By Patricia Hintz and Christie Galinski

Law360 (July 28, 2020, 5:53 PM EDT) --

Patricia Hintz

Christie Galinski

Borrowers with Paycheck Protection Program loans should be aware of an important tax downside.

According to Internal Revenue Service Notice 2020-32, business expenses that would normally be deductible in computing taxable income may not be deductible if the taxpayer uses funds from a forgiven loan to pay such expenses.[1]

Some tax preparers may decide to claim the deductions in spite of IRS guidance because, in part, the intent of Congress here is up for debate.

Background of PPP

The PPP loans are meant to help small businesses with fewer than 500 employees pay their employees and certain other permitted expenses through the COVID-19 crisis. A PPP loan, which is administered by the Small Business Administration, may be forgiven if the funds are used during the 24 weeks after the origination of the loan to pay for covered costs: payroll, mortgage interest, certain rental payment obligations and business utility payments.

Under the original terms of the Coronavirus Aid, Relief and Economic Security, or CARES, Act, the SBA could forgive a PPP loan for covered costs incurred within eight weeks of the origination date, or covered period.

But on June 5, the president signed the Paycheck Protection Program Flexibility Act into law, which increased the covered period to 24 weeks.

Further, the Flexibility Act extended the end date of the loan availability period from June 30 to Aug. 8, giving businesses additional time to submit their applications and secure PPP loan funding.

The SBA has also issued guidance that allows borrowers to apply for PPP forgiveness before their covered period expires so long as they have utilized their PPP funds.[2] Therefore, a borrower does not have to wait until its covered period is over before requesting forgiveness, as long as it has used all of the loan proceeds for which it is requesting forgiveness.

However, an early application for forgiveness may be risky. For example, if a borrower applies for forgiveness before the end of its covered period and the borrower has reduced any employee's salary or wages in excess of 25%, the borrower must account for the excess salary reduction for the full covered period.

Thus, if a borrower applies for forgiveness early, it foregoes the safe harbor that allows the borrower to restore salaries or wages by Dec. 31.

Tax-Free PPP Loan Forgiveness

Usually, the initial infusion of cash from a loan is not treated as taxable income when the loan is made because the borrower is legally obligated to repay it. However, when a loan is forgiven, a borrower does have income because it is relieved of its obligation to repay the loan. Therefore, when a borrower's debt is cancelled or forgiven, the amount of the debt is usually treated as income to the borrower at the time it is cancelled or forgiven.

Fortunately, Section 1106(i) of the CARES Act addresses this situation specifically, and states that any PPP loan amount that is forgiven will be excluded from federal taxable gross income, even though applicable law would generally require that it be included.  

It should be noted that this provision in the CARES Act covers only the federal income tax treatment of the forgiven loan amount. For state income tax purposes, the forgiven amount may be included in taxable income. State law must be consulted in order to determine whether a particular state will exclude PPP loan forgiveness amounts from state taxable income.

IRS Notice Denies Deductions for PPP Expenses

Unfortunately, neither the CARES Act nor the PPP Flexibility Act addresses whether deductions that are otherwise allowable under the Internal Revenue Code are still allowed when the borrower uses forgiven PPP funds to pay for them.

Code Section 265(a) generally provides that deductions are not allowed for any amount that is allocable to income that is wholly exempt from tax.[3] In other words, if a taxpayer receives tax-free income allocated to expenses that are usually deductible, Code Section 265(a) disallows the deduction. Tax professionals questioned whether this code section would apply to PPP loan forgiveness.

In May, the IRS issued Notice 2020-32 to address the deductibility question for expenses funded by forgiven PPP loans and concluded that those expenses should not be deductible.

Its reasoning is based on Code Section 265(a) and prior case law in which deductions are denied for expenses if a taxpayer received tax-free income to pay for those expenses. The IRS states that the purpose of this rule is to prevent a double tax benefit.

In reaching its conclusions regarding deductibility of expenses paid with PPP funds, the notice relies in part on a U.S. Tax Court case called Manocchio v. Commissioner, in which a veteran going to a flight-training course in 1977 received tax-free funds from the VA to cover 90% of the cost of his classes.

The classes were related to his profession as an airline pilot.[4] The payments he received were exempt, so the veteran did not report them as taxable income. However, he also deducted the full cost of the course from his taxable income.

The taxpayer in Manocchio argued that Code Section 265 only disallowed deductions incurred in the production of exempt income, and should not apply to expenses funded with exempt income. In other words, he claimed the training expenses were related to the taxable income he earned through his work as a pilot and should therefore not be disallowed by Code Section 265.

The Tax Court rejected this interpretation and denied the deduction. It found there was a fundamental nexus between the exempt funds and the cost of the training since the right to reimbursement arose only when the U.S. Department of Veterans Affairs received a certification from the flight school of the actual training received and the cost of such training.

The Tax Court in Manocchio also noted that there was nothing in the legislative history of the veterans' provisions to suggest that Congress intended for a veteran to have both an exemption and a tax deduction when the reimbursed flight-training expenses otherwise qualified as deductible business-related education — there is also no indication from Congress indicating that Code Section 265 does not apply to forgiven PPP loans.

However, the court in Manocchio did note that most of the benefits received from the veterans' benefits were not intended to reimburse any specific expenses incurred by the veteran and so it would be unrealistic to assume that Congress even considered the deductibility of educational expenses.

Furthermore, the court stated, there would obviously be instances where flight training expenses would be nondeductible for reasons outside of Code Section 265. For example, the veteran might not have sufficient itemized deductions to take advantage of the deduction.

The notice also cited several other authorities in which expense deductions were disallowed because the taxpayer used tax-exempt income to pay for them.

In Christian v. U.S. an English literature teacher travelled to England three times over three years in the 1950s to do original research in the area of her particular interest — the Bronte sisters.[5] Her expenses were financed through a fellowship award from the American Association of University Women. The district court found that Code Section 265 disallowed deductions for this travel because the fellowship award was wholly exempt from taxes.

Banks v. Commissioner involved a veteran who received $509 in 1948 from the G.I. Bill of Rights in order to pay tuition and book expenses for an advanced degree in chemistry after being released from the Navy.[6] Since the income from the G.I. Bill is exempt, the Tax Court held that the veteran could not deduct those expenses paid for with income from the G.I. Bill and called the contention wholly without merit.

In Heffelfinger v. Commissioner, another case from the 1940s based on a prior version of Code Section 265(a), the taxpayer claimed a deduction for Canadian taxes paid, but the Tax Court denied the deductions since the income taxed by Canada was exempt under applicable U.S. tax law.[7]

In Revenue Ruling 74-140, the taxpayer was denied deductions for state income taxes paid on income that was exempt as cost-of-living allowances for certain workers living abroad.[8]

In some of the cases, such as Manocchio, Christian and Banks, the exempt income can be more directly linked to the expense at issue. The exempt income in those cases would not have been available if the taxpayer had not taken the class or travelled to England to research the Bronte sisters.

But in the other cases, the link is not clearly a dollar-for-dollar link. The notice cites Revenue Ruling 83-3 for the rule that Code Section 265 will apply to disallow a deduction where tax-exempt income is earmarked for a specific purpose and deductions are incurred in carrying out that purpose.[9]

In Rev. Rul. 83-3, three scenarios were considered under Code Section 265 and the deductions were denied in all three of them.

First, a veteran received payments from the VA intended to provide educational assistance and the veteran incurred expenses for tuition books and fees in connection with classes required by his employer.

Second, a minister received a tax-free rental and utility allowance from his church and then incurred expenses directly related to providing a home.

Third, a taxpayer received tax-free scholarship funds solely attributable to tuition.

The notice concludes that, like the three examples in Revenue Ruling 83-3, there is a direct link between the PPP loan forgiveness and otherwise deductible payments made by PPP loan recipients for eligible PPP expenses. Therefore, it disallows such deductions.[10]

Criticism of the IRS Notice

Some tax professionals disagree with the notice's conclusion. They argue that the income exclusion for the debt forgiveness in Section 1106(i) of the CARES Act is pointless if the deductions are disallowed.

Could Congress have intended this result? If expense deductions are denied for all expenses paid for by the forgiven PPP loans then the benefit of tax-free loan forgiveness could be completely offset.

In addition, the language of Code Section 265 may also disallow deductions for expenses paid in pursuit of the PPP loans, such as attorney and accountant fees, which amplifies the bad result of Notice 2020-32.

Furthermore, as discussed above, there should be a good connection between the exempt income and the denied deductions under Code Section 265.

Some prior cases have a more straightforward dollar-to-dollar link, but a taxpayer could argue that these PPP expenses would have been paid regardless of the PPP loans and were not sufficiently connected to them to cause the loss of that tax benefit.

Finally, the notice does not address the fact that the wholly exempt income at issue is debt cancellation income from future contingent loan forgiveness, which may — or may not — happen months or years after the expenses are deducted.

The taxpayer may not be certain that a PPP loan will be forgiven until months after the disbursement of the loan, maybe not even until the next taxable year. It would be impractical to ask taxpayers to amend their 2020 return to remove prior year deductions because of a loan forgiven in the year 2021.

Legislative Fix

Sen. John Cornyn, R-Texas, has introduced a measure to allow companies to deduct PPP expenses.[11] The American Institute of Certified Public Accountants has expressed its support for the bill in a letter to Cornyn and the other senators sponsoring the bill.

In addition, House Democrats have included a similar provision in the Health and Economic Recovery Omnibus Emergency Solutions Act — the COVID-19 relief bill that was passed by the House but has not been passed by the Senate.[12]

Senators and representatives disagree on whether lawmakers intended to disallow related deductions when the original bill was drafted. U.S. Department of the Treasury Secretary Steven Mnuchin supported the notice and said allowing businesses to deduct expenses funded by forgiven PPP loans would provide an unintended double tax benefit.

Therefore, given the state of U.S. politics, taxpayers cannot depend on Congress to fix the issue. A congressional solution to clarify the question of the deductibility of PPP expenses is the best solution that taxpayers can expect, but they will have to strategize in the meantime. 

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Patricia Hintz is a partner and Christie R. Galinski is an associate at Quarles & Brady LLP.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] Notice 2020-32, 2020-21 IRB (May 1, 2020), https://www.irs.gov/pub/irs-drop/n-20-32.pdf.

[2] Business Loan Program Temporary Changes; Paycheck Protection Program -- Revisions to Loan Forgiveness and Loan Review Procedures Interim Final Rules, 85 Fed. Reg. 38,304 (June 26, 2020), https://home.treasury.gov/system/files/136/PPP--IFR--Revisions-to-Loan-Forgiveness-Interim-Final-Rule-and-SBA-Loan-Review-Procedures-Interim-Final-Rule.pdf.

[3] IRC Section 265(a)  .

[4] Manocchio v. Commissioner , 78 TC 989 (1977).

[5] Christian vs. U.S. , 201 F. Supp. 155 (E.D. La. 1962).

[6] Banks vs. Commissioner , 17 TC 1386 (1952).

[7] Heffelfinger v. Commissioner , 5 TC 985 (1945).

[8] Rev. Rul. 74-140, 1974-1 CB 50.

[9] Rev. Rul. 83-3, 1983-1 CB 72.

[10] The notice also mentions, without discussion, that there are cases and rulings that deny deductions for otherwise deductible payments for which the taxpayer receives reimbursement. This is an argument outside of Code Section 265.

[11] S. 3612.

[12] H. 6800.

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