The CARES Act established the Paycheck Protection Program, providing critical liquidity to small businesses to fund payroll costs during the early stages of the Coronavirus pandemic. Referred to as “PPP Loans,” the Paycheck Protection Program is a low-interest government funded lending program implemented by the Small Business Administration and Treasury Department. Unlike traditional loans, however, upon compliance with numerous technical requirements, PPP Loans are forgiven in full. Under the CARES Act, forgiven PPP Loans are excluded from the borrower’s income. This tax-free forgiveness of PPP Loan debt may include an unexpected tax boon for S-corporation shareholders in the form of a “free” increase in stock basis.

Taxpayers are generally subject to federal income tax on discharged debt unless an exception applies under the Internal Revenue Code (the “Code”). PPP Loans are specifically excluded from federal income tax under the CARES Act, not the Code. PPP Loans are unique as their discharge relates to S-corporation stock basis. The root of this unique treatment lies in the relationship between the U.S. Supreme Court’s decision in Gitlitz v. Commissioner, 531 U.S. 206 (2001) and Sections 108, 1366 and 1367 of the Code. Provided the Supreme Court’s Gitlitz rationale remains sound, S-corporation shareholders may find that discharged PPP Loans increase the basis of their S-corporation stock.

In Gitlitz, the shareholders of an S-corporation increased their stock basis by the amount of a discharged corporate debt. The IRS challenged the basis increase because the discharged debt escaped income tax under Code Sec. 108. The Supreme Court applied a literal reading of the Code and held for the taxpayers, reasoning that discharged debt remains income even if it is not “taxable income”.

The Supreme Court’s decision rested on the express terms of Code Sections 1366 and 1367. A shareholder’s basis in S-corporation stock is determined under Code Section 1367, which provides that basis is increased by the shareholder’s share of “items of income” described in Code Sec. 1366(a)(1)(A). The flush language of Code Sections 1366 and 1367 do not specify that those items of income must be “items of taxable income.” In Gitlitz, the taxpayers argued, and the Supreme Court agreed, that discharged debt that escapes inclusion in taxable income under Code Sec. 108 remains an “item of income” for other federal income tax purposes, and therefore a stock basis increase under Code Sec. 1367 was appropriate. Afterall, not all income is subject to tax.

Following the Gitlitz decision, Code Section 108 was amended to include "Special Rules for S-Corporations" to close this basis increase loophole. These special rules apply only to discharged debt income excluded under Code Section 108. PPP Loans are forgiven and excluded from income under the CARES Act, not Code Sec. 108. This begs the question, does the Gitlitz rationale still apply? If so, an argument can be made that S-corporation shareholders can increase their stock basis by forgiven PPP Loans. As the Supreme Court stated, discharged debt is an item of income under general federal income tax principles. Therefore, Code Section 1366 and 1367 should still apply as written to provide for an increase in stock basis.

The Gitlitz issue has garnered little attention except amongst the savviest tax practitioners. (Interestingly, this issue was first raised by Walter Abbott, CPA in a conversation with Lucien Gauthier, Esq. of the Boston Tax Institute on behalf of which Attorney Bilodeau presents live video conferences.) For S-corporation shareholders seeking a “free” increase in stock basis, perhaps to permit the pass-through of prior year losses, the Gitlitz strategy warrants consideration.

The federal government’s rapid legislative response to the Coronavirus pandemic, as evidenced by the CARES Act, necessitated a departure from the administrative scrutiny to which most proposed legislation is subject. This rapid response may have unintended tax consequences that create planning opportunities for taxpayers. The tax attorneys at McLaughlinQuinn LLC strive to remain at the forefront of this rapidly changing legal landscape. For more information on this newsletter, contact Cory J. Bilodeau, Esq., LL.M., Tax Planning Partner, at (401) 655-2203 or via email at This email address is being protected from spambots. You need JavaScript enabled to view it., or Matthew R. Joyce, Esq., LL.M., Tax Counsel, at (401) 655-2208 or via email at This email address is being protected from spambots. You need JavaScript enabled to view it..