The IRS has answered one of the key unanswered tax questions involving the PPP loan program, and the answer is one that taxpayers will not like. In Notice 2020-32[1] the IRS has provided that any otherwise deductible expenses that result in forgiveness of a PPP loan pursuant to Section 1106 of the CARES Act will not be deductible in computing the taxpayer’s income.

The Notice begins by pointing out that while Congress told us PPP loan forgiveness is not taxable income, they said nothing about deducting the expenses paid with such loan proceeds:

Neither section 1106(i) of the CARES Act nor any other provision of the CARES Act addresses whether deductions otherwise allowable under the Code for payments of eligible section 1106 expenses by a recipient of a covered loan are allowed if the covered loan is subsequently forgiven under section 1106(b) of the CARES Act as a result of the payment of those expenses. This Notice addresses the effect of covered loan forgiveness on the deductibility of payments of eligible section 1106 expenses.[2]

IRC §265(a)(1), the provision the IRS will look at to see if the deduction is barred, states the following:

(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.

The Notice explains the meaning of a class of income wholly exempt from tax in general terms:

The term “class of exempt income” means any class of income (whether or not any amount of income of such class is received or accrued) that is either wholly excluded from gross income under any provision of subtitle A of the Code or wholly exempt from the taxes imposed by subtitle A of the Code under the provisions of any other law. See §1.265-1(b)(1). The purpose of section 265 of the Code is to prevent a double tax benefit.

The key part of the Notice comes next, as the IRS analyzes §265(a)(1) and related case law that has interpreted that section in the past:

Section 265(a)(1) of the Code applies to otherwise deductible expenses incurred for the purpose of earning or otherwise producing tax-exempt income. It also applies where tax exempt income is earmarked for a specific purpose and deductions are incurred in carrying out that purpose. In such event, it is proper to conclude that some or all of the deductions are allocable to the tax-exempt income. See Christian v. United States, 201 F. Supp. 155 (E.D. La. 1962) (school teacher was denied deductions for expenses incurred for a literary research trip to England because the expenses were allocable to a tax-exempt gift and fellowship grant); Banks v. Commissioner, 17 T.C. 1386 (1952) (certain educational expenses paid by the Veterans’ Administration that were exempt from income tax, were not deductible); Heffelfinger v. Commissioner, 5 T.C. 985 (1945), (Canadian income taxes on income exempt from U.S. tax are not deductible in computing U.S. taxable income); and Rev. Rul. 74-140, 1974-1 C.B. 50, (the portion of a state income tax paid by a taxpayer that is allocable to the cost-of-living allowance, a class of income wholly exempt under section 912, is nondeductible under section 265).

In Manocchio v. Commissioner, 78 T.C. 989 (1982), a taxpayer attended a flight-training course that maintained and improved skills required in the taxpayer’s trade or business. As a veteran, the taxpayer was entitled to an educational assistance allowance from the Veterans’ Administration pursuant to 38 U.S.C. section 1677 (1976) equal to 90 percent of the costs incurred. Because the payments received were exempt from taxation under 38 U.S.C. section 310(a) (1976), the taxpayer did not report them as income. The taxpayer did, however, deduct the entire cost of the flight training course, including the portion that had been reimbursed by the Veterans’ Administration. In a reviewed opinion, the court held that the reimbursed flight-training expenses were nondeductible under section 265(a)(1) of the Code.[3]

After reading that analysis the IRS puts forth, it seems clear that this will not be a good Notice for taxpayers—and the final portion of the Notice explicitly states the bad news, beginning with an all uppercase header that reads “NON-DEDUCTIBILITY OF PAYMENTS TO THE EXTENT INCOME RESULTING FROM LOAN FORGIVENESS IS EXCLUDED UNDER SECTION 1106(i) OF THE CARES ACT.”

That section begins with the agency’s conclusion:

To the extent that section 1106(i) of the CARES Act operates to exclude from gross income the amount of a covered loan forgiven under section 1106(b) of the CARES Act, the application of section 1106(i) results in a “class of exempt income” under §1.265-1(b)(1) of the Regulations. Accordingly, section 265(a)(1) of 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. Consistent with the purpose of section 265, this treatment prevents a double tax benefit.[4]

The agency follows this with a defense of the ruling:

This conclusion is consistent with prior guidance of the IRS that addresses the application of section 265(a) to otherwise deductible payments. In particular, Rev. Rul. 83-3, 1983-1 C.B. 72, provides that, where tax exempt income is earmarked for a specific purpose, and deductions are incurred in carrying out that purpose, section 265(a) applies because such deductions are allocable to the tax-exempt income. In accordance with the analysis set forth in Rev. Rul. 83-3, the direct link between (1) the amount of tax exempt covered loan forgiveness that a recipient receives pursuant to section 1106 of the CARES Act, and (2) an equivalent amount of the otherwise deductible payments made by a recipient for eligible section 1106 expenses, constitutes a sufficient connection for section 265(a) to apply to disallow deductions for such payments under any provision of the Code, including sections 162 and 163, to the extent of the income excluded under section 1106(i) of the CARES Act.

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.[5]

Is this Notice the final word on this issue? Very possibly not. First, it is possible a taxpayer may decide to challenge this position in court. Whether they would or would not prevail is open to question, and the other big problem is being able to afford the litigation to begin with.

The more likely road to relief would be if Congress were to act in the next Coronavirus bill (assuming there will be such a bill, as many do assume) to simply enact an amendment to make clear that expenses used to justify PPP loan forgiveness are deductible, regardless of any provision in the IRC contrary to that conclusion. But that assumes Congress can agree that this is a step they want to take.

[1] Notice 2020-32, April 30, 2020, https://www.irs.gov/pub/irs-drop/n-20-32.pdf (retrieved April 30, 2020)

[2] Notice 2020-32, Section II

[3] Notice 2020-32, Section III

[4] Notice 2020-32, Section III (It appears the IRS may have intended to label the header as IV, but the initial version posted did not do so. It is possible the agency will post a corrected Notice that will label this as Section IV.)

[5] Notice 2020-32, Section III