Tuesday, June 15, 2021

Part 2 of 3: How Massachusetts Attempted to Tax S Corporations and Their Shareholders

Can Massachusetts reach that debt forgiveness income excluded from federal gross income and include it on the shareholder’s MA personal income tax return?  They said that they could because MGL Ch. 62C, §3 allows the commissioner to write regulations and rulings which are a proper interpretation of statute.  The legislature, however, granted that broad brush authority with an important limitation---it must not be inconsistent with law.  The commissioner has stated that this is so in Letter Ruling      08-11(7/7/2008)---“The Department of Revenue is an administrative agency charged with carrying out the laws of the Commonwealth…In doing so, the Department may issue rulings, but only such as are not inconsistent with law.”


Well, we know that the commissioner has disregarded the changes to the current federal Code (i.e. federal law), but does he have state law on his side?  Read on…


Under MGL Ch. 62, §2(a), the commissioner is allowed to modify applicable federal law to adjust for “(F) Amounts included in or considered to be Massachusetts gross income under any other provision of this chapter.”  Golly, that looks like a loophole which is big enough for a Mack truck!  Have they found something? 


The big problem for the Mass. Department of Revenue at this point is the clear language of a state regulation (written by the commissioner) CMR 62.17A.2(3)(b)…


“S corporation shareholder-level taxation.  The taxation of S corporation shareholders for Massachusetts personal income tax purposes under MGL Ch. 62 is generally modeled on the federal rules that apply to S corporations under the Code.”


Now, you would wonder, what part of that easy to understand language is unclear to those whose job it is to interpret state rules and regulations?  The Congress just gave us an update to the federal rules, so how can MA not follow or agree with the Congress?


Well, they apparently reasoned, we still have the upper hand.  We can add an adjustment to MA form 355S, Schedule S under Other Income (line 11) and now it will flow to each shareholder on Schedule SK-1, and when it lands (somewhere) on the state personal income tax return it will be taxed!  Problem solved.


That takes us to a new problem for the commissioner.  Is this inconsistent with law?  If it isn’t, cite the law which allows this adjustment.  This the commissioner has not done.  Instead, the department of revenue has cited their authority to write rules, but we have already seen that what they write must be lawful.  We were promised, in an FAQ which announced the commissioner’s position, that technical advice would follow.  You editor hasn’t seen it, nor does he expect to, because the state legislature stepped in and changed state law on how this income is taxed (or did it?---read on).


Now we fast forward to the MA legislature, which apparently wanted to exempt this income from taxation on one’s individual income tax return.  Newly enacted legislation (taken from the language in Senate Bill No. 35) – Section 23:


“…the following items shall be deducted from federal gross income for the purpose of determining Massachusetts gross income under section 2 of chapter 62 of the (Mass) General Laws…”


Let’s pause here and think about what they are saying.  MGL Ch. 62, Sec. 2 refers to the taxation of individuals.  The legislature is saying that there is something in federal gross income (i.e. debt forgiveness income) which “shall be deducted” in order to arrive at Mass. gross income, so they are following the reasoning of the Mass. Department of Revenue (it’s in there for personal taxation and we can tax it).


Then the newly enacted legislation says:  “…an amount which, but for this section, would be included in gross income, in whole or in part, of an eligible recipient, as described in subsection (a) of the [CARES] Act…”


Let’s pause again…The legislature is saying that the deduction shall apply to an eligible recipient.  We know what that means---someone who borrowed and then had the loan forgiven, because that is what the Congress said. 


Now we really have a problem because this new legislation does not extend the deduction from gross income to all of those whom the Mass. Department of Revenue proposes to tax---all individual shareholders.  The legislature has only extended a helping hand to those who completed a loan application and received a PPP loan, and our corporate shareholders didn’t do that.  Their corporate entity did that.


Are we skunked because the MA legislature did not forgive that individual shareholder “debt.”  They only forgave it for sole-proprietors.  Stay tuned, because next week we will give you the surprising answer…      

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