As previously published in Forbes by Jason B. Freeman.
The SBA’s newly-issued PPP guidance for self-employed individuals got it exactly, precisely—wrong. I covered that guidance in yesterday’s summary, providing an overview of the new guidance and some of the interpretive issues that it creates. Today, I will discuss why that guidance drops the ball when it comes to self-employed individuals.
Fundamentally, the SBA begins from a misconception of what being “self-employed” entails. In setting out a justification for its general approach in the guidance, the SBA explains its belief that:
[M]any self-employed individuals have few of the overhead expenses that qualify for forgiveness under the Act. For example, many such individuals operate out of either their homes, vehicles, or sheds and thus do not incur qualifying mortgage interest, rent, or utility payments. As a result, most of their receipts will constitute net income.
What? “Most of their receipts will constitute net income?” Do most self-employed individuals work out of a shed and not incur rent or utility payments? The SBA’s unfortunate choice of wording is, at best, a gross oversimplification that stems from a misinformed stereotype about the world of self-employment; it is, at worst, a complete and utter whiff.
But let’s get to the source of the shortcomings in the guidance. Under the SBA’s guidance, the starting point for calculating a self-employed individual’s PPP loan is “Line 31, Net profit or (loss)” of the taxpayer’s 2019 Form 1040, Schedule C. Never mind the fact that the IRS, weeks ago, specifically informed self-employed taxpayers that they would not need to file their 2019 tax return until at least July 15th. That is notable—and super inconvenient—but it is really just a red herring to the much, much deeper problems with the SBA’s guidance.
Let’s ask an important question: What goes into this all-important “Line 31” figure?
For starters, Line 31 is not a “gross” figure. It is a “net” figure—a net figure that is calculated by, roughly speaking, subtracting “expenses” from “gross income.” The devil is in the detail.
To better understand where this is going, let us step back so that we do not miss the forest for the trees. A Schedule C is not a true measure of actual economic performance during an annual period. It is, instead, a tax-code-engineered measurement of a sole proprietor’s taxable net income. Few people (at least, few people who understand it) would use it as an accurate reflection of a business’s actual economic performance.
To demonstrate why this is the case, let’s take a simple example of what is included in the “expenses” that are deducted from gross income. The tax code allows for the deduction of depreciation. To be precise here, Line 13 of Schedule C requires that “depreciation” be deducted from gross income before ultimately arriving at Line 31 Net profit or (loss). Section 168(k) of the tax code provides for so-called bonus depreciation—something that the CARES Act actually expanded. Bonus depreciation allows a business taxpayer (think, sole proprietor) who purchases equipment to write the entire amount off in one fell swoop. Great. That leads to a lower tax bill during that year because the taxpayer is allowed to deduct the entire cost of the equipment at once. From a purely economic perspective, economists would say that this violates the “matching” principle, because the taxpayer will likely derive use from (and earn income from) the equipment in years to come. If we wanted to accurately reflect economic activity, we would attempt to match the costs with the income that they generate over time. But we do not, and our tax code does this deliberately—it is not an accident. It is a tax incentive that is designed to encourage investment now, rather than later.
But the rub here is that this kind of accelerated depreciation—which, by the way, is currently the rule, rather than the exception—directly decreases the amount of a PPP loan that a sole proprietor will qualify for because it directly decreases Line 31. In many cases, it will actually make a borrower completely ineligible for a PPP loan by reducing the taxpayer’s reported taxable income. The SBA’s guidance determines that sole proprietors with a Line 31 total of zero (which may be largely due to this accelerated depreciation) are categorically ineligible for a PPP loan. But sole proprietors with low or even negative taxable income in a particular year can have employees too—some of them, in fact, have many employees and also run economically profitable businesses. Congress intended for this program to protect those employees as well.
Congress expanded bonus depreciation (retroactively, by the way) through the CARES Act as an added policy weapon in an attempt to allow taxpayers to amend prior year returns and claim additional deductions in order to obtain refunds that can be used now to pay employees. But the SBA’s policy actually undercuts that congressional policy by taking away the incentive to use bonus depreciation because it decreases one’s PPP loan. The policy is even worse than that for a further reason. The SBA’s position is not fair—in the highfalutin lexicon of tax jargon, we say it violates “norms” or expectations of horizontal equity—because it discourages sole proprietors from taking advantage of bonus depreciation if they want a full PPP loan, but it does not force other similarly-situated businesses to make this choice.
The SBA’s guidance also runs afoul of the plain text of the CARES Act. Congress tied the amount of the typical borrower’s PPP loan to 2.5 times the borrower’s “payroll costs.” Congress used the following relevant language in the text of the CARES Act itself to define “payroll costs” with respect to a “sole proprietor or independent contractor:”
the sum of payments of any compensation to or income of a sole proprietor or independent contractor that is a wage, commission, income, net earnings from self-employment, or similar compensation and that is in an amount that is not more than $100,000 in 1 year, as prorated for the covered period[.]
In the legal system, lawyers and judges apply certain rules to interpret the precise meaning of legislation. First and foremost, Congressional intent is what governs, and Congress’s unambiguous language must be given effect. Second, one should avoid an interpretation that renders words or phrases superfluous—that is, we should give meaning to every word that Congress used, and not assume that any word is mere surplusage.
The problem with the SBA’s interpretation, as a textual matter, is that it violates the cardinal rules of textual interpretation. It plucks one phrase—“net earnings from self-employment,” a phrase that has a very specific and carefully-defined meaning within the nation’s tax laws—and gives that phrase paramount meaning to the exclusion of all the other phrases in the definition. By exclusively using Line 31, Net profit or (loss) from Schedule C the SBA has quite simply defined “payroll costs” as “net earnings from self-employment” in this context. In effect, it has collapsed the Act’s phrase, “a wage, commission, income, net earnings from self-employment, or similar compensation,” into one simplified item: “net earnings from self-employment,” and in the process, it has rendered all of the other language surrounding it mere surplusage. That is a no-no.
In fact, the contextual language implies even more support for this textual argument. The SBA’s interpretation also fails to give meaning to the word “any,” in the phrase “any compensation to or income of a sole proprietor or independent contractor.” You do not need a law degree to recognize that “any” is not a term that is intended to limit the language that it modifies here; instead, it is intended to convey a broad and encompassing scope with respect to all of the items that it modifies. Congress did not say “some compensation [or income];” it said “any compensation [or income].” The SBA’s interpretation, however, effectively reads this language to mean “only compensation . . . that is . . . net earnings from self-employment.” Clearly, that is not what Congress wrote.
But wait, there is more. The SBA’s interpretation completely reads the disjunctive article, “or,” out of the definition. The language of the definitional provision refers to “a wage, commission, income, net earnings from self-employment, or similar compensation.” The disjunctive, “or,” indicates that there are alternatives—multiple types of payments that may be “compensation” or “income.” It does not signify a restrictive interpretation. Again, the SBA’s interpretation completely reads this word and its function out of the statute. It fails, in other words, to give effect to the congressional language.
Yet another mode of textual interpretation leads to the same conclusion and ties these threads of analysis together. Let’s go back to where we started up above: Line 31 provides for a “net” income figure. The SBA, by choosing to use this figure as its definition in the context of self-employed individuals, effectively defined payroll costs as a net figure: “net earnings from self-employment” to be precise. But Congress did not restrict the relevant definition to a net figure. In fact, as we have seen, Congress defined it as “the sum of payments of any compensation to or income of a sole proprietor or independent contractor that is a wage, commission, income, net earnings from self-employment, or similar compensation.” Congress used “net earnings” as an example of one of the types of income. That shows that Congress was aware of the concept of “net” income and clearly knew how to use the modifier “net” if it had wanted to restrict the definition to only a net income figure, rather than also allowing for a gross income figure—as the disjunctive, “or,” indicates. The fact that it did not do so in modifying the word “income” when it used the word “income” immediately before the “net earnings” phrase in the definition demonstrates that it deliberately chose to allow self-employed individuals to calculate income on an alternative basis. The SBA’s guidance, however, prohibits this.
And if you are unmoved by these textual arguments, let’s see if this last policy reason resonates: The Act allows a self-employed individual to use PPP loan proceeds for other allowed costs, which include mortgage interest payments, business rent payments, and business utility payments, among others. But these are precisely the costs that must be deducted on the Schedule C—on lines 16, 20, and 25 to be precise—in order to arrive at Line 31, which serves as the basis for calculating the amount of the loan. Why would the Act specifically allow PPP funds to be used for these costs, but specifically require that they be deducted in order to calculate the amount of the allowed loan? That seems like poor policy. But only if you assume that is what Congress intended. It did not.
As I said at the beginning, the SBA’s newly-issued PPP guidance for self-employed individuals got it wrong. Now to cut the SBA some slack, it is frantically trying to issue guidance in the midst of a whirlwind of activity and its new guidance just came out some 24-plus hours ago. But sole proprietors are in the middle of that same whirlwind. They and their employees need the relief that Congress intended as much as anyone. And there may still be time to fix it.
For similar resources, see:
- The World 2.0: Is Coronavirus The Great Disrupter?
- Flattening The Economic Curve: The High Points Of Coronavirus Tax Relief
- PPP Loans: Do Private Equity And Venture Capital Backed Companies Qualify?
- Five Things Every Paycheck Protection Program Borrower Should Do After Receiving A Loan
- Freeman Law’s Compendium of Recent Coronavirus Legislation and Regulatory Reform
For videos, see:
- CORONAVIRUS (COVID-19) RECENT TAX AND BUSINESS RELIEF_WHAT YOU NEED TO KNOW,
- UPDATES ON CORONAVIRUS (COVID-19) TAX AND BUSINESS RELIEF_THE LATEST DEVELOPMENTS
- CORONAVIRUS AND RECENT TAX AND BUSINESS RELIEF-WHAT YOU NEED TO KNOW
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