Deducting Expenses Paid With Paycheck Protection Loans

There was a case in 1931 that is influencing a public controversy today.

Let’s talk about it.

The taxpayer (Slayton) was in the business of buying, holding and selling tax-exempt bonds. He would at times borrow money to buy or to carry tax-exempt bonds he already owned.

Slayton had tax-exempt interest income coming in. That amount was approximately $65 thousand.

Slayton was also paying interest. That amount was approximately $78 thousand.

COMMENT: On first read it does not appear that dear old Slayton was the Warren Buffett of his day.

Time came to file his tax return. He omitted the $65 grand in interest received because … well, it was tax-exempt.

He deducted the $78 grand that he was paying to carry those tax-exempt securities.

The IRS said no dice.

Off to Court they went.

Slayton was hot. He made several arguments:

(1)  The government was discriminating against owners of tax-exempt securities and – in effect – nullifying their exemption from taxation.

(2)  The government was discriminating against dealers in tax-exempt bonds that had to borrow money to carry an inventory of such bonds.

(3)  The government was discriminating in favor of dealers of tax-exempt bonds who did not have to borrow to carry an inventory of such bonds.

I admit: he had a point.

The government had a point too.

(1)  The income remained tax-exempt. The issue at hand was not the interest income; rather it was the interest expense.

(2)  Slayton borrowed money for the express purpose of carrying tax-exempt securities. This was not an instance where someone owned an insubstantial amount of tax-exempts within a larger portfolio or where a business owning tax-exempts borrowed money to meet normal business needs.

The link between the bonds and the loans to buy them was too strong in this case. The Court disallowed the interest expense. Since then, tax practitioners refer to the Slayton issue as the “double-dip.”  The dip even has its own Code section:

        § 265 Expenses and interest relating to tax-exempt income.

(a)  General rule.

No deduction shall be allowed for-

(1)  Expenses.

Any amount otherwise allowable as a deduction which is allocable to one or more classes of income other than interest (whether or not any amount of income of that class or classes is received or accrued) wholly exempt from the taxes imposed by this subtitle, or any amount otherwise allowable under section 212 (relating to expenses for production of income) which is allocable to interest (whether or not any amount of such interest is received or accrued) wholly exempt from the taxes imposed by this subtitle.

Over the years the dip has evolved to include income other than tax-exempt interest, but the core concept remains: one cannot deduct expenses with too strong a tie to nontaxable income.

Let’s fast forward almost 90 years and IRS Notice 2020-32.

To the extent that section 1106(i) of the CARES Act operates to exclude from gross income the amount of a covered loan forgiven under section 1106(b) of the CARES Act, the application of section 1106(i) results in a “class of exempt income” under §1.265- 1(b)(1) of the Regulations. Accordingly, section 265(a)(1) of the Code disallows any otherwise allowable deduction under any provision of the Code, including sections 162 and 163, for the amount of any payment of an eligible section 1106 expense to the extent of the resulting covered loan forgiveness (up to the aggregate amount forgiven) because such payment is allocable to tax-exempt income. Consistent with the purpose of section 265, this treatment prevents a double tax benefit.

I admit, it is not friendly reading.

The CARES Act is a reference to the Paycheck Protection loans. These are SBA loans created in response to COVID-19 to help businesses pay salaries and rent. If the business uses the monies for their intended purpose, the government will forgive the loan.

Generally speaking, forgiveness of a loan results in taxable income, with exceptions for extreme cases such as bankruptcy. The tax reasoning is that one is “wealthier” than before, and the government can tax that accession to wealth as income.

However, the CARES Act specifically stated that forgiveness of a Paycheck Protection loan would not result in taxable income.

So we have:

(1)  A loan that should be taxable – but isn’t - when it is forgiven.

(2)  A loan whose proceeds are used to pay salaries and rent, which are routine deductible expenses.

This sets up the question:

Are the salaries, rent and other qualified expenses paid with a Paycheck Protection loan deductible?

You see how we got to this question, with Section 265, Slayton and subsequent cases that expanded on the double dip.

The IRS said No.

This answer makes sense from a tax perspective.

This answer does not make sense from a political perspective, with Senators Wyden and Grassley and Representative Neal writing to Secretary Mnuchin that this result was not the intent of Congress.

I believe them.

I have a suggestion.

Change the tax law.

SBA Paycheck Protection Program

The last couple of weeks here at Command Center have been … unprecedented.

We have sent employees home, although we have not let anyone go.

Critical personnel (including me somehow) are still coming in, although we are instituting a policy of one-person-in-the-office-at-a-time.  

I understand working at home, but a typical accounting firm is not geared to work from home indefinitely. For one thing, it takes administrative staff to keep the information and document flow going to the at-homers, and there is no administrative staff.

Fortunately, the IRS and many (if not most) states have acknowledged the reality of the situation and are allowing extensions of time to file and pay. There was probably no choice: preparers were not going to be able to get the work done anyway. It is likely that your return will be extended this year, even if you have never extended before.

Some of our clients have shut down. One, for example, works with product promotion at Kroger’s. Have you been to a Kroger’s recently? The last problem they have is moving merchandise.

Let’s talk about something. There is a brand-new SBA program for emergency funding. It may be that you have never considered government assistance before, but these are extreme times.

We are talking about the “Paycheck Protection Program.” Congress took an existing SBA loan program and sweetened the pot. Its purpose is – flat out – to encourage employers to retain employees and – if the employer has already furloughed employees -to hire them back.

Here are the general features of the program:

(1)  It expires June 30, 2020.

(2)  Think businesses with less 500 employees, but there are exceptions.

(3)  In a bit of a surprise for the SBA, the program includes nonprofits (again, with less than 500 employees)

(4)  The maximum loan amount is 2.5 times average payroll during the one-year period before the date the loan is made.

a.    With adjustments for new businesses, of course.

(5)  That maximum caps out at $10 million.

(6)  The loan is principally to fund payroll (with some limitations), but it will also cover health insurance, rent, utilities and some interest expense.

(7)  Now think math:

A times B

A is the sum of those expenses described in (6) for the 8 weeks after you get the loan.

(8)  Let’s talk B.

B is a fraction. The government wants to know whether your workforce has gone up or down in number.

The numerator is going to be the number of employees between February 15 and June 30, 2020.

The denominator is the number of employees during the same period in 2019.

There are adjustments for real-life situations that do not fit the above periods.

There is also a test which substitutes payroll dollars for the number of employees. You fail the test if your payroll reduction (dollar-wise) exceeds 25%.

(9)  So what, you ask.

Let’s say you have 17 employees for the 2020 period.

Let’s say you had 16 employees for the 2019 period.

Fraction-wise, that is over 100%. Let’s round that down to 100%.

Let’s multiply that 100% by something.

What is the something?

The loan you took out.

Let’s say the loan was $125,000.

Multiply $125,000 by 100%.

You get $125,000.

The government will forgive 100 PERCENT of the loan! The entire $125,000 is gone, forgiven, paid-off, hasta luego, soyonara.

Wow.

(10)      Is there a follow-up to that?

Yep.

Generally, the forgiveness of debt results in income to the person whose debt was forgiven. It is why people get those 1099s in the mail from the credit card companies which have given up on collecting.

For purposes of this loan, the forgiveness will NOT count as income.

So let’s get this straight. You keep your employees on board. The government loans you money for your payroll. The government forgives the money. You walk away scot-free.

What happens if you don’t get to 100%? Then a portion of the loan remains. You pay interest not to exceed 4% and repay that portion of the loan over a period of up to 10 years. Still … not bad.

Folks, if this is you – please check it out before the deadline or the funding runs out.

What Happens To Inherited IRAs in Bankruptcy?

Let us discuss IRAs.

You may be aware that there is bankruptcy protection for IRAs. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 exempts up to $1 million in IRAs created and funded by the debtor. Employer plans have even more favorable protection.

Why? The government has expressed interest that citizens be able to save for their retirement. This diminishes the odds of future government assistance and deemed in the public interest.

Fair enough. But I have one more question.

Let us say that you inherited the IRA. Does the above protection still apply to you?

Why wouldn’t it, you might ask. It is like an ice cream bar. It is still an ice cream bar whether you or I take it from the freezer, right?

This very question made it to the Supreme Court in the recent case of Clark v Rameker. While a bankruptcy case, it does have tax implications.

In 2001 Ruth Heffron established a traditional IRA and named her daughter as beneficiary.

NOTE:  “Traditional” means the classic IRA: contributions to it are deductible and withdrawals from it are taxable. Contrast this with a “nondeductible” IRA (contributions are nondeductible and withdrawals are taxable, according to a formula) and Roths (contributions are nondeductible and withdrawals are nontaxable).

Mrs Heffron passed away a year later – 2001 – and left approximately $400,000 to her daughter in the IRA account. Inherited IRAs have special rules on distributions, and one has to take distributions over a life expectancy or withdraw the entire balance within five years. Her daughter – Ms. Heffron-Clark - elected to use life expectancy with monthly distributions.

Fast forward to 2010 and Ms. Heffron-Clark and her husband file for Chapter 7 bankruptcy. The IRA has approximately $300,000 remaining, and you can bet that the couple considered the IRA to be an exempt asset. The unsecured creditors of the bankruptcy estate disagreed, thus beginning the litigation.

·       The Bankruptcy Court said that the IRA was not exempt and could be reached by creditors.

·       The District Court reversed, saying that the IRA was exempt and could not be reached by creditors.

·       The Appeals Court for the Seventh Circuit reversed, saying that the IRA was not exempt and could be reached by creditors.

This set up disagreement between the Fifth and Seventh Circuits, so the Supreme Court agreed to hear the case.

Believe it or not, the Bankruptcy Code does not define the term “retirement funds,” resulting in the above courts drawing such different conclusions. The Supreme Court declared that the term must be defined in order to arrive at a correct conclusion. The Court looked a dictionary and saw that “retirement” is defined as …

       … withdrawal from one’s occupation, business or office.”

The Court wanted to look at the legal characteristics of funds set aside for the day one stops working. It focused on three:

(1)  One can put additional monies into a retirement account.

POINT: One cannot put additional monies into an inherited account. In fact, if one inherits again, one cannot mingle the two accounts. Each is to remain separate and unique.

COUNTERPOINT: One cannot put additional monies into an IRA after age 70 ½.

(2)  Holders of an inherited account are required to begin distributions in the year following the death.

POINT: There are no age 59 ½ or 70 ½ minimum distribution requirements here. It does not matter whether the beneficiary is three years old or ninety-three; distributions must begin in the year following death, unless one fully depletes the account over 5 years.

OBSERVATION: The Court asked obvious question: how does this distribution requirement tie-in to the beneficiary’s retirement in any way?

(3)  The beneficiary can withdraw the entire balance at any time, without penalty.

POINT: You and I cannot do that with our own IRA until we are age 59 ½. 

OBSERVATION”: The Court noted that there is a ‘stick” if one wants to access a traditional IRA early – the 10% penalty. That expresses Congress’ intent to discourage use of traditional IRA s for day-to-day non-retirement purposes. The inherited IRA has no such prohibition. What does that say about Congress’ intent with inherited IRAs?

Rest assured that Ms Heffron-Clark was arguing furiously that the funds in that inherited IRA are “retirement funds” because, at some point, they were set aside for retirement.

The Court looked at the three criteria above and said that the inherited IRA certainly constitutes “funds,” but it cannot see how they rise to the level of “retirement funds.” They simply do not have the characteristics of normal retirement funds.

The Supreme Court unanimously decided that an inherited IRA do not constitute “retirement funds” and are not exempt from bankruptcy claims. Ms. Heffron-Clark’s creditors could in fact reach that $300 grand.

Granted, this is a bankruptcy case, but I see two immediate tax consequences from this decision:

(1) First, a surviving spouse (that is, the widow or widower) has a tax  option offered no other IRA beneficiary.

The surviving spouse can take the IRA as an inherited IRA (and be subject to bankruptcy claims) or he/she can rollover the IRA to his/her own personal name.

In the past, this decision was sometimes made based on the survivor’s age. For example, if the surviving spouse thought he/she might need the money before age 59 ½, the tax planner would lean towards an inherited IRA. Why? Because there is no 10% penalty for early withdrawals from an inherited IRA. There would be penalties on early withdrawals from a rollover IRA.

This decision now gives planners another reason to consider a spousal rollover.

(2) Second, there may be increased attention to IRA accumulation trusts.

A trust is allowed to be an IRA beneficiary, but at the cost of some highly specific tax rules. There are two types of permitted trusts. The first is the conduit trust. The trust receives the annual minimum required distributions (MRDs) but is required to immediately pay them out to the beneficiary.  While you may wonder what purpose this trust serves, consider that the trust – while unable to protect the annual income – can still protect the principal of the trust.

The second type is the accumulation trust. It is eponymous: it accumulates. There are no required distributions to the beneficiaries. The tax cost for this can be enormous, however. A trust reaches the maximum federal tax rate at the insanely low threshold of approximately $12,000. Obviously, this strategy works best when the beneficiaries are themselves at the maximum tax bracket.

The other point that occurred to me is the future of stretch IRAs. There has been considerable discussion about imposing a five-year distribution requirement (with very limited exceptions) on inherited IRAs. This of course is in response to the popular tax strategy of “stretch” IRAs. The stretch is easy to explain: I leave my IRA to my granddaughter. The IRA resets its mandatory distributions, using her life expectancy rather than mine (which is swell, as I am dead). Say that she is age 11. Whereas there are mandatory distributions, those distributions are spread out over the life expectancy of an eleven-year-old girl. That is the purpose and use of the “stretch.”

Consider that the Court just decided that an inherited IRA does not constitute “retirement funds.” This may make it easier for Congress to eventually do away with stretch IRAs.

Two Brothers, An Offshore Trust And An Ignored CPA

Here is the cast of characters for today’s discussion:

Brian             orthopedic surgeon and idiot tax savant

Mark             Brian’s brother and idiot business manager

Michael         long-suffering CPA

Lynn              the “other” CPA

All right, maybe I am showing some bias.

Let us continue.

The two brothers attend a seminar about using domestic and offshore trusts to delay taxes until the monies were brought back into the United States. In the meanwhile, one could tap into the money by using a credit card.

Sure. Sounds legit.

The brothers return and are excited about this new tax technique. They ask Michael’s advice. Michael tells them that the seminar promoter was “a person to avoid” and to consult an independent tax attorney. 

Brian blew off Michael. Brian signed up for the offshore trust. He may have received a toaster with his new account.

Michael – who does the accounting - sees a $15,000 check to the promoter. He writes Brian:

I am writing to you because I am concerned for you and the risks you may inadvertently be taking.

It seems to me that the promoters are relying on an elaborate chain of complex entities to conceal taxable income. I am especially suspicious when I learned that they will provide you with a VISA card to access the money.

I am asking that you consider the worst case scenario in which the IRS takes the position that you are committing tax evasion. They have the power to assess huge penalties and interest, to prosecute you, to ruin your career, and seize your property. Is the risk worth it?”

Michael talks with Mark. He believes that the brothers have finally listened to his advice.

Meanwhile, the brothers did not listen to anything. They set up a series of interlocking companies and hired Lynn to prepare taxes for those companies. Lynn is associated with the promoters of this tax scheme.

• In year one the brothers transfer $107,388 offshore and deduct it as management fees 
• In year two they transfer and deduct $199,000 
• In year three they transfer and deduct $175,000

The IRS swoops in on the trust promoters. They take Lynn’s computer. Lynn calls Mark, explains all that, and recommends that they see a tax attorney. Maybe they should amend the tax returns.  Mark, after his many minutes of tax education, training and experience, told Lynn that he was not amending anything.

It gets better.

The promoter contacts the brothers and says that they have a NEW AND IMPROVED program that will be bulletproof against the IRS. The brothers sign on immediately.

The brothers receive their sign soon thereafter. 

• In year four they transfer and deduct $650,000

Michael is preparing this tax return. He calls Mark and asks about the “management fee.” Michael has Mark write him a letter that all was on the up-and-up.

• In year five they transfer and deduct $460,000

Michael is not preparing this tax return. He has had enough, and he has a career to protect. He wants a letter from an attorney that the transactions are above board.

Mark fires Michael.

And, in another surprise, daytime was followed by darkness.

A year later, Michael (the hero of our story) sends the brothers a press release about the “dirty dozen tax scams.” Sure enough, theirs is on the list. There is still time to send back the sign.

• In year six they transfer and deduct $180,000

In addition, Brian taps the offshore account for $270,000 for the purchase of a new home.

A couple of years later Michael receives a subpoena from the IRS for records pertaining to Brian and his company. This is when all that communication back-and-forth with Mark and Brian may have taken its toll, as Brian was virtually giving the IRS a roadmap.

The brothers, perhaps whiffing that they may have missed a key lecture in their vast tax education, decided to amend Brian's personal returns, adding most of the so-called management fees back to his income. Brian sends a big check to the government.

This case goes to Court. This is not a regular tax case. No sir, this is a fraud case. Someone is going to jail.

There was an eleven-day trial. The brothers were found guilty on all counts.

There was something interesting in here during interrogatories. The IRS never discussed the amended returns when they were presenting their fraud case. The brothers objected, but the Court sustained the government. The brothers introduced the amended returns when it was their turn.

The brothers had a point. The government was not out ALL the money, because Brian had paid a chunk of it with the amended returns. Why then did the Court sustain the government? Here is the Court:

As an initial matter, we note that the amended returns were submitted years after the false returns had been filed and months after[Michael] warned [the brothers] that their records had been subpoenaed. We have previously said that ‘there is no doubt that self-serving exculpatory acts performed substantially after a defendant’s wrongdoing is discovered are of minimal probative value as to his state of mind at the time of the alleged crime.”

Wow. There were no brownie points with this Court for doing the right thing.

By the way, Brian got 22 months at Club Fed and his brother got 14 .

But they got to keep the sign.