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

Last week, we were at the point where the MA legislature was going to pull us out of the tax trap developed by the department of revenue, but they failed to do so…

 

Well, now we have the DOR coming to our rescue with recently revised Tax Filing Season Frequently Asked Questions. 

 

FAQ – Did Massachusetts update the treatment of loan forgiveness income?

 

Yes.  Loan forgiveness income is excluded from gross income for personal income taxpayers…”

 

OK, so here (apparently) is how things stand.  Self-employed individuals who would otherwise be taxed by MA on debt forgiveness income are no longer subject to tax.  They meet the federal and MA definition of an eligible recipient.  Individual shareholders of MA S corporations who would be taxed by MA on their corporation’s non-existent debt forgiveness income, will no longer be taxed on income which was never there and which the legislation did not mention! 

 

Apparently, the Department of Revenue reconsidered its position and reversed itself by issuing an FAQ.  This was followed-up by TIR 21-6 (4/30/21) wherein the Commissioner said (Part IV) “…PPP loan borrowers subject to the Massachusetts personal income tax, including Schedule C filers, certain partners in a partnership, and S corporation shareholders should not include in Massachusetts gross income the amount of a PPP loan forgiven under §1106(b) of the CARES Act during the 2020 tax year.”

 

However, the TIR, unlike the FAQ, only allows the “deduction” for tax year 2020.  It is a correct reflection of the state statute, which says…

 

“SECTION 23.  Notwithstanding any general or special law to the contrary, for the taxable year beginning January 1, 2020, the following items shall be deducted from federal gross income…”

 

This means that any PPP loan forgiveness income for tax year 2021 is fully taxable to Massachusetts S corporation shareholders if the Commissioner’s previous deviation from the language in the CARES Act is allowed to stand.

 

An excerpt from a noteworthy DC Circuit Court of Appeals decision may be appropriate here.  In Loving v. Internal Revenue Service, DC Cir. Ct. of Appeals No 13-5061 (2/11/2014) (written primarily by Circuit Judge Brett Kavanaugh, now of the US Supreme Court) the Court said:

 

“The IRS is surely free to change (or refine) its interpretation of a statute it administers…But the interpretation, whether old or new, must be consistent with the statute.”

 

The same admonition is surely appropriate to the administration of the Massachusetts Department of Revenue.  If you assert a position, issue the necessary authority consistent with the requirement to do so under statute.  If your position changes, issue the necessary authority consistent with the requirement to do so under statute.

 

Ask yourself this one last question---why did our state legislature only authorize a state tax deduction from income for individual taxpayers who meet the definition “…of an eligible recipient, as described in subsection (a) of the [CARES] Act…”  S corporation shareholders do NOT meet that definition (since they were never indebted) so why didn’t the MA legislature grant them a deduction from their income?

 

Could it be that the MA legislature actually looked at the federal CARES Act (someone did because they quoted from it) and concluded that S corporation shareholders were never taxable to begin with (contrary to the position taken by the MA DOR) so why grant tax relief to someone who does not need it?  Perhaps that explains why the MA DOR backed-away from its inconsistent interpretation of statute when it issued a subsequent FAQ/TIR---the state legislature did not agree with them.

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…      

Part 1 of 3: How Massachusetts Attempted to Tax S Corporations and Their Shareholders

Back in the late 1970s, your editor wanted to test the boundaries of his newly minted graduate degree in taxation, so what better way to do so (thought he) than to sign-up for the annual tax seminar offered each year at Boston University.  This was strictly a tax lawyer presentation, so could I now follow it and read tax law with them?  To my delight, when I attended and started to follow the presentations it appeared that I could, thanks to my Bentley College training!

 

In the afternoon, there was a panel discussion of MA state taxation and whether or not the Commonwealth could reach beyond the water’s edge and tax the overseas income of international corporations which filed returns in MA.  The speaker was a deputy commissioner whose every word on taxation was closely followed and even referenced in CCH MA taxation material.  Absent a Code or MGL citation, he was cited as the authority because of a presentation he had made somewhere.

 

The deputy commissioner argued, yes we can tax beyond the water’s edge.  He was challenged by another panel member, the tax counsel for a major CPA firm, and a former MA Commissioner of Revenue.  The former Commissioner argued no you cannot, and provided a cite.  Well, thought I, this will be interesting but my little balloon soon burst when the deputy commissioner responded by saying…

 

                         What difference does it make, we are doing it!

 

You could hear a pin drop in that room, and the attention of the panel swiftly changed to another topic.  No one else had a word to say to the guy who made tax law in MA.

 

Some of you will remember one of our annual state tax update seminars when we held them in Sturbridge.  Fred Laskey became MA Commissioner of Revenue in 1991 and he attended one of our seminars and spoke about his plans for the revenue department.  He told us about a national survey which had been conducted to rank state departments of revenue and MA ranked dead last.  Commissioner Laskey pledged to reform things and do better.  Both he and his successors did just that, until now.

 

Are we falling back to the “old” way of doing things (what difference does it make, we are doing it)---read on and make up your own mind.

 

When the Congress first enacted the PPP (paycheck protection program) we were told that most employers would qualify for a $10,000 loan and that part or all of it might later qualify for debt forgiveness.  This looked like free money, so folks applied and sought our help with their applications.  And, it did prove to be so, the SBA was forgiving the debt and this really looked like free money.  Then the IRS stepped in (as they were required to do, so don’t fault them) and reminded us that debt forgiveness income is taxable.  IRC §61(a)(11).

 

Well, everyone was upset---how can this be, said they.  Yes, how can this be said the Congress???  It’s easy---you guys didn’t exempt or exclude it when you wrote the law, so the IRS is just reminding us that you wrote a failed attempt to pass on a free lunch.  Later, when the Congress enacted the CARES Act they decided to fix the problem and declared that their intent was for this to be tax free.  [CARES Act §1106(c) - Treatment of Amounts Forgiven].

 

The way that the Congress did this was simple.  They said that the amount of the forgiven loan shall be excluded from the gross income of an eligible recipient.  The Act carefully explains this---if you are either an individual or an entity who received the loan proceeds, the funds are not part of your gross income.  Gross income is what you start with.  Example (for an individual):

 

Wages…………………………………………………………………..$ 50,000

Debt forgiveness income……………………………………………… 10,000

 

Gross Income…………………………………………………………… 60,000

 

The Congress said that this eligible recipient (individual) now has:

 

Wages……………………………………………………………………$ 50,000

 

Gross Income……………………………………………………………$  50,000

 

Now you see it; now you don’t, said the Congress.  The $10,000 has disappeared---it has been EXCLUDED from the starting point, and this is what we meant to do the first time, when we got it wrong.  Now the Department of Revenue has a problem---the Congress made this income disappear, so how can they tax something which isn’t there (in the current federal tax Code).  Well, it doesn’t matter reasoned the Department, because individuals are taxed based on the federal tax Code in effect on 1/1/2005, and the Congress didn’t change that Code, so we can tax individuals who are shareholders of S corporations even though they did not borrow, nor did they receive the funds.  We have all the authority which we need under state statute to include this in S corporation pass-through income, so they didn’t change their position to conform with expressed Congressional intent.

 

                              What does it matter, we are doing it.

 

Can they do that (ignore the Internal Revenue Code) and pass-through the income to an S corporation shareholder.  Stay tuned because next week we will give you the answer to that important question.