This post corrects an error I made in the piece I wrote for MCFE on SALT deduction cap workarounds, as well as describing my preference for structuring a PTE workaround, and provides more babble on taxing PPP loan forgiveness in light of recent state budget and legislative developments.
SALT cap workarounds
MCFE published my piece on other states’ laws and the Minnesota bill that allow optional entity-level taxes on pass-through entities (PTEs), such as S corps and partnerships, to circumvent TCJA’s $10,000 cap on itemized deductions of SALT payments. Those interested can read it on MCFE’s website (“A Closer Look at Minnesota’s Proposed SALT Cap Workaround”).
The piece was only posted for a short time before an alert reader pointed out a bonehead mistake that I made in footnote 4 – Minnesota’s credit for taxes paid to other states already allows entity-level taxes paid by partnerships to qualify for the credit. So, the Minnesota bill does not need to be modified as I suggested. That provision was enacted years ago to accommodate partnerships that file composite returns and pay tax on behalf of their nonresident owners so they can avoid the hassle of filing returns in multiple states. The provision will cover workaround taxes just fine. I had forgotten about it and failed to go back and reread the statute. Mea culpa.
The reader, however, did point out that Minnesota’s credit, at least as applied by DOR, does not allow entity taxes imposed on disregarded LLCs to qualify. It should, especially if Minnesota enacts an optional workaround SALT PTE entity tax covering disregarded LLCs (as the current legislative bill provides) and even if it does not (in my opinion) to avoid constitutional issues.
I did not think it was appropriate to express it in the MCFE piece, but I have a strong preference for drafting a SALT workaround proposal using the model adopted by Rhode Island, Maryland, and New Jersey, rather than the Wisconsin and Louisiana model as in the Minnesota bill. The difference is that the Wisconsin model imposes the state’s corporate tax on the PTE, whereas the Rhode Island approach imposes the PTE tax on the income deemed distributed to the entity (i.e., the in-state source amounts reported on K-1s to PTE owners).
In the MCFE piece I identified the advantages of the Rhode Island approach as twofold: (1) avoiding the complexity of requiring the PTE to recalculate its income and tax under the state’s corporate regime and (2) the differences in the bases of the two taxes. I think either of them is sufficient to tip the balance toward the Rhode Island approach.
On the base differences, I did not mention it in the MCFE piece, but I think a wild card is the dividend received deduction. The Minnesota bill appears to allow a PTE to claim this deduction, since the corporate franchise tax rules would apply, and the deduction is available to C corporations. I do not know if that was intended but a strict reading of the bill appears to me to allow it. In some unusual circumstances it could result in tax savings for an electing PTE. Common stock dividends are fully taxable to PTE owners as ordinary income. C corporations are allowed a 70- or 80-percent deduction, by contrast, depending upon their ownership stake in the dividend payor. If the bill continues to allow disregarded LLCs to elect the optional PTE tax, an individual with a substantial stock portfolio could move dividend paying common stocks into a disregarded LLC and realize substantial Minnesota tax savings, even if the proposed IRS regulations do not allow the workaround to disregarded entities (as I expect they will not). That would be true for S corporations or partnerships with common stock dividends too. If allowing the deduction was not intended, it would be prudent to modify the bill to explicitly prohibit that. Of course, that minimizes one advantage of using the corporate tax model – applying the same entity tax rules to all entities, I guess.
In drafting a PTE entity option, I would also add an explicit provision that requires an electing PTE to report the amount of total state and Minnesota tax that is excluded from distributions of income made by the PTE (i.e., the amount excluded from AGI) to facilitate compliance with and enforcement of the requirement that those taxes be added back in calculating the owners’ individual level taxes. If that addback is not made, the taxes will be deducted for Minnesota purposes (roughly analogous to deducting tax paid in calculating the taxes). DOR could impose an administrative requirement to do that, but it is probably simpler to include the general requirement in the bill.
PPP loan forgiveness
The big swing in the budget forecast (now a $1.6 billion surplus rather than a $1.3 billion deficit) and the legislative tea leaves, at least based on my reading of the media coverage (often misleading or a partial picture based on my past experience as an insider), strongly suggest that the legislature will go down the federal road of giving some sort of double exemption to businesses that receive PPP loan forgiveness. As anyone who reads my blog knows, I think that is bad policy, but the PR juggernaut rolls on and it now appears inevitable for at least some subset of PPP loan recipients. Here are links to three recent news pieces:
A common theme portrayed is that the failure of the state to both exempt the income and allow expenses paid to be deducted is “absolutely stunning” or “ridiculous.” The underlying theme is that failure to follow the federal double exemption approach would impose a big burden on the affected businesses. It does not bother me if the legislature decides both to enact a business tax cut and that the way it prefers to do that is to give a break to some or all businesses that got PPP loan forgiveness. But it would be nice if there was some evidence that they recognized the realities of such an exemption. I would better if I knew that they were not being swayed by a misleading narrative about the financial effects of not letting these businesses both have their cake and eat it too. (When I was working and talked directly to legislators it was easier for me to understand that was the case – “yeah, I know this is dumb policy, but I have to do it politically” was all I needed to hear. Because I no longer have those conversations with legislators, I am stuck guessing. The few public discussions I have heard are not encouraging that legislators understand the financial reality. That, of course, does not mean they don’t – challenging testifiers or explaining complicated stuff just might not be worth the blowback.) I will briefly try (yet again) to make it clear what I think is going on – in two ways, conceptually and with an example.
Conceptually. PPP loan forgiveness can be thought of as a federal grant that pays a portion of a business’s expenses – i.e., the payroll, rent, and utilities legally required to qualify for forgiveness – because the pandemic reduced the recipient business’s revenues. The simple conceptual (“tax neutral”) way to do that it to keep the entire transaction outside of the tax system – the business’s tax return would show neither the grant/loan forgiveness (income reported) nor the payroll, rent, utilities the grant/loan forgiveness pays (expenses deducted). Mechanically, that can be done either of two ways – (1) exclude the income and disallow the expense deductions (that is what would have happened under the CARES Act and the IRS administrative rulings) or (2) include the income and allow the expense deductions (that is what Minnesota law now provides). In either case, the treatment is tax neutral. The income is not taxed, and the PPP loan’s payment of expenses does not affect calculation of how much other income the business has. Put more concisely, it is a matter of NEITHER or BOTH.
The proponents, however, are arguing for something that is not tax neutral but rather gives an extra or double benefit. It would do that by excluding the income (loan forgiveness) AND allowing the PPP-paid expenses to reduce the taxes paid on other income. That is a double benefit for those businesses lucky enough to (1) get a PPP loan and have it forgiven and (2) have other income on which they will pay tax. That means two identical businesses – one that got a PPP loan forgiven and another in otherwise identical situation but that reduced its expenses (e.g., laid off employees) or spent down working capital to avoid laying off workers would be treated quite differently for tax purposes. An example follows to illustrate.
Example. This example is simplified and stylized to avoid getting bogged down in business and tax nuances and to make the point clear. Assume there are three businesses, each of which normally has $200,000 in annual revenue, expenses of $180,000, and taxable net income (profits) of $20,000. To keep things simple, assume a flat 10% tax rate. The pandemic hits and cuts each business’s revenue by $40,000. In year two after the pandemic is over (this is an unrealistic hypothetical!), the businesses return to normal operations, earning $200,000 on expenses of $180,000.
Business #1 takes out a PPP loan for $40,000 which is forgiven. Business #2 (with a hard-hearted libertarian owner who refuses government support on principle) forgoes taking a PPP loan and instead lays off employees, which we simplistically assume reduces expenses by $40,000. Business #3 (soft-hearted libertarian owner) also forgoes the PPP loan but uses $40,000 of working capital to keep paying her employees. The table below contrasts how the new federal and the current Minnesota system (no conformity) would treat the three owners. Only #1 needs two columns (fed and MN model), since #2 and #3 have no PPP loan forgiveness.
|Pandemic year||#1 biz fed model||#1 biz MN model||#2 biz||#3 biz|
|Tax @ 10%||0||2,000||2,000||0|
|Tax @ 10%||0||2,000||2,000||0|
|2-yr net income||40,000||40,000||40,000||0|
The examples illustrate that the federal model (essentially a double exemption) treats the PPP business the same as the business that uses its own resources to maintain its payroll. Neither pays any tax but the PPP loan means the business that accepted the loan has $40,000 more in resources/net income that #3, the soft-hearted libertarian. (To me, that does not seem fair but maybe that is just my priors?) By contrast, the Minnesota model treats the PPP loan recipient equally with #2, the hard-hearted libertarian who cut expenses by laying off employees. Both continue to pay the same tax as normal because the layoffs and the PPP loan had identical effects on their profits.
These examples illustrate why the PR narrative that the current taxation of PPP loan forgiveness disadvantages its recipients is false. For example, here is one quote to that effect from the MPR story linked above:
[Business owner] said the PPP loan he got covered about two and a half months worth of payroll for his 65 employees at a pair of west suburban child care centers.
“I was not thinking about the tax implications at the time,” [he] said. “I was just trying to figure out how to make it through the next six months to stay open for our families that needed us.”
Had he known about the tax obligations, he might have gone a different direction — laying off half of his staff because of sliding enrollment. And that, he said, would have been a bigger burden on state resources.Brian Bakst, Businesses that tapped pandemic loan program now find it may cost them (2/24/21) MPR
The obvious implicit point is that he is worse off than if he had laid off his employees, instead of taking the PPP loan. The examples illustrate that if he had cut his deductible expenses by the equivalent of the PPP loan and forgone the loan, he would have paid the same tax as he would under the current Minnesota tax rules (assuming, of course, that reducing payroll did not hurt his sales/revenues). Essentially, he would move from #2 to #3. But what he and the business lobby are arguing for is to treat him the same as #3, the hypothetical business owner who used her own resources (not the federal government’s) to maintain payroll.
The media coverage makes it is obvious that the legislature will enact some sort of PPP loan forgiveness tax break. I assume that budget realities and competing demands for resources mean that will need to be a partial deal. They are not going to spend over $400 million on this. So, the question becomes how to craft a partial break that will give the politicians cover without breaking the bank and doling out too much money to the undeserving. The media stories suggest that the House DFLers are moving to limit qualification to some subset of businesses based on their line of business. An obvious way to do that would be to restrict qualification to the same businesses that the December special session provided direct aid. See Minn. Laws 7th spec. sess. ch. 2, art. 1 § 1, subd. 1(a) for the definition of qualifying businesses. These are the businesses that were hardest hit by the public health restrictions and have already been agreed upon by the legislature as deserving of assistance. I would add to that a requirement that the 2020 revenues declined over their 2019 revenues by some multiple of the PPP loan amount (at least 2X). That will winnow out businesses that got PPP loans but really did not need them or the PPP loan replaced much of their lost revenue. (Giving startups a pass on this would likely not create a loophole.) The combination of the two provision should target the provision somewhat and dramatically reduce the revenue loss. Another possibility would be to limit the deductibility of the expenses paid with forgiven PPP loans to tax years 2021 and 2022, so that this does not produce long term carryover losses.