PPP Loan Forgiveness & SE Income

Interested to hear whether others have encountered this question and how they resolved it.

Under Section 401(c)(2)(iv), for 401(k) earned income purposes, net earnings from self-employment is calculated “without regard to items which are not included in gross income for purposes of this chapter, and the deductions properly allocable to or chargeable against such items.” 

The plan sponsor, which is a partnership, had a PPP loan that was used for deductible payroll expenses. The loan was fully forgiven. The forgiven PPP loan amount was (properly) excluded from gross income. The “deductions properly allocable to” the non-taxable PPP loan forgiveness amount arguably would be the payroll expenses covered by the PPP loan proceeds during the loan period. 

The CARES Act and later COVID tax-relief laws clarified that no deduction would be denied (i.e., the original payroll expenses could still be deducted on the partnership's tax return) solely by reason of a non-taxable PPP loan forgiveness, but I'm not sure that alone would override the relevant portion of 401(c) that says the deductions associated with a tax-exempt item of income should be disregarded for purposes of calculating 401(k) earned income. 

Disregarding the deductions would increase 401(k) earned income by the amount of deductible payroll expenses paid with the non-taxable PPP loan proceeds (and increase each partner’s earned income on which contributions are allocated).

Would appreciate everyone's thoughts. 
 

Tom Callahan, Sr. once said, "Of course, I can get a hell of a good look at a t-bone steak by sticking my head up a bull's ass, but I'd rather take the butcher's word for it."  CPA generates income values on K-1, as the TPA I'm going to take his word that they're reliable (excepting any prefunded employee allocations).

Disregarding the deductions would increase income tax and SE taxes that would not be overcome by additional retirement income deductions.

The tax code requires SE income to be reduced by deductions that are allowed or allowable and I don't think a taxpayer has the option to not deduct expenses.  If audited, the IRS would make adjustments.

Thanks for the replies. Some points I may have needed to expand on initially. 

The partnership and K-1 SE income account for all deductions. So from an income tax perspective, all deductions are being taken and the starting point for determining earned income for plan allocation purposes is the actual K-1 amount provided by the CPA, including all deductions. 

The issue arises when calculating "earned income" for plan allocation purposes, which is defined under section 401(c). That section says to start with the SE income amount from the K-1, then make certain adjustments (1/2 of SECA; employer deductions for plan contributions; etc.). One of those adjustments in section 401(c) says to calculate earned income "without regard to" deductions that are allocable to items of tax-exempt income. In other words, when calculating plan "earned income" you should disregard any deductions allocable to items of tax-exempt income.

The IRS's original position was that eligible expenses paid with PPP loan proceeds were not deductible under section 265 because the eligible expenses were allocable to an item of tax-exempt income (tax-free PPP loan forgiveness). Later legislation specifically overturned that outcome, but in a way specific only to PPP loan eligible expenses, not section 265 or any other general income tax principle. 

So the question is, if the eligible expenses are still deductions allocable to tax-exempt loan forgiveness income, should those deductions be added back to the earned income amount for plan purposes?

EBECatty, I think this or a related issue may have come up earlier on BL, because I remember making the 108(b) point that I make below maybe a year or so ago.
 

As paraphrased in Rev. Proc. 2021-48, the legislation states:

Section 276(b) of the COVID Tax Relief Act provides substantially similar guidance with regard to PPP Second Draw Loans, as do §§ 278(a)(1) and (2) with regard to Section 1109 Loans. Specifically, § 7A(i) of the Small Business Act and §§ 276(b) and 278(a) of the COVID Tax Relief Act provide that, for purposes of the Code, no amount is included in the gross income of an eligible recipient or an eligible entity, as appropriate, by reason of the forgiveness of a PPP Loan, and no deduction is denied, no tax attribute is reduced, and no basis increase is denied, by reason of such exclusion from gross income.

On the one hand, one could argue that reducing earned income by the amount of wages arguably "allocable to" the forgiveness of indebtedness income is either indirectly denying the higher deduction amount under 404 (somewhat confusingly by requiring an exclusion in a preliminary calculation) or reducing a tax "attribute;" arguably, earned income is a tax attribute. On the other hand, one could argue that disregarding the wages is not denying a deduction, but only appropriately reducing it, and that the "tax attribute[s]" being referred to in the Covid Tax Relief Act are the tax attributes listed in Section 108(b) of the Code that would otherwise get reduced if you are allowed to avoid current tax on forgiven debt by burying the income in your balance sheet.

Supporting the latter argument would also be the notion that in 404(c)(2) the Code is trying to give the taxpayer a break by not in effect double counting the expenses incurred to produce excludable income, and now the taxpayer is trying to instead double dip by both taking the exclusion from income but then also taking a larger deductible plan contribution by including the allocable expenses for purposes of the contribution limit. However, the strength of this logic is undercut by the fact that the whole point of the provisions in question of the Covid Tax Relief Act was to require the IRS to stop making the argument that the wages could not be deducted because of a "double dipping" principle.

One could even argue, I suppose, that the wages are not really "allocable to" or "chargeable against" the debt forgiveness in the conventional accounting sense that Congress likely had in mind when it enacted 401(c)(2), which I believe was  as part of the 1954 Code; rather, one could argue, the wages are only "related" to the loan and its forgiveness, in the way that  a dog's stretching out its paw is related to its getting a treat, even the "cause" of getting the treat, but not "allocable to" or "chargeable against" the treat.

But on the other other hand, if this were a closely held corporation, the amounts would just be compensation for 415 and wages for 404, and maybe self-employeds should have parity?

Without specific IRS guidance, just seems confusing.

Thanks for your thoughts, Luke. 

44 minutes ago, EBECatty said:

Thanks for your thoughts, Luke. 

Sure, EBECatty. Thanks for such an interesting question.

Wouldn't the meat from a T-bone be better if derived from a steer than from an (uncastrated) bull?

I'm not a butcher, but at a younger age a bull would provide leaner cuts than a steer.  Due to the resultant stunted growth rate, steers tend to have higher fatty deposits at the same processing weight; although two animals raised in one environment with similar feeds will have indistinguishable marbling and flavor in the lean cut itself.

PSA, the grinding process destroys marbling and texture, so a waygu burger is completely pointless.

Thanks for an interesting thread to read. There is a lot to take into consideration about this topic.
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The initial response by Nate S is one of my favorites. Put it in the Hall of Fame.