC Sec. 166.

[lxix] Reg. Sec. 1.166-5.

[lxx] Of course, this leaves open the question of what property to transfer to the trust.

[lxxi] IRC Sec. 675(4).

[lxxii] IRC Sec. 671.

[lxxiii] Rev. Rul. 85-13.

[lxxiv] https://www.taxlawforchb.com/2020/03/think-before-you-gift-but-dont-take-too-long/

[lxxv] Don’t worry, I’m not singing the Disney song.

The Code as a Tool

The Internal Revenue Code is one of the tools employed by Congress to encourage certain behaviors that it has determined are in society’s long-term best interest and, therefore, worthy of the public’s financial support. Among the socially-desirable behaviors to which the Code is applied, perhaps the best-known is that of charitable giving by individuals and businesses to privately founded charitable organizations. The Code promotes the tax-paying public’s financial support for charitable organizations and their missions by allowing taxpayers to claim a deduction for certain charitable contributions, thereby subsidizing such contributions by reducing the taxpayers’ federal income tax liability.[i]

By its nature, the Code, like most statutes, takes a long-term view toward achieving the goals to which it has been dedicated; after all, human behavior can rarely be modified overnight. However, there are instances in which the Code may be, and has been, used to direct funds as quickly as practicable from the general public to those of its members that, as a result of some unforeseen disaster, natural or otherwise, are in greatest need.

What to Do?

While considering the recently enacted Coronavirus Aid, Relief and Economic Security (“CARES”) Act, Congress looked into its toolkit to see what means it had available for addressing the various consequences of the economic emergency arising from the government-ordered shutdown of many businesses, nonprofit organizations, and social institutions in response to the spread of COVID-19.

In the end, Congress decided to include in the CARES Act[ii] – along with other measures[iii] – a greatly enhanced charitable contribution deduction,[iv] based on the theory that those taxpayers who can afford to make such contributions either will be encouraged to do so or, if they were already predisposed, will be motivated to make gifts in larger amounts than they were otherwise planning.

Before describing those provisions of the Act that are directed at charitable giving, it would be helpful to understand, generally, how the Code promotes such giving.

The Charitable Contribution Deduction

In order to be deductible in determining a taxpayer’s federal income tax liability for a given year, the taxpayer’s transfer of property to a charitable organization (in the broadest sense) must meet several requirements: (i) the recipient must be an organization that Congress has determined is eligible to receive tax-deductible charitable contributions;[v] (ii) the transfer must be made with gratuitous intent and without the expectation of receiving a benefit of substantial economic value in return; (iii) the transfer must be complete (generally, it cannot be contingent);[vi] (iv) the transfer must be of a taxpayer-donor’s entire interest in the contributed property (generally, it cannot represent a partial interest);[vii] (v) the transfer must be made within the taxable year for which the deduction will be claimed; (vi) the transfer must be of money or property – not a contribution of services;[viii] and (vii) the transfer must be properly substantiated.[ix]

In the case of an individual, the taxpayer must be one who itemizes eligible expenditures[x] on their federal income tax return in determining their taxable income, rather than claiming the so-called “standard” deduction.[xi]

Limits – Generally

Ironically, at the same time that the Code encourages charitable giving by a taxpayer, it also imposes certain limitations upon the amount of the deduction that may be claimed by the taxpayer. Thus, the deductibility of a taxpayer’s charitable contributions in a given year is limited to a percentage of the taxpayer’s income for such year.[xii] Similarly, other special rules limit the deductible value of a contributed property.[xiii] In each case, the application of these limitations depends upon the nature of the property transferred and upon whether the recipient organization is a public charity[xiv] (one which generally receives its financial support from a broad segment of the public) or a private foundation (one which generally receives its support from a single family or business).

Percentage Limits

For example, an individual’s charitable contribution deduction for a taxable year is limited to a specified percentage of the individual’s gross income for such year (with certain adjustments; the “contribution base”). More favorable percentage limits apply to contributions of cash, than to in-kind contributions of capital gain property. One reason for this distinction is the fact a taxpayer who donates an unencumbered appreciated capital gain asset to a charity is not required to recognize the gain inherent in the property, yet may still claim a fair market value charitable deduction therefor.

More favorable limits also generally apply for contributions to public charities than for contributions to grant-making private foundations; this distinction is based, in part, upon the fact the former are “accountable” to the general public, while the latter are less so.

Specifically, the deduction for charitable contributions of cash by an individual taxpayer to a public charity may not exceed 50 percent of the taxpayer’s contribution base.[xv] (But see below regarding a temporary change by the Tax Cuts and Jobs Act.) In contrast, a cash contribution to a private foundation may be deducted up to 30 percent of the taxpayer’s contribution base.[xvi]

An individual taxpayer’s contributions of appreciated capital gain property to a public charity generally are deductible up to 30 percent of the taxpayer’s contribution base.[xvii] Contributions of such property to a private foundation are deductible up to 20 percent of the taxpayer’s contribution base.[xviii]

In the case of a corporate donor, the charitable contribution deduction is limited to 10 percent of the corporation’s taxable income for the year (with certain adjustments).[xix]

A taxpayer’s charitable contribution that exceeds the applicable percentage limit generally may be carried forward by the taxpayer for up to five years.[xx]

Property Limits

In general, charitable contributions of cash are deductible in the amount contributed, subject to the percentage limits discussed above. In addition, a taxpayer generally may deduct the full fair market value of long-term capital gain property contributed to a public charity.[xxi]

In certain cases, however, the Code limits the deductible “value” of the contribution of appreciated property to the donor’s tax basis in the property. This limitation generally applies for: (1) contributions of inventory or other ordinary income or short-term capital gain property;[xxii] (2) contributions of tangible personal property if the use of the property by the recipient charitable organization is unrelated to the organization’s tax-exempt purpose (for example, the donation of a rare violin to a hospital);[xxiii] and (3) contributions of any property to a grant-making private foundation (other than contributions of stock that is long-term capital gain property for which market quotations are readily available on an established securities market).[xxiv]

Special Inventory Rule

Although most charitable contributions of property are valued at fair market value or at the donor’s tax basis in the property, certain contributions of appreciated inventory and other property (for example, contributions of “apparently wholesome food”[xxv]) may qualify for an enhanced deduction that exceeds the donor’s tax basis in the property, but which is less than the fair market value of the property.[xxvi]

Record-Keeping

A donor who claims a deduction for a charitable contribution must maintain reliable written records regarding the contribution, regardless of the value or amount of such contribution. No charitable contribution deduction is allowed for a separate contribution of $250 or more unless the taxpayer-donor obtains a contemporaneous written acknowledgement of the contribution from the recipient charity indicating whether the charity provided any good or service (and an estimate of the value of any such good or service) to the taxpayer in consideration for the contribution.[xxvii]

If the total charitable deduction claimed for noncash property is more than $500, the taxpayer must attach a completed IRS Form 8283 (Noncash Charitable Contributions) to the taxpayer’s federal income tax return or the deduction is not allowed. If the deduction claimed is more than $5,000, the taxpayer must also obtain a qualified appraisal and attach a summary thereof to the tax return.[xxviii]

The Tax Cuts and Jobs Act (“TCJA”) of 2017

As part of the tax legislation passed in 2017,[xxix] Congress increased the income-based percentage limit for certain charitable contributions of cash by an individual taxpayer to public charities from 50 percent to 60 percent. To the extent such contributions exceed the 60 percent limit for any taxable year, the excess is carried forward and treated as a charitable contribution that is subject to the 60 percent limit in each of the five succeeding taxable years in order of time.[xxx]

This enhanced deduction provision applies to the amount of charitable contributions taken into account for taxable years beginning after December 31, 2017, and before January 1, 2026.[xxxi] The 50 percent limit is reinstated for cash contributions to public charities for taxable years beginning on or after January 1, 2026.

The CARES Act

The Act revisited the income-based percentage limitation for charitable contributions. Specifically, it amended this, as well as other related provisions – effective for taxable years ending after December 31, 2019[xxxii] – with the goal of maximizing the influx of immediately available funds to charitable organizations that are directly engaged in activities for the benefit of the general public.

Under the Act, an individual who itemizes deductions and makes a cash payment as a charitable contribution to a public charity during the calendar year 2020,[xxxiii] may elect[xxxiv] to claim a deduction in respect of such contribution of an amount up to 100 percent of the taxpayer’s 2020 contribution base;[xxxv] thus, the TCJA’s 60 percent limitation is suspended for 2020, and the taxpayer-donor may use a cash contribution to offset their entire 2020 income.

Consistent with the above-stated intent, contributions to a private foundation, to a supporting organization, or to a public charity for the establishment of a new (or for the maintenance of an existing) donor-advised fund,[xxxvi] will not qualify for the enhanced deduction under the Act because such funds will not necessarily be immediately employed in charitable activities. For example, there are no minimum distribution requirements for a donor-advised fund;[xxxvii] a private foundation can get away with distributing only 5 percent of the aggregate fair market value of its assets;[xxxviii] supporting organizations may perform a number of functions on behalf of a public charity, not all of which result in immediate liquidity for use by the supported charity.[xxxix]

In the case of a corporation, such a cash contribution to a public charity during 2020 will be allowed as a deduction in an amount up to 25 percent of the corporation’s taxable income (rather than the otherwise applicable 10 percent).[xl]

Any amounts in excess of the taxpayer’s applicable contribution base may be carried forward by the taxpayer for up to five years.[xli]

Looking Forward

Most of the country has been on lockdown since early-to-mid-March; in the case of New York, the lockdown is scheduled to continue at least through mid-May.

The CARES Act became law on March 27. At that time, the Congress was necessarily working with less than adequate data and making a number of semi-educated assumptions.[xlii]

A lot has happened since then. For example, we have discovered that the $349 billion that had been set aside to fund SBA-guaranteed loans to small businesses and nonprofits under the Paycheck Protection Program was woefully inadequate, having been fully expended by mid-April.[xliii] Many business groups have been clamoring for Congress to provide a massive amount of additional funding for the program, and Congress is certain to comply in fairly short order.[xliv]

We have seen the number of jobless claims exceed 22 million over just a four-week period of coronavirus-related shutdowns.

Many state and local governments are reporting that they are nearly financially broke.

Despite these developments, most states remain wary of re-opening their economies in the near-term for fear of allowing a second wave of coronavirus infections to spread.

Finally, and most relevant to this post, many nonprofit organizations[xlv] are already urging Congress to further expand the tax breaks for charitable contributions by individuals[xlvi] – in other words, to go beyond the mere one-year suspension of the income-based percentage limitation for cash gifts to public charities – only three weeks after the enactment of the CARES Act.

Where does that leave us insofar as charitable giving and nonprofits are concerned? Intuitively, it is unreasonable to expect that any tax-based incentive would cause the general public to even consider increasing their charitable giving under the circumstances in which we find ourselves; businesses are even less likely to do so.

It is unfortunate, but for the same reason that many businesses will fail, so will many nonprofits – it is likely that not all of them can be saved. At this point, only those nonprofits that are deemed “essential” should be the beneficiaries of additional governmental support. Others should adapt as best they can to their changed circumstances, both today and after the health crisis passes; in some cases, that may require a reduction in activities, or a redirection of efforts; in others, it may require some degree of collaboration with other organizations, both nonprofit and for profit.

At the same time, perhaps we should encourage nonprofits to establish reserves, or to otherwise modify their behavior or structure so as to build or develop their resilience.[xlvii] We’re in a strange new world. This may be the time to experiment with new models of behavior for nonprofits and their supporters. The Code can be a very effective tool in this process.


[i] IRC Sec. 170.

[ii] P.L. 116-136.

[iii] See, for example, https://www.taxlawforchb.com/2020/04/coronavirus-vs-the-code-today-but-what-about-tomorrow/

[iv] Section 2205 of the CARES Act.

[v][v] IRC Sec. 170(c).

[vi] Reg. Sec. 1.170A-1(e).

[vii] IRC Sec. 170(f)(3).

[viii] Reg. Sec. 1.170A-1(g).

[ix] IRC Sec. 170(f)(8); Reg. Sec. 1.170A-13, 1.170A-15, 1.170A-16 and 1.170A-17.

[x] IRC Sec. 63(d).

[xi] IRC Sec. 63(c).

[xii] IRC Sec. 170(b).

[xiii] IRC Sec. 170(e).

[xiv] IRC Sec. 509(a).

[xv] IRC Sec. 170(b)(1)(A).

[xvi] IRC Sec. 170(b)(1)(B).

[xvii] IRC Sec. 170(b)(1)(C).

[xviii] IRC Sec. 170(b)(1)(D).

[xix] IRC Sec. 170(b)(2).

[xx] IRC Sec. 170(d).

[xxi] IRC Sec. 170(e).

[xxii] IRC Sec. 170(e)(1)(A).

[xxiii] IRC Sec. 170(e)(1)(B).

[xxiv] IRC Sec. 170(e)(5).

[xxv] If you ask me, “apparently wholesome” is in the eye of the beholder. What can appear more wholesome-looking than a double quarter pounder with cheese, I ask you? Alas, Congress is presumptuous enough to define “apparently wholesome food” by reference to the Bill Emerson Good Samaritan Food Donation Act. Seriously?

[xxvi] IRC Sec. 170(e)(3)(C).

[xxvii] IRC Sec. 170(f)(8).

[xxviii] Reg. Sec. 1.170A-13, 1.170A-15, 1.170A-16 and 1.170A-17.

[xxix] P.L. 115-97.

[xxx] IRC Sec. 170(b)(1)(G).

[xxxi] IRC Sec. 170(b)(1)(G)(i).

[xxxii] Section 2205(c) of the CARES Act.

[xxxiii] Section 2205(a)(3)(A) of the CARES Act.

[xxxiv] Section 2205(a)(3)(A)(ii) of the CARES Act. The application of the relaxed income-based limitation is elective with the taxpayer. In the case of a contribution by a partnership or an S corporation, the election is made separately by each partner or shareholder. Section 2205(a)(3)(C) of the CARES Act.

[xxxv] Section 2205(a)(1) and Section 2205(a)(2)(A) of the CARES Act.

[xxxvi] Section 2205(a)(3)(B) of the CARES Act.

[xxxvii] IRC Sec. 4966.

It should be noted that a public charity which sponsors a donor-advised fund may itself be engaged in a number of direct charitable activities, contributions to which would qualify for the enhanced charitable deduction.

[xxxviii] IRC Sec. 4942.

[xxxix] Their public charity status is derived from that of the public charities which they support. IRC Sec. 509(a)(3); Reg. Sec. 1.509(a)-4.

[xl] Section 2205(a)(1) and Section 2205(a)(2)(B) of the CARES Act.

[xli] Section 2205(a)(2)(A)(ii) and Section 2205(a)(2)(B)(ii) of the CARES Act.

[xlii] One might say, with less than a full deck . . . of information.

[xliii] It was originally intended that loans would be available through the end of June.

[xliv] But only after the parties have walked around the proverbial ring a bit, holding each other up like a couple of punch-drunk boxers.

[xlv] Who may also qualify for the forgivable, unsecured loans under the Paycheck Protection Program.

[xlvi] The greatest part of charitable giving comes from individuals, not from corporations or foundations. The so-called “1 percent” account for approximately one-third of all charitable giving.

[xlvii] https://www.taxlawforchb.com/2020/03/lou-vlahos-op-ed-economic-losses-blame-the-virus-not-entirely-published-in-the-empire-report/

The Coronavirus Aid, Relief and Economic Security (“CARES”) Act became law[i] on March 27, 2020. Almost immediately, “small” businesses[ii] from every industry – including real estate – began the process of determining whether they would be eligible for the forgivable, unsecured, non-recourse loans to be made under the Paycheck Protection Program, which is viewed by most closely held businesses as the centerpiece of the legislation.[iii]

However, there are a few tax-related provisions in the legislation that may assist a qualifying business to obtain through a refund – or to retain through lower taxes – some of the liquidity needed for the operation of the business. Although most of these tax provisions represent the temporary – and in some cases retroactive – relaxation of certain amendments made by the Tax Cuts and Jobs Act of 2017,[iv] they promise to mitigate the adverse economic effects of the health crisis [v]for many businesses.

Not to be outdone by Congress,[vi] the IRS has acted quickly to implement these changes. In addition, with the President’s declaration of a national emergency, the IRS has taken steps to address some of the specific concerns of taxpayers in the real estate industry.[vii]

We begin with a brief description of certain provisions of the Act that may be of interest to real estate businesses. This is followed by a summary of actions undertaken by the IRS with respect to like kind exchange transactions that were “interrupted” by the health crisis.

NOLs

The Act temporarily reinstates and expands the NOL carryback that had been eliminated by the TCJA.[viii] Specifically, the Act allows a business that realizes a net operating loss (“NOL”) during a taxable year beginning after December 31, 2017 and before January 1, 2021 to carry its NOL back to each of the five taxable years preceding the year of the loss.[ix] If the business had taxable income during those earlier years, the carryback of the NOLs may create an opportunity for an immediate refund claim and more liquidity.[x]

The Act also suspended the TCJA’s “80 percent of taxable income” limitation for NOL carryovers arising in taxable years beginning before January 1, 2021.[xi] Thus, for a taxable year beginning in 2018, 2019 or 2020, an NOL carryover may be utilized to offset all of the business’s taxable income for that year; it is not limited to 80 percent thereof. As in the case of the carryback, the retroactive elimination of the “80 percent” cap may give rise to a refund claim for an eligible taxpayer.

The TCJA’s elimination of the NOL carryback, and its imposition of the 80 percent limitation on NOL carryovers, are reinstated for taxable years beginning after December 31, 2020.

The IRS

As indicated above, taxpayers whose NOLs may now be carried back to an earlier taxable year will generally be able to file amended returns to claim refunds resulting from the temporary change in the law. Unfortunately, the Act did not provide additional time for certain taxpayers to file tentative carryback adjustment applications[xii] – basically, an expedited procedure for tax refunds resulting from the carryback of the NOL.

In response, the IRS has extended the deadline[xiii] for filing an application for a tentative carryback adjustment with respect to the carryback of an NOL that arose in any taxable year that began during calendar year 2018 and that ended on or before June 30, 2019.[xiv]

For example, in the case of an NOL that arose in a taxable year ending on December 31, 2018, a taxpayer normally would have until December 31, 2019, to file an application; because of this relief, however, the taxpayer will now have until June 30, 2020, to file.

Excess Business Loss

For taxable years beginning after December 31, 2017 and before January 1, 2026, the TCJA limited the ability of a non-corporate taxpayer – basically, individuals – to offset their nonbusiness income with losses arising from their business. Instead, such losses are required to be treated as part of the taxpayer’s NOL carryforward to subsequent taxable years.[xv]

The Act retroactively defers the effective date of these “excess business loss” rules. Specifically, the rules will now apply only to taxable years beginning after December 31, 2020 and before January 1, 2026.[xvi]

Consequently, an individual taxpayer who realized, or realizes, a loss from an operating business in a taxable year beginning before January 1, 2021 – whether as a sole proprietor, as a partner in a partnership, or as a shareholder in an S corporation – and who successfully runs the gauntlet of the basis limitation, at risk and passive loss rules,[xvii] will be allowed to apply such losses against their other income for such taxable year, including salary and investment income.

This change may afford those taxpayers, to whom the excess business loss rules have already been applied, an opportunity to claim a refund with respect to their taxable years beginning in 2018 and 2019.

Business Interest Deductions

Generally speaking, interest paid or accrued by a business is deductible in the computation of taxable income, subject to a number of limitations. The TCJA added one more limitation: for taxable years beginning after December 31, 2017, a taxpayer’s deduction for business interest for a taxable year is capped at 30 percent of the taxpayer’s “adjusted taxable income” for the taxable year. Any “excess interest deduction” will be carried forward to succeeding taxable years.[xviii]

The Act reduces the impact of this rule by increasing the limitation from 30 percent to 50 percent of adjusted taxable income for any taxable year beginning in 2019 or 2020.[xix] In this way, a taxpayer filing their income tax return for 2019 may take advantage of the increased limitation to reduce their income tax liability and to retain the tax savings in the business.

In addition, for a taxable year beginning in 2020, the Act permits a taxpayer to use their 2019 adjusted taxable income for purposes of determining their “interest deduction limitation” for 2020.[xx] Thus, if the taxpayer’s 2019 adjusted taxable income is greater than that for 2020 – which may very well be the case – the taxpayer may claim a greater interest deduction and, thereby, further reduce their tax liability.

Although the relaxation of the limitation on interest deductions[xxi] may entice a taxpayer to borrow funds during 2020, it is important for the taxpayer to recognize that the TCJA’s 30 percent cap will be reinstated in 2021.

Notwithstanding the foregoing, it should be noted that the limitation does not apply to taxpayers with average annual gross receipts, for the three-taxable year period ending with the prior taxable year, that do not exceed $25 million.[xxii]

In addition, at the taxpayer’s election, any real property trade or business is not treated as such for purposes of the limitation, and therefore the limitation does not apply to such a trade or business.[xxiii] The election to be excluded from the interest limitation rule, however, comes at a price: the electing taxpayer is not allowed to claim bonus depreciation,[xxiv] and is required to extend the depreciation period for its real properties.[xxv] In addition, once made, the election is irrevocable; thus, it is binding for all succeeding years.

However, the IRS has recognized that a taxpayer who made an election in 2018 to exclude their real property business from the TCJA’s “30 percent interest limitation” rule, may have acted differently had the Act’s 50 percent limitation been in effect instead. Thus, the IRS has issued guidance[xxvi] that allows a qualifying taxpayer to withdraw the otherwise irrevocable election.

Specifically, for a 2018 or 2019 taxable year, a taxpayer must timely file an amended Federal tax return for the year in which the election was made, along with an election withdrawal statement.[xxvii] The amended return must be filed on or before October 15, 2021, but in no event later than the applicable period of limitations on assessment[xxviii] for the taxable year for which the amended return is being filed. The amended tax return must include the adjustment to taxable income for the withdrawn election and any collateral adjustments to taxable income or to tax liability. A taxpayer also must file amended returns, which include such collateral adjustments, for any affected succeeding taxable years.

An example of such a collateral adjustment – and a possible reason for withdrawing the election in the first place – is the amount of depreciation, including bonus depreciation, allowed or allowable in the applicable taxable year for the property to which the withdrawn election applies.

In other words, a taxpayer may be able to take advantage of both the temporary 50 percent limitation on interest deductions, and the ability to claim an increased depreciation deduction (including bonus depreciation) for those years to which the election would otherwise have applied. Thus, the taxpayer will have another opportunity for a refund of taxes paid.

Bonus Depreciation

The Act corrects an error in the TCJA which prevented “qualified improvement property” from qualifying for bonus depreciation.

Qualified improvement property is generally defined as any improvement to an interior of a nonresidential building that is placed in service after the building was placed in service.[xxix]

The Act retroactively amended the Code, effective for property placed in service after December 31, 2017, to treat such property as 15-year property for which bonus (100 percent) depreciation may be claimed.[xxx]

A taxpayer affected by this change may be able to amend their 2018 returns in order to take the bonus depreciation deduction and thereby generate a refund claim. The change may also allow a taxpayer to claim a larger deduction in determining their 2019 income tax liability.

Like Kind Exchange

The TCJA amended the Code so as to restrict the tax deferral benefit of the like kind exchange rules to exchanges involving only real property held for productive use in a trade or business, or for investment.[xxxi]

Most like kind exchanges with real property are effected as deferred exchanges, with the replacement property being acquired sometime after the sale of the relinquished property. Generally speaking, in order for such a transaction to qualify for tax deferral as a like kind exchange, the replacement property must be identified no later than 45 days after the date of the sale of the relinquished property (the “identification period”),[xxxii] and it must be acquired no later than 180 days after the date of such sale (or, if earlier, by the tax return due date, determined with extensions, for the year of the sale; the “exchange period”).[xxxiii]

The above-described dates are prescribed by statute and, generally, cannot be changed by the IRS; however, an exception may apply where the President has declared a national emergency.[xxxiv]

On March 13, 2020, President Trump declared a national emergency[xxxv] regarding the COVID-19 outbreak.

The IRS recently invoked its power – arising under such a federally declared emergency – to postpone the time to perform specified “time-sensitive actions” for taxpayers who are affected by the health emergency.[xxxvi]

Among these time-sensitive actions[xxxvii] are the identification of a replacement property, and the acquisition of such replacement property, in connection with a transaction intended to qualify as a like kind exchange under Section 1031 of the Code, including a “safe harbor” reverse, or “parking,” exchange.[xxxviii]

The Treasury has determined that any person performing such an act which is due to be performed on or after April 1, 2020, and before July 15, 2020, will be treated as someone “affected” by the health emergency, and the period for performing the act will be automatically extended to July 15, 2020, unless the taxpayer elects out of the extension.[xxxix]

In other words, only identification and exchange period deadlines occurring between April 1 and July 15, 2020 (the “relief period”) are extended. For example, if a taxpayer sold real property on February 29, 2020, they would normally have until April 14, 2020 to identify a replacement property. As a result of the IRS’s response to the health emergency, however, the end of the identification period is extended to July 15, 2020.[xl]

It is worth noting that the exchange period in the above example does not appear to be affected because it does not fall within the relief period – thus, it remains August 27, 2020, a mere 43 days after the close of the identification period.

Alternatively, if the taxpayer’s 180-day exchange period for acquiring the replacement property would normally end within the relief period (say, for example, on April 15, 2020), the end of the replacement period would be extended to July 15, 2020.

What’s Next?

The IRS will be implementing the foregoing measures over the coming weeks.

During that time, members of the real estate industry and their advisers will likely ask a lot of questions and to offer many suggestions; they are also likely to make a lot of requests – for clarification, and probably also for expansion of the relief already provided.

In light of the relatively brisk pace at which guidance under the Act has thus far been issued, updated, and then amended – all within the span of two weeks[xli] – and with the prospect of more legislation in the near future,[xlii] taxpayers and their advisers would be well-served to digest what has already been published, and to remain vigilant and keep informed of developments in our nation’s capital.

 

[i] P.L. 116-136 (the “Act”).

[ii] In general, a business is eligible for a loan under the PPP if it has no more than 500 employees or, if greater, the number of employees set by the SBA as the “size standard” for a particular industry. The SBA’s definition of “small business concern” also has to be considered. Section 1102(a)(2)(D) of the Act.

[iii] The liquidity to be provided under the PPP is intended to be used primarily for payroll costs, though borrowers may also apply a portion of the proceeds toward rent, utilities, and the interest on certain pre-existing indebtedness. However, in order to qualify for forgiveness of the loan, at least 75% of the proceeds have to be used to cover payroll costs. https://www.farrellfritz.com/sba-7a-loans-under-the-ppp/

[iv] P.L. 115-97 (the “TCJA”). See https://www.taxlawforchb.com/2018/01/the-real-property-business-and-the-tax-cuts-jobs-act/ for a discussion of how the TCJA affected real estate businesses.

[v] More accurately, caused by the government-ordered shutdowns employed (pun intended) to combat the spread of the coronavirus.

[vi] The power of the purse under Article I of the Constitution. Similarly, though I am loath to quote Baron Harkonnen from Frank Herbert’s Dune, “He who controls the spice controls the universe.”

[vii] Let me pause a minute, here. Following the TCJA, the IRS was presented with the challenge of issuing badly needed regulations – basically, legislating – to implement and clarify many of the very complex changes enacted by the TCJA. At the same time, the agency was told to make due with fewer resources – makes a lot of sense, right? Now, as the Service sees a light at the end of the TCJA tunnel, it is confronted with the Act. What’s more, like the rest of us, its personnel are working remotely. Oh, and yes, it is “tax return filing season.” I hope that folks in the White House and in Congress are not too forgetful.

[viii] IRC Sec. 172(b).

[ix] Sec. 2303(b) of the Act. Before the TCJA, the carryback period was two years. The five-year carryback affords taxpayers a greater chance of applying the loss to a profitable year.

The assumption, or expectation, of course, is that everything will have returned to normal before the end of 2020.

[x] IRC Sec. 6401 and Sec. 6511.

[xi] Sec. 2303(a) of the Act.

[xii] IRC Sec. 6411. See also IRS Forms 1139 (for corporations) 1045 (for other taxpayers).

[xiii] IRC Sec. 6081 authorizes the IRS to grant a reasonable extension of time to file.

The usual deadline for filing the application is on or after the date of filing for the return for the taxable year of the NOL from which the carryback results and within a period of 12 months after such taxable year.

[xiv] Notice 2020-26. The Notice also explains what a taxpayer must do to take advantage of the extension for requesting a tentative refund based on the carryback of the NOL.

[xv] IRC Sec. 461(l).

[xvi] Section 2304 of the Act. Again, the hope is that the economy will be back on its feet by the end of 2020.

[xvii] IRC Sec. 704(d)/1366(d), 465 and 469, respectively.

[xviii] IRC Sec. 163(j).

[xix] Section 2306 of the Act. Special rules apply for partnerships.

[xx] IRC Sec. 163(j)(10)(B).

[xxi] That, plus the low interest rate environment in which we find ourselves.

[xxii] IRC Sec. 163(j)(3).

[xxiii] IRC Sec. 163(j)(7)(B).

[xxiv] IRC Sec. 168(k)(2)(D).

[xxv] IRC Sec. 168(g)(8).

[xxvi] Rev. Proc. 2020-22. Among other things, this guidance requires the filing of an election withdrawal statement that should be titled, “Revenue Procedure 2020-22 Section 163(j)(7) Election Withdrawal.”

[xxvii] Special rules apply for “BBA partnerships” under Revenue Procedure 2020-23.

[xxviii] IRC Sec. 6501.

[xxix] IRC Sec. 168(e)(6). There are exceptions; for example, any improvement for which the expenditure is attributable to an elevator or escalator.

[xxx] Section 2307 of the Act. IRC Sec. 168(e)(3)(E), Sec. 168(k).

[xxxi] IRC Sec. 1031(a)(1).

[xxxii] Reg. Sec. 1.1031(k)-1(c)(4) provides special rules for the identification of alternative or multiple replacement properties.

[xxxiii] IRC Sec. 1031(a)(3).

[xxxiv] IRC Sec. 7508A. Rev. Proc. 2018-58.

[xxxv] Effective March 1, 2020.

[xxxvi] Notice 2020-23.

[xxxvii] See, for example, Rev. Proc. 2018-58.

According to Notice 2020-23, another “time-sensitive action” is the taxpayer’s investment in a qualified opportunity fund of an amount equal to the taxpayer’s capital gain; the investment must be made during a statutorily-prescribed 180-day period in order for the taxpayer to defer the recognition of such gain, and to take advantage of the other benefits offered under the qualified opportunity zone regime. IRC Sec. 1400Z-2(a)(1)(A).

[xxxviii] Rev. Proc. 2000-37.

[xxxix] Notice 2020-23. An election out may be appropriate if the taxpayer no longer want to complete a like kind exchange, and wants to obtain the relinquished property sale proceeds from the qualified intermediary sooner rather than after the end of the extended period. Reg. Sec. 1.1031(k)-1(g)(6).

[xl] Qualified intermediaries (“QIs”) are probably all over this change. If you are in the midst of an exchange, contact you QI immediately.

[xli] It feels much longer, doesn’t it? Working remotely has certainly contributed to our losing track of time. Thankfully, I have not yet experienced a Ground Hog Day moment.

[xlii] Perhaps by the end of April.

Public Health Disaster

Rarely has so much been expected by so many from a single legislative act.

The C.A.R.E.S. Act[i] became law on March 27, 2020, approximately two and one-half months after the country confirmed its first case of the virus. During that short period, the number of confirmed cases has increased dramatically, especially in New York.

In order to contain the spread of the virus, public gatherings were canceled. Shortly thereafter, many states[ii] and municipalities ordered the closure of most businesses within their jurisdictions. In general, individuals were directed to remain in their homes so as to avoid close contact with one another and, thereby, prevent the further transmission of the virus.

Notwithstanding these measures, and despite the efforts of healthcare workers, many of the afflicted have lost their lives and, unfortunately, many more are certain to follow. Society, broadly defined, will feel these losses on many levels.[iii]

Then there is another loss.

Economic Disaster

In response to the coronavirus and the public health strategy that governments have adopted to fight it, the stock market has gone from a record high in mid-February, to the beginnings of a bull market in mid-March.[iv] Many individuals have looked on as a significant portion of their retirement savings vanished.

With few exceptions, factories, service businesses, retailers, restaurants, hotels, not-for-profits, schools, and others have been ordered by government to close their doors in order to protect their employees and the public at large. Among those remaining open are hospitals, food markets and pharmacies.

Last week, the New York Times reported that approximately 10 million jobs disappeared over a two-week period, the Federal Reserve chairman said that he expects a contraction in Gross Domestic Product in the second quarter, and the Fed’s St. Louis district projected that the country may see a 30 percent unemployment rate.

Those who can work remotely from home are doing so but, given the interconnectedness of so many businesses (globally and domestically), the general feeling of uneasiness within the business community, the drop in economic activity, and the ensuing drop in business and consumer confidence, one has to wonder how sustainable this work-from-home approach will be.[v]

The Federal Response[vi]

This state of affairs called for an aggressive move by the Federal government, and it finally came on March 27, 2020 when the president signed the Act.[vii]

The main thrust of the legislation is to get massive amounts of money into the hands of businesses and their employees[viii] The principal vehicle by which $349 billion[ix] of these funds will be disbursed to “small businesses” – generally speaking, a business with no more than 500 employees – is the Paycheck Protection Program (the “PPP”), which will be administered by the Small Business Administration.[x] This is a forgivable loan program predicated on the requirement that any borrowing business will, during the 8-week period following the origination of its loan, expend at least 75 percent of its loan proceeds[xi] on payroll costs;[xii] the remaining 25 percent may be applied toward rent, utilities, and the interest on certain pre-existing indebtedness of the business.[xiii]

For example, if an eligible small business receives a PPP loan on April 20, 2020, it will have to expend all of the proceeds by June 15, 2020,[xiv] with at least 75% of these applied to payroll costs and the balance to rent, utilities, interest on qualified indebtedness.

The PPP will support the continued existence of some closely held businesses that do not lay off their employees and do not cut their salaries, especially those businesses that had few reserves[xv] before they were suddenly shut down. But will it help these businesses to “reboot” after the health crisis passes? It remains to be seen, but I have my doubts.

Consider the following excerpt from a report issued by the New York State Comptroller in 2019, “Small Business in New York State: An Economic Snapshot” – it speaks for itself:

While an enterprise can be classified as a small business based upon its number of employees, its annual income or both, the U.S. Small Business Administration  (SBA) and this report primarily define a small business as one with fewer than 500 employees.

Over the last five years for which data are available, employment at New York’s small businesses rose by 9.2 percent, slightly faster than the national pace. Total payroll showed strong growth, rising to $212.6 billion in New York . . .  Among the more than 465,000 businesses in New York in 2016, 99 percent were small businesses. In addition, the State was home to over 1.7 million non-employer businesses, which largely comprise self-employed individuals.

Of the small businesses with paid employees in 2016, almost two-thirds had fewer than five employees, with over 81 percent having fewer than 10 employees, as shown in Figure 2. These 374,000 microbusinesses provided over 957,000 jobs with total payroll close to $43 billion.

Altogether, small businesses accounted for just over half of all private sector jobs in New York in 2016, providing over 4.1 million jobs. In addition, these businesses provided over $212 billion in payroll, nearly 40 percent of the total private sector payroll.

. . .

Small businesses account for the vast majority of firms in every industry sector in New York. In 2016, over 95 percent of all the firms in each industry sector were small businesses. Three of the 12 industry sectors account for almost half of all small businesses in New York. As defined by the U.S. Census Bureau, payroll includes all forms of compensation paid to all employees, such as salaries, wages, commissions, bonuses, vacation allowance, and sick leave pay.

. . .

The rest is simple math.[xvi]

Tax Relief? Maybe

Other parts of the Act, however, may assist certain businesses to obtain some badly needed cash relatively quickly, and to thereby mitigate the economic effects of the health crisis; for others, the benefit may come too late.

I am referring to the few business tax-related provisions in the legislation. These are not “new” tax benefits or incentives; rather, they represent the temporary relaxation of amendments enacted as part of the Tax Cuts and Jobs Act of 2017 (the “TCJA”)[xvii] – amendments that were intended to compensate for lost tax revenue attributable to the reduction of the Federal corporate income tax rate to a flat 21 percent.[xviii]

In sum, the intended effect of the Act’s tax provisions is to allow businesses that realized losses during prior years (before 2020) to convert those losses into refunds that will be payable (and usable) currently, and to permit business owners to use other losses to offset otherwise taxable income, thereby enabling those tax dollars to be applied elsewhere.

NOLs

A taxpayer’s net operating loss (“NOL”) for a taxable year is equal to the amount by which a taxpayer’s business deductions exceed its gross income from the business for that year.[xix]

In general, prior to the TCJA, an NOL could carried back two years and carried forward 20 years to offset the taxpayer’s taxable income in such years.[xx] An NOL would offset taxable income in the order of the taxable years to which the NOL would be carried.[xxi]

In the case of a business that was coming out of a challenging period, the two-year carryback often provided a ready source of liquidity where the carryback years were profitable years for which income taxes were paid. By reducing the taxable income for those carryback years, the business could generate a refund of monies that it could then expend in its operations.

NOLs after the TCJA

The TCJA amended the Code so as to limit a taxpayer’s NOL deduction for a taxable year to 80 percent of the taxpayer’s taxable income for such year (determined without regard to the deduction).

Carryovers to other years were adjusted to take account of this limitation, and would be carried forward indefinitely.[xxii] The two-year carryback of NOLs was repealed.

These changes were effective for NOLs arising in taxable years beginning after December 31, 2017. For example, NOLs for taxable years ending on December 31, 2018, or on December 31, 2019 (for calendar year taxpayers) could not be carried back. The same applied for any taxable year beginning on or after February 1, 2018 and ending on or after January 31, 2019 (for fiscal year taxpayers); thus, in the case of an NOL realized during the taxable year starting June 1, 2019 and ending May 31, 2020, the NOL could not be carried back to an earlier year.

NOLs after the CARES Act

The Act allows a taxpayer that realizes an NOL during a taxable year beginning after December 31, 2017 and before January 1, 2021 to carry such NOL back to each of the five taxable years preceding the year of the loss.[xxiii]

Thus, a taxpayer that realized an NOL during a taxable year beginning in 2018 or in 2019 may carry those NOLs back five years, which may create an opportunity for a refund claim in 2020 with respect to an earlier year for which the taxpayer had an income tax liability.

Unfortunately for a taxpayer that suffers a loss during a taxable year that begins in 2020, the tax benefit attributable to the carryback of such loss will not be realized until the taxpayer files its return for that year, in 2021, which is still several months away. That is not to say that a refund at that time would not be welcomed – it’s just that the liquidity it may provide would likely be more helpful sooner rather than later.

The Act also repealed the “80 percent of taxable income” limitation for NOL carryovers arising in taxable years beginning before January 1, 2021.[xxiv]

Thus, an NOL realized in a taxable year beginning in 2018 that is carried to 2019 and 2020, and an NOL realized in a taxable year beginning in 2019 that is carried back to 2018 and forward to 2020, may be utilized without regard to the TCJA’s “80 percent limitation” – the NOLs may be used to offset all of the taxpayer’s taxable income.

Unfortunately for a taxpayer that suffers a NOL in a taxable year that begins in 2020, any tax benefit attributable to the carryback or carryforward of such loss will not be realized until the taxpayer files its return for that year, which is still several months away.

The 80 percent limitation is reinstated for taxable years beginning after December 31, 2020.

As indicated earlier, this change may create opportunities for refunds for those taxpayers who realized losses during the years indicated.

Non-Corporate Taxpayer Loss Limitations

The passive loss rules – which generally apply to individuals, estates and trusts – limit deductions from passive trade or business activities. A passive activity for this purpose is a trade or business activity in which the taxpayer owns an interest, but in which they do not materially participate. A taxpayer is treated as materially participating in an activity only if the taxpayer is involved in the operation of the activity on a basis that is regular, continuous, and substantial. Deductions attributable to passive activities, to the extent they exceed income from passive activities, generally may not be deducted against other income. Deductions that are suspended under these rules are carried forward and treated as deductions from passive activities in the next year. The suspended losses from a passive activity are allowed in full when a taxpayer makes a taxable disposition of their entire interest in the passive activity to an unrelated person.[xxv]

TCJA Excess Business Loss

Following the enactment of the TCJA, for taxable years beginning after December 31, 2017 and before January 1, 2026, the “excess business losses” of a taxpayer other than a corporation are not allowed for the taxable year. Instead, such losses are carried forward and treated as part of the taxpayer’s NOL carryforward in subsequent taxable years.[xxvi]

A taxpayer’s excess business loss for a taxable year – which is determined after the application of the passive loss rules – is the excess of the aggregate deductions of the taxpayer attributable to trades or businesses of the taxpayer, over the sum of aggregate gross income or gain of the taxpayer (whether or not related to a trade or business) plus a “threshold amount.” The threshold amount for a taxable year is $250,000 per taxpayer.[xxvii]

In the case of a partnership or an S corporation, the provision applies at the partner or shareholder level. Each partner’s distributive share and each S corporation shareholder’s pro rata share of items of income, gain, deduction, or loss of the partnership or S corporation are taken into account in applying the limitation under the provision for the taxable year of the partner or S corporation shareholder.

The provision was to be effective for taxable years beginning after December 31, 2017.

Excess Business Losses after the Act

The Act defers the effective date of the excess business loss rules.[xxviii] Specifically, the rules will apply only to taxable years beginning after December 31, 2020 and before January 1, 2026.

Consequently, an individual taxpayer who realizes a loss from an operating business in a taxable year beginning before January 1, 2021 – whether as a sole proprietor, as a partner in a partnership, or as a shareholder in an S corporation – and who runs the gauntlet of the basis,[xxix] at risk[xxx] and passive loss rules, will be allowed to apply such losses against their other income for such taxable year, including salary and investment income.

As in the case of NOLs described above, this change will afford some taxpayers an opportunity to claim a refund with respect to their taxable years beginning in 2018 and 2019, and to use the proceeds therefrom in their business.

Business Interest Deductions

Generally speaking, interest paid or accrued by a business is deductible in the computation of taxable income, subject to a number of limitations. In the case of a taxpayer other than a corporation, the deduction for interest on indebtedness that is allocable to property held for investment (“investment interest”) is limited to the taxpayer’s net investment income for the taxable year. Disallowed investment interest is carried forward to the next taxable year.

TCJA Interest Deduction Limitation

The TCJA limited a taxpayer’s deduction for business interest for a taxable year to an amount equal to the sum of (1) business interest income;[xxxi] and (2) 30 percent of the adjusted taxable income of the taxpayer for the taxable year. The amount of any business interest not allowed as a deduction for any taxable year is treated as business interest paid or accrued in the succeeding taxable year. Excess interest deductions are carried forward indefinitely, subject to certain restrictions.[xxxii]

For purposes of this limitation, “adjusted taxable income” generally means the taxable income of the taxpayer computed without regard to any item of income, gain, deduction, or loss which is not properly allocable to a trade or business; certain other adjustments are also made.

The limitation does not apply to taxpayers with average annual gross receipts for the three-taxable year period ending with the prior taxable year that do not exceed $25 million. In addition, at the taxpayer’s election, any real property trade or business is not treated as such for purposes of the limitation, and therefore the limitation does not apply to such a trade or business.

This rule applies to taxable years beginning after December 31, 2017.

A More Relaxed Rule

In the case of any taxable year beginning in 2019 or 2020, the Act increases the limitation from 30 percent to 50 percent of adjusted taxable income.[xxxiii]

In this way, a taxpayer filing their income tax return for 2019 may take advantage of the increased limitation to further reduce their income tax liability and to retain the tax savings in the business.

In addition, for a taxable year beginning in 2020, the Act permits a taxpayer to use their 2019 adjusted taxable income for purposes of determining their “interest deduction limitation” for 2020. Thus, if the taxpayer’s 2019 adjusted taxable income is greater than that for 2020 – which may very well be the case given our circumstances today – the taxpayer may claim a greater interest deduction and, thereby, further reduce their income tax liability.

What Else?

In addition to the foregoing “amendments” to the TCJA, the Act adds a number of other provisions that are intended to improve the cash flow of many businesses that have been impacted by our strategy for containing the coronavirus. For example, the employee retention credit for qualifying employers,[xxxiv] and the deferred remittance over a two-year period of certain payroll taxes accrued during 2020 may help a number of businesses.[xxxv] Ironically, as the restaurant industry teeters on the brink, the Act retroactively amended the Code to treat “qualified improvement property”[xxxvi] as 15-year property for which bonus depreciation may be claimed – taxpayers affected by this change should file refund claims for 2018 or 2019, as the case may be.

What’s Next?

We have to wonder how a health crisis like the present one should cause as much harm as it has, as quickly as it has. Many businesses will fail that should not have failed. As a consequence, people will lose jobs they should not have not lost. The ripple effects are obvious, and I doubt they will be short-lived.

Those closely held businesses that survive – whether because they were “lean and mean” before the coronavirus-induced economic crisis, or had adequate reserves or other financing sources, or for some other reason, including plain luck – are still likely to have realized not insignificant losses. They are also likely to be in need of new capital.

I am not an economist. I have never served in government. I’m a tax attorney.[xxxvii] I recognize that tax legislation can be a powerful tool for promoting the achievement of long-term[xxxviii] economic and other goals that our society deems worthy. One such goal should be the security of business and, thereby, of jobs.

Why not use the Code to encourage a business to establish emergency reserves for salaries and other expenses for a prescribed period of time (say, between 30 and 60 days?), that may be accessed only in the event of a “crisis” as declared by the President or, where appropriate, by the governor of a State? For example, the business would retain as reserves in a segregated account a portion of those funds that would otherwise have been distributed to owners. In exchange, the business would receive a tax credit. Or provide that a business may claim a tax deduction for the creation of a reserve based on the amounts that would otherwise have been paid as executive compensation?[xxxix] These tax benefits may be coupled with the protection of such accounts from the claims of creditors. In addition, perhaps we can “reform” the purpose for captive insurance to serve as a kind of rainy day fund for these kinds of situations, to which the insureds – a community of businesses – would make tax deductible contributions.

I am sure there are many other possibilities for using the Code in this manner.

__________________________________________________________________________________________________

[i] The Coronavirus Aid, Relief and Economic Security Act (the “Act”); H.R.748 – 116th Congress (2019-2020).

[ii] Forty-two at last count.

[iii] Perhaps even as a disruption in whatever it is that binds us to one another as humans.

Of course, I am echoing Obi-Wan Kenobi: “I felt a great disturbance in the Force. As if millions of voices cried out in terror, and were suddenly silenced. I fear something terrible has happened.” Star Wars Episode IV: A New Hope.

[iv] There were a couple of record-setting drops in between – a true crash.

[v] Like so many others, I expect that the workplace and the way we work will undergo a major transformation once we have closed this chapter in our history.

[vi] The States have taken a beating. Reserves have disappeared, and surpluses have turned into deficits. As a result of the economic downturn, tax revenues are waning. Many state and local governments are reducing their workforce. They are requesting Federal assistance.

[vii] The legislation was introduced in the Senate in Mid-March, while the House was on recess. After a couple of failed attempts by the Senate leadership to bring the bill to a vote, Nancy Pelosi threatened that the House would offer its own, very different bill. After some typical Washington wrangling, the two parties announced on March 25 that they had come to an agreement. That same day, the Senate passed the Act by a vote of 96-0. The House, though still in recess, approved the legislation by voice vote the next day.

There was one surprise, however, when Rep. Massie of Kentucky tried to force a roll-call vote. John Kerry tweeted: “Congressman Massie has tested positive for being an asshole. He must be quarantined to prevent the spread of his massive stupidity.”

[viii] Including those who have been furloughed or fired.

[ix] This is nowhere near enough.

[x] In case you haven’t gotten up to speed, the loans will be made by private banks, and will be 100% guaranteed by the SBA, will not require collateral or personal guarantees, and will be non-recourse to the owners of the borrowing business. What’s more, the loan is forgivable provided the borrower expends the proceeds during an 8-week period for certain enumerated purposes; in fact, at least 75% must be applied to payroll costs. If forgiven, the loan will not be included in the borrower’s gross income as cancellation of indebtedness income.

SBA-approved banks were supposed to start accepting loan applications under the PPP on Friday, April 3. Unfortunately, several large banks – you may recall that the U.S. taxpayer bailed them out during the Great Recession – are still sitting on the sidelines.

[xi] In general, equal to the lower of (i) 250% of its payroll costs, and (ii) $10 million.

[xii] Including employee wages, salaries, retirement benefits, paid leave, health care, and other items.

[xiii] The PPP is clearly structured to help employees weather the virus-induced storm. It provides them with the funds needed to pay for food and shelter.

But it should be noted that not every business expends over 70% of its budget on the cost of labor – some service businesses may, but not a manufacturer or other capital intensive businesses. The former generally have relatively high margins, while the latter have relatively slim ones.

What’s more, an employee may be better off if they were laid off. The PPP provides for $600 per week to an employee who has lost their job as a result of the health crisis; this is in addition to whatever State benefits they are receiving. In many cases, the total will exceed what they make while gainfully employed.

Of course, in that case, the employer-business will not qualify for a loan under the PPP. (See the required certification, above.)

[xiv] Eight weeks later.

[xv] Query how many closely held businesses maintain “rainy day” funds? It is often the case that they do not enjoy years in which they realize substantial windfalls that may be set aside. The funds are, instead, used to repay loans from third parties and from the owners themselves. Then there is the advice they receive from their attorneys not to leave “excess” funds in the business where they may be reached by its creditors or other claimants. In the case of C corporations that have accumulated earnings in excess of the “reasonable needs of the business,” the accumulated earnings tax has to be considered – perhaps we need to rethink what that means.

See my Op Ed piece in The Empire Reporthttps://www.taxlawforchb.com/2020/03/lou-vlahos-op-ed-economic-losses-blame-the-virus-not-entirely-published-in-the-empire-report/

[xvi] Especially when you consider all the taxes payable by a New York business in respect of employee salary; for example, Social Security, Medicare, Federal Unemployment, NY State Unemployment, NY Re-employment, NY Disability Benefits and, in many cases, NY Metropolitan Commuter Transportation Mobility Tax. Phew!

[xvii] P.L. 115-97.

[xviii] This replaced a graduated rate regime with a maximum rate of 35 percent.

[xix] IRC Sec. 172(c).

[xx] IRC Sec. 172(b)(1)(A) before the TCJA. Different carryback periods applied with respect to NOLs arising in different circumstances. Extended carryback periods were allowed for NOLs attributable to specified liability losses and certain casualty and disaster losses. IRC Sec. 172(b)(1)(C) and (E).

[xxi] IRC 172(b)(2) before the TCJA.

[xxii] The 20-year carryforward period was eliminated.

[xxiii] Section 2303(b) of the Act. Thus, these changes have retroactive effect.

A slightly modified version of the 80% limitation remains in effect for taxable years beginning after 2020.

[xxiv] Section 2303(a) of the Act.

[xxv] IRC Sec. 469.

[xxvi] IRC Sec. 461(l).

[xxvii] Or twice the otherwise applicable threshold amount in the case of a joint return. The threshold amount is indexed for inflation.

[xxviii] Actually, it suspends it retroactively.

[xxix] IRC Sec. 704(d), Sec. 1366(d).

[xxx] IRC Sec. 465.

[xxxi] Business interest means any interest paid or accrued on indebtedness properly allocable to a trade or business. Business interest income means the amount of interest includible in the gross income of the taxpayer for the taxable year which is properly allocable to a trade or business. Business interest does not include investment interest, and business interest income does not include investment income.

[xxxii] IRC Sec. 163(j).

[xxxiii] Sec. 2306 of the Act.

[xxxiv] Section 2301 of the Act. This amounts to a $5,000 credit per employee. Of course, a business that participates in the PPP is not entitled to the claim.

[xxxv] Section 2302(d)(3) of the Act.

[xxxvi] Section 2307 of the Act. Basically, improvements to a nonresidential building which are placed in service after the building. IRC Sec. 168(e)(3)(E).

[xxxvii] Dr. McCoy anyone? “I’m a doctor, not an engineer.” There were many variations on this line throughout the Star Trek series.

[xxxviii] This should be stressed. Tax policy has to take a long-term view in order to be effective.

[xxxix] Perhaps we can allow the business to borrow a limited amount from its account for short periods (like a bridge)?

The IRS has determined that any person required to pay Federal gift tax or generation-skipping transfer tax or to file IRS Form 709 (United States Gift and Generation-Skipping Transfer Tax Return) on April 15, 2020, is deemed to be affected by the COVID-19 emergency and, so, should be granted an extension of time within which to file such returns and to pay the related tax.

Specifically, the due date for filing Forms 709 (United States Gift and Generation-Skipping Transfer Tax Return) and for making payments of Federal gift and generation-skipping transfer tax that would otherwise be due on April 15, 2020, is automatically postponed to July 15, 2020. See IRS Notice 2020-20.

This relief is automatic; in other words, there is no requirement to file IRS Form 8892 (Application for Automatic Extension of Time to File Form 709 and/or Payment of Gift/Generation-Skipping Transfer Tax) in order to obtain the benefit of this filing and payment postponement until July 15, 2020.

However, a taxpayer may choose to file an application for extension by July 15, 2020, in order to obtain an extension to file Form 709 by October 15, 2020. Please note, however, that any Federal gift and generation-skipping transfer tax liabilities reflected on such returns, the payment of which has been postponed by Notice 2020-20, will still be due on July 15, 2020.

As a result of the postponement of the due date for filing Forms 709 and for making Federal gift and generation-skipping transfer tax payments from April 15, 2020, to July 15, 2020, the period beginning on April 15, 2020, and ending on July 15, 2020, will be disregarded in the calculation of any interest, penalty, or addition to tax for failure to file a Form 709 or to pay Federal gift and generation-skipping transfer taxes shown on that return and postponed by the Notice.

Instead, interest, penalties, and additions to tax with respect to such postponed Forms 709 and payments will begin to accrue on July 16, 2020.

One lingering question: What about the Federal estate tax? Unfortunately, the normal filing and payment due dates continue to apply to the estate tax.


If you would like to discuss how the $2 trillion CARES Act affects you, your family or your business, please do not hesitate to contact Lou Vlahos, Tax Partner at Farrell Fritz or your Farrell Fritz Relationship Partner.

For additional resources, please visit our COVID-19 Crisis Response and Help page.

Optimal Timing?

During the last twenty years, there have been a number of times during which the owners of closely held business entities have been encouraged – “urged” might be a better word, at least in some cases – by many advisers to take advantage of what may be described as “adverse” economic circumstances to do some gift and estate planning.

A sluggish economy, one with slow or no growth, is usually the catalyst. This is invariably accompanied – or caused? – by dropping consumer confidence which, in a service-based economy such as ours, only makes matters worse. The stock market will reflect[i] this less-than-positive outlook and, as the market declines, so will the value of most people’s retirement funds. The Fed will drop rates to encourage spending by businesses and consumers in the hope of limiting and hopefully reversing the effects. Government may “start” spending more in order to spark economic activity.

Where is the silver lining in all of this? “It’s the perfect environment,” many might say to a business owner, “to do some estate tax planning.” Why is that? “Because the value of your business has likely declined.”

To these folks, I say, “Slow down, don’t move too fast.”[ii]

The Goal of E-Tax Planning

The goal of estate tax planning, of course, is to transfer from members of a family’s older generation to members of its younger generation – without incurring a gift tax liability[iii] – those assets which now have a relatively low value – whether as a result of a downturn in the business, in its industry, in the economic generally, or otherwise – but which are reasonably expected to appreciate in value over time.

In theory, that is one way in which a gift tax or estate tax plan may be implemented – it is somewhat analogous to the adage about “buying low and selling high.”[iv]

For example, Parent owns an established business that may take off in a couple of years because of anticipated regulatory changes in its industry, or Parent may have recently started a business that is developing a new technology that promises to one day change the way widgets[v] are manufactured, or Parent’s business may be confident of eventually obtaining Federal approval for a new drug it is developing. In the hope of sharing with their children some portion of the future value of this business, Parent may decide to make a gift of some equity in the business to a trust for the benefit of the children.[vi] Because the value of this equity interest is relatively low as compared to what Parent reasonably believes are its prospects, such a gift makes sense.[vii] Their transfer of an equity interest to a child will not consume a large part of Parent’s federal exemption amount. What’s more, the transfer to a child or to a trust for their benefit removes the interest from Parent’s gross estate for purposes of the Federal estate tax; it also removes the future growth in the value of the interest from their estate.

That’s the underlying theory.

Flashback

It is a basic precept of estate planning that Parent should not dispose of any interest in their business that they are not comfortable giving up[viii] – whether for business or personal reasons – regardless of how much such a transfer may ultimately save in gift and estate taxes. It may not be the smartest decision from a tax planning perspective, but it is Parent’s property.

Do you recall the end of 2012? The Federal unified exemption amount, which was set at $5.12 million per person, was scheduled to revert on January 1, 2013, to its 2002 level of $1 million per person.[ix] Many business owners panicked at the thought of losing the opportunity to pass at least a portion of the value of their business to their children on a tax-sheltered basis.

What did they do in the face of this pending calamity? They made gifts before the clock struck 12:00 am on January 1, 2013. On that day, however, Congress passed the American Taxpayer Relief Act,[x] which President Obama signed into law on January 2, 2013, with retroactive effect.

On January 3, 2013, many of those business owners who had rushed to make gifts in December 2012 called their attorneys to see how they could rescind their 2012 transfers. “You’ll have to buy it back,” they were told,[xi] or “your kids will have to gift it back to you.” I can tell you, no one wanted to hear that.[xii]

In the case of those who made their gifts into a grantor trust with respect to which they retained a power of substitution,[xiii] the resulting income tax liability of such a repurchase was avoided. In those other cases . . . Oh well.

The “Recalcitrant” Parent

In some instances, Parent may be reluctant to part with any of their voting power in the business, though this may be easily addressed by providing for voting and nonvoting equity interests,[xiv] with only the latter being gifted.

In addition, a well-drafted shareholders’ or partnership/operating agreement can go a long way in securing Parent’s control over the business.

Parent’s Economics

In other instances, Parent may be loath to give up any of the economic benefits, including the right to distributions, associated with their ownership of the business.

In many cases, the “lost” cash flow may be addressed, in part, by structuring the transfer to the kids as one in which Parent retains an interest in the transferred property,[xv] or as one that is made in exchange for consideration.[xvi]

This has two beneficial consequences: the amount of the gift is reduced by the amount of the consideration to be received by Parent, and it provides Parent with a flow of funds. One potentially adverse result is that the transfer may be treated as a sale for income tax purposes which may cause Parent to have a taxable gain.

GRAT

For example, Parent may contribute some of their equity in the business to an irrevocable trust,[xvii] but will retain the right to be paid an annuity (basically, a fixed amount) from the trust every year, for a specified number of years[xviii] – a grantor retained annuity trust, or GRAT.[xix] When the term of Parent’s retained annuity interest ends, the property remaining in the trust will either remain in trust for the benefit of Parent’s children, or the trust may liquidate, with the property passing to the children as the beneficiaries of the remainder interest.

The trust is typically drafted so that the annuity amount payable to Parent is based upon a percentage of the value of the property as of the day the property was transferred by Parent to the trust.[xx] Once the annuity amount has been determined, Parent may calculate the amount of the gift arising from their transfer to the trust – i.e., the present value of the remainder interest, which is determined as of the date of the transfer to the trust using an interest rate prescribed by the IRS.[xxi]

In addition, the GRAT is typically drafted so as to be treated, for purposes of the income tax, as a so-called “grantor trust” – in general, a trust with respect to which the grantor has retained an interest such that the grantor will continue to be treated as the owner of the income and assets of the trust.[xxii] Because a taxpayer cannot sell property to themselves, and because the grantor is treated as owning the trust property, any transfers of property and payments of cash between Parent and the grantor trust will be disregarded for income tax purposes.[xxiii]

Sale

Alternatively, Parent may sell some of their equity interest in the business to a grantor trust[xxiv] in exchange for a promissory note with a face amount equal to the value of such equity interest. The loan should bear interest at least equal to the applicable federal rate (“AFR”), as determined by the IRS.[xxv] This interest may be payable on a current basis,[xxvi] with a balloon payment of principal when the note matures.[xxvii] Hopefully, the equity “sold” to the trust will have appreciated enough by then so that the trust may satisfy its obligation under the note by returning some of the equity to Parent. In this way, Parent avoids making a taxable gift while also avoiding taxable gain on the sale.

If there is little gain inherent in the equity interest to be transferred, Parent may choose to sell the property outright to child or to a non-grantor trust in exchange for a note bearing interest at the AFR.[xxviii]

The Federal transfer tax gambit in the case of a GRAT is that the equity interest transferred by Parent will appreciate, or will produce income, at a rate that is greater than the AFR – i.e., the interest rate that the IRS requires to be applied in determining the value of the gift in the case of the GRAT. If such appreciation or income levels are realized, then the excess will remain in the trust at the end of the term of Parent’s retained annuity interest. Thus, in a low interest rate environment like the one in which we now find ourselves, the GRAT may prove effective in removing value from Parent’s future estate.

In the case of an installment sale, the AFR represents the minimum rate of interest that the IRS requires be charged under the notes in order to avoid an imputed gift of any foregone interest.

Does Gifting Make Sense?

However, under the economic circumstances assumed herein, including the reduced value of the business – which likely stems in no small part from a not-insignificant drop in its revenues – one may question the wisdom, let alone the need, for Parent to transfer any of their equity interest in the business to, or for the benefit of, their child for the purpose of reducing Parent’s potential estate tax exposure.

As a result of the Tax Cuts and Jobs Act,[xxix] every individual has a combined Federal gift/estate tax exemption of $11.58 million;[xxx] in the case of married persons (especially a couple that takes advantage of “portability”), the exemption is $23.16 million per couple. Thus, an individual may, by a combination of lifetime and testamentary dispositions, transfer property with an aggregate fair market value of $11.58 million without incurring Federal gift or estate taxes. Where such property consists of interests in an ongoing, closely held business for which there is no ready market, the valuation of such interests will reflect their lack of liquidity.

In light of the foregoing, many business owners may ask “why give up any interest in the business?” The owner may feel that they need complete ownership – and whatever economic benefits they can derive or extract from such ownership – until the business stabilizes and starts to recover. Until then, they may not want to risk giving up any of its value or cash flow, especially if they feel they may need to sell the business down the road in order to fund their retirement because their IRA or other retirement accounts have taken a beating.

2026 or 2021?

As if a near economic disaster isn’t enough, enter the scheduled sunset of the increased gift/estate tax exemption amount. Specifically, for gifts made and for decedents dying after 2025, the exemption amount will revert to its pre-2018 levels; basically, it will be cut in half.

“But, Lou, you realize that we’re only in 2020, right?”

There is a more imminent threat to the higher exemption amount than the 2025 sunset: the November 2020 presidential election. The Democrats already control the House of Representatives – will they retain it? They need to win only three or four seats (depending on who wins the vice presidency) to take the Senate. What if they also win the White House?

Given the tenor and clear message of the Democratic primary contests, a reduction in the gift/estate tax exemption amount and an increase in the maximum gift/estate tax rate[xxxi] should be expected in 2021 in the event the Democrats do well this November.[xxxii]

What’s more, it is no longer only a question of principle or fairness or redistribution of wealth – the government must somehow come up with a way to pay for the $2.2 trillion economic stimulus package enacted on March 27, 2020,[xxxiii] and these Federal transfer taxes are fair game. In other words, the taxpayers at whom these taxes are targeted would be fortunate if we reverted to pre-TCJA law.

Scylla and Charybdis[xxxiv]

What to do?

Dispose of as much of the business as possible while the exemption amount is still high? Utilize GRATs and sales to grantor trusts to preserve some of the cash flow from the business to the owner? Retain only enough of an interest in the business so as to enable one’s estate to qualify for installment reporting of the estate tax attributable to the business?[xxxv] Hold on to the business, and purchase additional life insurance in an irrevocable trust?

All of the above? Probably.

Unfortunately, there’s a lot to think about here, but not a lot of time to plan.


[I] And reinforce? I have always viewed the stock market as a reactive element in the chemistry of the economy. You add information to the pot, and “it” responds based on some mix of perceived short-term and long-term self-interest. I’m sure that others view it differently.

[ii] Remember “The 59th Street Bridge Song”? Have you wondered whether we should now be calling it the “Ed Koch Queensboro Bridge Song”? I don’t think S&G would approve. “Slow down, you move too fast.”

[iii] New York no longer imposes a gift tax, though it will pull back into a decedent’s taxable estate any taxable gifts made by a resident decedent during the three-year period ending with the decedent’s date of death. NY Tax Law Sec. 954(a)(3). This claw-back provision applies to decedents dying before January 1, 2026. Would anyone be surprised to see it extended? Nope.

[iv] The gift and estate taxes are sometimes referred to as “transfer taxes.”

[v] No, this is not some item from Harry Potter, like a horcrux or a golden snitch. It is much more practical than such childish imaginings. For attorneys, a widget is a smallish, fictional device that is manufactured by a hypothetical business that can’t seem to catch a break. This poor widget manufacturer is forever involved, it seems, in some form of litigation, whether based on a commercial or other tort, a breach of contract, a misplaced peppercorn, etc.

[vi] Lots of good reasons for a trust. Keeping the property out of the kids’ hands will help to keep it out of the hands of their spouses and creditors, and will make it financially more difficult for the kids to engage in harmful behavior, like gambling or substance abuse.

[vii] Especially when one considers the valuation methodology for a going concern. Add to that the fact that the gift may consist of a minority interest which is not easily transferable, and the valuation may be quite favorable from a gift tax perspective.

[viii] In the words of many planners, it should be “disposable.”

[ix] The “sunset” of EGTRRA’s estate and gift tax provisions (P.L. 107-16), as extended and modified by the 2010 Extension Act (P.L. 111-312).

In addition, portability of a predeceasing spouse’s unused exemption amount would have been eliminated, and the tax rate would have increased to 55 percent. Oy.

[x] P.L. 112-240.

[xi] After all, in order for a gift to be effective for estate and gift tax purposes, it has to be a completed transfer. Reg. Sec. 25.2511-2.

Many clients asked why they had to pay to recover the gifted property. “After all,” several of them said, “my kids have no idea I even established a trust for them.” Oy, again.

[xii] And I am certain that many engaged in “self-help” at that point.

[xiii] IRC Sec. 675(4).

[xiv] In the certificate of incorporation in the case of a corporation; in general, in the operating agreement, in the case of a partnership/LLC.

[xv] Instead of an outright gift.

[xvi] A partial gift.

[xvii] With an “understanding” trustee. It also helps if Parent has the right to remove a trustee and, within certain limits, to appoint another.

[xviii] The “term” of Parent’s retained annuity interest in the trust.

[xix] IRC Sec. 2702; Reg. Sec. 25.2702-3. The GRAT will typically rely upon receiving distributions from the property contributed to the trust in order to make the annuity payments. For this reason, where the GRAT is funded with an interest in a closely held business organized as a partnership/LLC or as an S corporation – i.e., a pass-through that is not itself taxable – more cash will be left for the trust with which to make the necessary distributions.

[xx] In the event the IRS were to ever successfully challenge the reported value for the property, the annuity amounts would likewise be adjusted, thereby reducing what otherwise would have been the increased value of the gifted remainder interest. Reg. Sec. 25.2702-3(b)(2).

[xxi] IRC Sec. 7520. Specifically, 120% of the short-term AFR under Sec. 1274.

[xxii] Under the grantor trust rules. See IRC Sec. 671 – 679. The deemed owner will continue to be taxed on the income and gains recognized by the trust. If the owner-grantor can afford bearing this income tax liability, the trust may grow without being reduced for taxes. What’s more, the grantor’s payment of the income tax is not treated as a gift by the grantor for purposes of the gift tax.

[xxiii] Rev. Rul. 85-13.

[xxiv] So as to avoid adverse income tax consequences; i.e., taxable gain from the sale.

[xxv] IRC Sec. 1274. If a lower rate were charged, the foregone interest would be treated as a taxable gift by Parent.

[xxvi] The note has to be respected as such for purposes of the gift tax. The payment of such interest is not taxable to the grantor-owner. They cannot pay interest to themselves.

[xxvii] An installment sale. On the death of Parent, the trust ceases to be treated as a grantor trust, and the sale in exchange for a note is completed for purposes of the income tax. A balloon payment is often used because if Parent dies while the note remains outstanding, their estate may be able to claim a step-up in basis for the equity interest “sold” and thereby avoid any gain recognition. Of course, the note is included in Parent’s gross estate for purposes of the estate tax.

[xxviii] If the value of the equity interest was less than Parent’s adjusted basis for the interest – i.e., a sale would result in the realization of a loss – Parent may want to reconsider selling the interest to a family member; that’s because IRC Sec. 267 disallows (suspends, really) the recognition of loss arising from a sale or exchange between certain related persons.

[xxix] P.L. 115-97 (the “TCJA”). Effective for gifts made and decedents dying after 2017.

[xxx] IRC Sec. 2010(c)(3) and (c)(4); Sec. 2505. This is in addition to the annual gift exclusion amount of $15,000. IRC Sec. 2503.

[xxxi] The current maximum rate is 40 percent.

[xxxii] In addition, one should expect a Democratic assault on the discounts commonly taken when valuing interests in a closely held business for purposes of the gift and estate taxes.

[xxxiii] The Coronavirus Aid, Relief and Economic Security Act.

[xxxiv] No, not the line from Wrapped Around My Finger by The Police. Rather, the mythical monsters that were thought to inhabit opposite sides of the Straits of Messina and who preyed on passing sailors. They figured prominently in Homer’s Odyssey. Given the severity of the choices described here, we may want to throw in a Cyclops for good measure.

[xxxv] IRC Sec. 6166. https://www.taxlawforchb.com/2020/03/recapitalizing-debt-to-defer-payment-of-the-estate-tax-good-idea/