Pandemic Tax Policy in the Land of Oz
Author: Lawrence J. Kaplan
The pandemic swept quickly throughout the land of Oz, affecting virtually all of the citizens of Oz’s two states, Blue and Red.
Emperor, the President of Oz, mused to himself, “Everyone in Blue marches lockstep in one direction, and everyone in Red marches lockstep in another, but if I send them all some money, all throughout the land, for the first time in the history of Oz, they will march lockstep together.”
So Emperor announced that he would send money, and everyone in Red and Blue who received the money was happy and said how wonderful Emperor was.
Patterned after the Paycheck Protection Program–implemented in response to the pandemic which was simultaneously sweeping throughout the United States– Oz’s pandemic program was structured as a loan. Such loan, when used primarily by employers for continuing wages for employees, would in substance be converted into a tax free grant which would not need to be paid back.
One day, Emperor’s senior advisor, Taxlaw, said to Emperor, “Far be it from me to inquire of Emperor, but have you considered the tax ramifications of your Pandemic financial relief?” Emperor responded, “Tell me more.”
“Well,” said Taxlaw, “The basic accounting equation is: Assets=Liabilities plus Equity, or rephrased, Assets minus Liabilities=Equity. In general, a loan results in an equal increase in assets and liabilities, and when repaid, results in an equal decrease in assets and liabilities. There is no effect on equity, and there is no income recognized. However, if a loan is forgiven, then there is an increase in the borrower’s equity because assets remain constant, and liabilities are decreased by the amount of the loan forgiven. This typically results in cancellation of indebtedness income which is taxable to the borrower.”
Emperor asked, “What if the loan proceeds under the United States Paycheck Protection Program do not need to be paid back because the loan proceeds are substantively converted into a grant when they are used for wages?”
Taxlaw explained further, “These loans become tax free grants which increase net worth when used primarily by employers for payroll. However, this results in a potential anomaly, because to the extent recipient employers receive a tax free increase in net worth, if unchecked, they would also receive a tax deduction when tax free funds are used for payroll. This could arguably be construed as an unintended windfall.”
“I bet the United States Internal Revenue Service has ruled on this,” said Emperor. “Oh wise Emperor, you are correct,” said Taxlaw. “In Notice 2020-32, which was issued on April 30, 2020, the IRS ruled that since the grant was a receipt of income tax free money, pursuant to Internal Revenue Code Section 265, there is no tax deduction when income tax free money is used to pay a business expense like payroll which would otherwise be deductible.”
“Is that fair?” asked Emperor. “Well, it depends on how you view the issue,” said Taxlaw. “If treated under traditional cancellation of indebtedness concepts, when the loan is not repaid, there should be cancellation of indebtedness income to the employer, which if followed by deductible payroll, would result in the taxable income and the tax deduction offsetting each other. Alternatively, if the loan which is not repaid—because it is substantively converted into a grant—- is not subject to traditional cancellation of indebtedness analysis and is also treated as a tax free receipt by the taxpayer, then the taxpayer arguably should not also receive a deduction when the payroll is paid with tax free income. However, you can argue that in implementing the Paycheck Protection Program, Congress did not want to limit the normal rules which allow for deductibility of wages, even though the wages were paid with tax free money.”
Taxlaw continued, “I understand that certain members of Congress are considering legislation which would provide that Paycheck Protection Program funds, even though tax free when spent for the designated purpose, can also be tax deductible.”
“Please keep me informed of future developments,” said Emperor. “I will,” said Taxlaw, who further stated “Emperor, please contact me if you have any questions or would like to further discuss the topic.”