As discussed in Part I of this series, the cancellation of indebtedness, whether in whole or in part, generally results in COD Income to a taxpayer which must be included in gross income. Section 108 of the Internal Revenue Code (the “Code”), though, provides a handful of exceptions to this general rule of income inclusion. However, due to Covid-19, Congress has expanded exceptions to the general COD Income rule beyond those in § 108. Furthermore, it is possible, based on measures passed during prior economic crises, that Congress will pass additional exceptions to the general COD Income rule and that situations will arise in which COD Income exceptions may be expanded beyond their typical scope.
CARES Act Provisions
The Coronavirus Aid, Relief, and Economic Security (“CARES”) Act was enacted on March 27, 2020, to provide economic relief for taxpayers adversely affected by Covid-19. Included among the relief measures in the CARES Act are provisions affecting traditional debt relief and COD Income rules, such as tax-free loan forgiveness for certain specified loans and the exclusion from an employee’s gross income of employer-paid student loan payments, both of which are discussed below.
PPP Loans and PPP Loan Forgiveness
Sections 1102 and 1106 of the CARES Act authorize loans made under § 7(a)(36) of the Small Business Act (commonly referred to as the “Paycheck Protection Program,” and the loans authorized under such act, “PPP Loans”), which are eligible for loan forgiveness if certain parameters are met. PPP loan forgiveness is not required to be included in a taxpayer’s gross income (the “PPP Loan Forgiveness Exclusion”). This exclusion, provided outside of the traditional § 108(a) exclusions, is an important and nuanced exclusion and care should be taken to ensure compliance with all guidance in order to take advantage of this exclusion.
As of the writing of this post, the Small Business Administration (“SBA”) has issued guidance addressing some of the procedural aspects of obtaining forgiveness of PPP Loans under the PPP Loan Forgiveness Exclusion, but additional guidance is needed. Current guidance has indicated that borrowers must apply to their PPP lender for loan forgiveness by completing the Paycheck Protection Program Loan Forgiveness Application and that the lender has 60 days from the date a borrower applies for forgiveness to determine whether and to what extent the borrower qualifies for forgiveness. Guidance has not yet been issued on the deadline for submitting Loan Forgiveness Applications.
In addition to ensuring compliance with the rules governing application, disbursement and forgiveness of PPP Loans, taxpayers and their advisors should carefully study the special rules regulating traditional deductions and the newly provided payroll deductions and credits, because receiving a PPP Loan and having amounts forgiven under the PPP Loan Forgiveness Exclusion can impact a taxpayer’s eligibility for deductions, credits and payroll tax deferral. While these provisions on deductions, credits and deferral do not directly affect the amount or treatment of forgiven PPP Loan proceeds, they are an important aspect of the PPP Loans that should be considered by taxpayers and tax professionals. For example, the CARES Act limits the ability of employers to take advantage of both the PPP Loan Forgiveness Exclusion and the provisions allowing for a delay of payment of employer payroll taxes, and it also prevents employers who receive a PPP Loan from receiving the new Employee Retention Credit. Furthermore, IRS Notice 2020-32 (which some members of Congress have expressed opposition to) states that there will be no deduction for typically deductible expenses paid using PPP Loan proceeds which are forgiven, although it is currently unclear how the amount of deductions denied will be determined.
Employer Payment of Employee Student Loans
In addition to the PPP Loan Forgiveness Exclusion, the CARES Act modifies the traditional treatment of debt relief as income in § 2206. Section 2206 of the CARES Act provides that employers may pay up to a set amount of student loans for their employees and that such payments will not be gross income to the employee-debtor. While payment of an employee’s student loans is not technically the cancellation of indebtedness because the debt is being paid, albeit by someone other than the debtor, it is conceptually similar to COD Income in that the debtor has an accession to wealth as a result of the payment of debt by the employer. Under traditional income tax principles, such a payment of the employee’s debt by the employer would be required to be included in the employee’s gross income. However, § 2206 of the CARES Act provides an exception to this general rule of inclusion. The exclusion in § 2206 is limited to an annual amount of $5,250 per employee and applies to payments made by the employer between March 27, 2020, and January 1, 2021.
Potential Additional Exclusions
It is possible that as the Covid-19 crisis continues, Congress will pass additional relief measures that impact the taxation of COD Income. For example, it is possible that taxpayers may be successful in lobbying for the revival of § 108(i), a provision which allowed deferred inclusion of COD Income for certain debts that were modified, reacquired, or forgiven in 2009 and 2010.
Applying Traditional Income Tax Concepts to Debt Relief
In addition to § 108 and congressionally enacted exceptions, it is possible that traditional concepts of income tax law may be invoked in attempts to exclude COD Income from gross income. Gifts and bequests, for example, are generally excluded from taxable income of the recipient under § 102, and there is an argument that a gift or bequest of cancellation of indebtedness would therefore be excluded from the recipient-debtor’s gross income.
The availability of a gift exception to COD Income, though, may depend on the context in which the discharge of indebtedness occurs, such as in a personal debtor-creditor relationship between family members or friends or in a business or commercial context. Income tax principles require that a gift result from a detached and disinterested generosity, generally stemming from love and affection, which, as a result, tends to limit the application of the gift exception in § 102 to transfers between family members and friends.
In light of Covid-19, several commentators have discussed instances of landlords, both residential and commercial, restructuring or forgiving accrued rent—a trend the commentators predict will likely continue as Covid-19 continues to cause economic upheaval. Would the traditional “love and affection” requirement mean, then, that the generosity of landlords, both commercial and residential, waiving rental payments is not excludable from a taxpayer’s gross income as a gift (assuming no other exceptions are applicable)?
While not likely, it may be possible in a proper situation that a gift argument could be made in the context of a non-personal, landlord-tenant relationship. There are some older cases in which courts have excluded COD Income resulting from a landlord’s forgiveness of accrued rent from a taxpayer’s gross income because the court determined the transaction, occurring in a commercial context, constituted a gift. More recent case law, however, has narrowed the applicability of the gift exception in the commercial context, finding the requisite donative intent present only in limited factual circumstances. House and Senate Reports to the Bankruptcy Tax Act of 1980 also cast doubt on the ability to use the gift exception in business and commercial settings—both reports state that there is not intended to be a gift exception to the general COD Income rule in the commercial context.
Because of the uncertainty surrounding the availability of the gift exclusion for COD Income arising in the business or commercial context, taxpayers should discuss their situation with a tax advisor and use caution in relying on such an exclusion. In addition, although it is not directly related to COD Income resulting from rent forgiveness, landlords and tenants should be aware of § 467 of the Code, which, if applicable, requires landlords and tenants to recognize rent and interest on deferred rent under the accrual method of accounting, regardless of their regular accounting method. Section 467 will be discussed in more detail in later installments in this series, but it is a provision commercial landlords and tenants should be aware of when discussing reductions or forgiveness of rent.
The § 108 exceptions to COD Income are complex on their own, but the current efforts by Congress to provide economic relief through, among other mechanisms, additional COD Income exceptions, require taxpayers and practitioners to stay up-to-date to ensure they are aware of all available exceptions, should they be needed.
Subsequent installments in this series will define what constitutes an indebtedness, discuss the tax consequences of the modification and restructuring of indebtedness, and explore in more detail the exceptions under § 108.
For any questions on this or any other tax-related matter, please feel free to contact Charles Pulman at firstname.lastname@example.org or by phone at (214) 749-2447 and Annie McGinnis at email@example.com by phone at (214) 749-2412. This blog was written based on the law as in effect on May 28, 2020.