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There are two tax issues here. First, are PPP loan expenses deductible? Second, can an S corporation shareholder increase stock basis for income from discharge of the PPP loan that CARES excluded from income?
Let’s look at three scenarios. In all three we will assume a sole S corporation shareholder with a capital investment, and stock basis, of $300,000. The corporation borrows $200,000 on a PPP loan and pays $200,000 of allowed expenses. The loan is then forgiven and the stock sold for $300,000.
First, we’ll assume the PPP expenses are not deductible and there is no basis increase allowed for excluded income from loan forgiveness. The stock basis stays at $300,000. The sale of the stock produces no gain.
Second, the corporation deducts the $200,000 of expenses but there is no basis adjustment allowed for debt forgiveness income that is excluded from income. The deductions reduce stock basis to $100,000. A stock sale then produces $200,000 of capital gain.
Third, the corporation deducts the $200,000 of expenses and the shareholder claims a $200,000 positive basis adjustment for debt forgiveness income that is excluded from income. Stock basis goes up and down but stays at $300,000. A stock sale then produces no gain.
Our first situation produces no tax result – from deductions or from income. This matches the economic result – the shareholder simply received his investment back. No economic result, no tax result.
The second situation produces $200,000 of business deductions in one period followed by $200,000 of capital gain. The income and deductions net to zero, again matching the economic result. But we may get deductions early and income late, plus tax-favored treatment of the capital gain.
The third situation allows $200,000 of business deductions with no income offset. Zero economic effect but a net $200,000 tax deduction.
Situation 2 creates non-economic deductions in one period to be offset by non-economic income in a later period. Situation 3 produces $200,000 of non-economic deductions with no offsetting income.
From a policy standpoint only scenario 1 should be right. So what? The question is not what should be right but what is right under the law as it is written.
Poorly written laws lead to illogical results. Abraham Lincoln said the best way to get a bad law repealed is to enforce it strictly.
In Gitlitz, an S corporation had cancellation of debt (COD) income that was excluded under Section 108 of the tax law due to the insolvency of the corporation. The Supreme Court held that the plain language of the statute treated COD as an item of income that allowed the shareholders to increase their stock basis notwithstanding the Section 108 insolvency exclusion.
Other courts had argued a basis increase would allow for a “double windfall.” The Supreme Court said “because the Code’s plain text permits the taxpayers here to receive these benefits, we need not address this policy concern.”
In response to the Gitlitz holding, Congress amended the law to deny a stock basis increase for COD income excluded under Section 108. The amendment applies only within Section 108, that is, only to COD income excluded by Section 108.
So does Gitlitz survive the congressional amendment designed specifically to deal with a policy concern when the amendment, by its plain terms, applies only to income excluded under Section 108?
If Gitlitz survived for non-Section 108 excluded income items, our third scenario is possible. It should not be but it might be.
Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at [email protected].