As businesses begin to receive emergency loans through the Paycheck Protection Program (PPP), many shareholders are wondering what impact this capital flow and potential loan forgiveness will have on their stock basis adjustments.
Under the Tax Cuts and Jobs Act of 2017, all contributions of capital by a government entity are subject to income tax, requiring a reduction of tax attributes, such as net operating losses (NOLs), to minimize tax obligations.
However, the Coronavirus Aid, Relief and Economic Security (CARES) Act provides that the PPP loan forgiveness will be tax-free income, which would normally increase shareholders’ tax basis without the need to reduce tax attributions as long as the taxpayer is solvent and not insolvent. A taxpayer is solvent as long as the fair market value of assets are greater than their outstanding liabilities.
Tax advisors will be looking to existing case law and IRS regulations to determine the treatment of the forgiven loan proceeds.
In the 2001 U.S. Supreme Court case, Gitlitz v. Commissioner, the Court allowed an insolvent S Corporation’s taxpayer to increase their stock basis from discharge of indebtedness income. This decision overturned prior case law in which insolvent taxpayers had to reduce their tax attributes of the tax loss, thus reducing the tax attributes of the personal NOLs flowing through to the shareholders.
However, the decision also created a double bonus for the taxpayer to use both stock and zero basis loans stepped up by the tax-free forgiveness to deduct losses, and the IRS responded by statutorily overruling Gitlitz. The IRS regulations issued later that year provided that, post October 11, 2001, income from the discharge of debt for an S corporation that is in bankruptcy or insolvent is excluded from its income under IRC 108(d)(7) and does not increase the basis of any shareholder’s stock in the corporation.
Application to PPP Loan Forgiveness
Based on current tax law, it would appear that the tax-free income provided through the PPP loan forgiveness would result in an increase in an S Corporation’s stock basis, as long as the business is solvent. The stock basis would be increased by the portion of the loan that was forgiven, and that increase would flow through to the shareholders.
While the IRS could issue regulations to change this favorable tax position, one would hope that fairness and leniency from Congress would prevail during a Presidentially declared disaster.
The S Corporation basis rules are important to understand not only for shareholder stock basis and shareholder loan basis purposes, but also for NOL carryback claims and NOL carryovers when deducting any significant losses of 2020.
Please consult with your Grassi tax advisor or contact Jeffrey Cohen, Tax Services Leader, at 516.336.2475 to learn more about the impact of PPP loan forgiveness on your S Corporation’s tax basis.