An issue that has not yet been addressed directly by the IRS is the treatment of certain expenses paid after a taxpayer received a Paycheck Protection Program (PPP) loan when the taxpayer’s tax year end concludes prior to either the filing of an application for or a grant of forgiveness.

The PPP loan program, established by the CARES Act signed into law in March of 2020[1], provided loans to eligible small businesses.  If the borrower used the loan proceeds to pay certain eligible expenses, an amount of the loan up to such eligible expenses would be forgiven under the law[2] and such forgiveness would not be treated as taxable income to the borrower.[3]

In Notice 2020-32 the IRS ruled that IRC §265(a)(1) applies to such amounts.  That provision reads:

(a) General rule

No deduction shall be allowed for—

(1) Expenses

Any amount otherwise allowable as a deduction which is allocable to one or more classes of income other than interest (whether or not any amount of income of that class or classes is received or accrued) wholly exempt from the taxes imposed by this subtitle, or any amount otherwise allowable under section 212 (relating to expenses for production of income) which is allocable to interest (whether or not any amount of such interest is received or accrued) wholly exempt from the taxes imposed by this subtitle.

Thus the ruling holds “the Code disallows any otherwise allowable deduction under any provision of the Code, including sections 162 and 163, for the amount of any payment of an eligible section 1106 expense to the extent of the resulting covered loan forgiveness (up to the aggregate amount forgiven) because such payment is allocable to tax-exempt income.”

Notice 2020-32 was issued in April of 2020.  In June of 2020 Congress passed the Paycheck Protection Program Flexibility Act (PPPFA) which greatly extended the time period for borrowers to use their PPP loan proceeds to pay expenses from the proceeds of the loan and be granted forgiveness.  As well, taxpayers were given 10 months after the end of the 24-week period over which to pay out such expenses to apply for forgiveness before any payments would need to be made on the loan.

Originally payments were only deferred for six months from the date the loan was received and the funds had to be spent within 8 weeks of the time the funds were received.  In that situation, most borrowers would presumably have applied for and received forgiveness before the end of their applicable tax year, especially if that year was a calendar year.  But, following the PPPFA revisions, it is becoming clear many borrowers will not have applied for forgiveness prior to their tax year end.

Year End Passes Without Forgiveness – Is the Expense Deductible?

Since the Notice referred to “resulting loan forgiveness” as being the issue that creates the disallowance of the expense, does that mean that a disallowance of the deduction awaits the formal forgiveness of the loan?  And, thus, if that event had not yet occurred, does that mean the expenses are to be deducted in the  year paid or accrued, with the taxpayer potentially facing reporting such items as income under the tax benefit rule in the year forgiveness is granted?

The AICPA has inquired about this issue with the United States Treasury, per an article published in Tax Notes Today Federal on November 11, 2020.[4]  The article noted:

Edward S. Karl of the American Institute of CPAs said Treasury officials told him they anticipated issuing more guidance before the end of the year, and possibly by the end of November, generally stating that if a borrower has a reasonable expectation of loan forgiveness, the expenses can’t be deducted to the extent they’re paid for with the loan. That’s true regardless of when the loan is forgiven, Karl added.[5]

Mr. Karl gave the same information in a session he presented online at the Pacific Tax Conference of the Washington Society of CPAs on November 7, 2020.

Another View – Reliance on the Bliss Dairy Case and the Tax Benefit Rule

Mr. Karl in his presentation to the conference noted that many advisers do not agree with this view, and that many cite the Supreme Court’s holding in Bliss Dairy to justify a current deduction followed by recovery under the tax benefit rule in the subsequent year.[6] 

Justice O’Connor outlined the facts in Bliss Dairy as follows:

As a cash basis taxpayer, in the taxable year ending June 30, 1973, it deducted upon purchase the full cost of the cattle feed purchased for use in its operations, as permitted by Section 162 of the Internal Revenue Code, 26 U.S.C. Section 162. A substantial portion of the feed was still on hand at the end of the taxable year. On July 2, 1973, two days into the next taxable year, Bliss adopted a plan of liquidation, and, during the month of July, it distributed its assets, including the remaining cattle feed, to the shareholders. Relying on Section 336, which shields the corporation from the recognition of gain on the distribution of property to its shareholders on liquidation, Bliss reported no income on the transaction.[7]

Under the then available corporate liquidation provisions used in Bliss’s situation, the feed effectively regained its basis in the hands of the shareholders in the liquidation who then were able to deduct the cost of this feed when it was used in the now unincorporated business.

In the end, the Supreme Court found that the corporation was to report income in the following year under the tax benefit rule, as the non-recognition of gain provision for the liquidation was inconsistent with the deduction that took place in a prior year.  

While not directly addressed by the Court, those seeing Bliss Dairy as applicable here note that even though Bliss Dairy almost certainly was aware that a liquidation would occur two days into the following year and had occurred by the time the prior year tax return was prepared, the Court did not find that a denial of the deduction in the prior year would have been the proper treatment.  Rather, Bliss Dairy was to pick up the income in the subsequent year, as that was the year when the event occurred that was inconsistent with the original deduction.[8]

Thus, supporters of this view would argue, if no forgiveness has been granted by year end, the event inconsistent with a deduction (the creation of tax-exempt forgiveness income) had not occurred at that time.  As with the taxpayer in Bliss Dairy, taxpayers who had not received forgiveness by their tax year end would initially deduct the expenses.  When the forgiveness occurs, the taxpayer would recognize income under the tax benefit rule.

That is, until the taxpayer obtains forgiveness there is no tax-exempt income.  And tax-exempt income is required before IRC §265(a)(1) denies a deduction.

While the argument is rather persuasive, the adviser should note that nothing in the opinion suggests that the IRS had put forward an argument for denying the initial deduction rather than invoking the tax benefit rule in the following year. Thus, the adviser may find the IRS arguing that the case did not deal with the year of deduction of the expense—and that had that issue been raised, the Supreme Court might have preferred the denial of the deduction in a situation where the taxpayer clearly foresaw the upcoming liquidation.  Of course, the Court could have used this logic to resolve the case and, the adviser can argue, it’s such an obvious option that, presumably, the Court decided against going that route.

The Other IRS Argument for Denying a Deduction

Although cited almost as an afterthought in Notice 2020-32, the IRS did offer up a second rationale for denying taxpayers a deduction for these forgivable expenses—one that specifically deals with a situation where the taxpayer pays an expense prior to the event that would make the payment nondeductible.

The IRS provides the following description of this rationale:

The deductibility of payments of eligible section 1106 expenses that result in loan forgiveness under section 1106(b) of the CARES Act is also subject to disallowance under case law and published rulings that deny deductions for otherwise deductible payments for which the taxpayer receives reimbursement. See, e.g., Burnett v. Commissioner, 356 F.2d 755, 759-60 (5th Cir. 1966); Wolfers v. Commissioner, 69 T.C. 975 (1978); Charles Baloian Co. v. Commissioner, 68 T.C. 620 (1977); Rev. Rul. 80-348, 1980-2 C.B. 31; Rev. Rul. 80-173, 1980-2 C.B. 60.[9]

Nathan T. Smith of CBIZ, Inc. is quoted as arguing that the two IRS rationales would lead to a different answer on deductibility when forgiveness is not granted by year end.  The article states the following from Mr. Smith:

Because the government offered two different positions for nondeductible treatment, the ancillary question about timing must be addressed discretely under each of those positions, Smith said. And as it turns out, the answer to the timing question appears to be different depending on which of the two positions from Notice 2020-32 a taxpayer chooses to follow, he added.

The primary and the alternative positions in Notice 2020-32 are distinct because receiving tax-exempt income isn’t the same as receiving an expense reimbursement, Smith said. He pointed to a few court decisions that held that expense reimbursements aren’t tantamount to gross income, and other cases showing instead that the reimbursement reduces the amount of the deduction. The rationale for that conclusion is that the taxpayer hasn’t made an expenditure or cost outlay, Smith said.

“On the other hand, the primary position that relies on section 265 relies on the existence of tax-exempt income — in this case loan forgiveness income,” Smith said. “So pick your poison — either tax-exempt income (income exists) or expense reimbursement (no income exists). Two different timing answers, depending on which one you pick.”[10]

What is An Adviser to Do?

Mr. Karl advised in his Pacific Tax Conference presentation that advisers need to discuss the options with their clients regarding whether or not to claim a deduction for these expenses if a return is being filed where no forgiveness was granted by year end. Ultimately, the taxpayer needs to decide which course of action best fits their risk tolerance and preferences on tax positions, based on those positions that the advisers believes have enough support to enable the adviser to sign the return.

As well, consideration should be given to disclosing the basis relied upon for the treatment on the tax return, especially if the IRS has issued guidance prior to the filing of the return and the taxpayer’s treatment is at odds with what the IRS indicates is the proper treatment.

Finally, it is possible that Congress will act to provide for a deduction for such payments, with the relief being retroactive to the date the CARES Act was enacted.  Such bills have been proposed by the chairs of both tax-writing committees and have sponsors from both parties.  This possibility has led some advisers to suggest that, if possible, these returns should be placed on extension to hopefully provide time for such a bill to become law.  Such a change in the law would render this entire question of dealing with a return when forgiveness had not been granted by year end no longer relevant.

[1] CARES Act Section 1102

[2] CARES Act Section 1106

[3] CARES Act Section 1106(i)

[4] Eric Yauch, “PPP Borrowers Brace for Potentially Problematic IRS Guidance,” Tax Notes Today Federal, November 11, 2020,

2020 TNTF 218-1, https://www.taxnotes.com/tax-notes-today-federal/partnerships/ppp-borrowers-brace-potentially-problematic-irs-guidance/2020/11/11/2d5zd (subscription required, retrieve

[5] Eric Yauch, “PPP Borrowers Brace for Potentially Problematic IRS Guidance,” Tax Notes Today Federal, November 11, 2020

[6]Hillsborough National Bank v. Commissioner, United States v. Bliss Dairy, 460 U.S. 370 (1983), March 7, 1983

[7] United States v. Bliss Dairy, 460 U.S. 370 (1983)

[8] United States v. Bliss Dairy, 460 U.S. 370 (1983)

[9] Notice 2020-32

[10] Eric Yauch, “PPP Borrowers Brace for Potentially Problematic IRS Guidance,” Tax Notes Today Federal, November 11, 2020