Expenses Paid with a Forgiven PPP Loan are Deductible, IRS is Wrong

Tax Deductions

Update (12/27/2020)

Congress passed the new COVID Relief Package (officially titled the Consolidated Appropriations Act 2021), which amends 15 USC § 9005(i) to add:

  • "No deduction shall be denied, no tax attribute shall be reduced, and no basis increase shall be denied, by reason of the exclusion from gross income."
  • "In the case of... a partnership or S Corporation, any amount excluded from income... shall be treated as tax exempt income for purposes of [determining an owner's basis under] Sections 705 and 1366... and, except as provided by [regulations], any increase in the adjusted basis of a partner's interest... under Section 705... shall equal the partner's distributive share of deductions resulting from costs giving rise to forgiveness."

This is what it does:

  • You can deduct PPP-funded expenses; and
  • Allows owners to increase their basis.

This is huge. The IRS's rationale behind initially rejecting the notion of deducting PPP-funded expenses was that it would constitute double-dipping. Congress just slapped down that idea and allowed tripple-dipping: PPP forgiveness is not income, you can deduct the expenses, and you can increase your basis in the company thereby limiting future capital gain in the future if and when you sell the company. That is nothing short of fantastic news for job creators in America. Congress understands the long-term goal of getting this economy back in shape whereas the IRS only sees the short-term narrow goal of increasing immediate tax revenue without considering the disastrous long-term effects it would have on our nation's economy.

Update (12/03/2020)

The Journal of Accountancy recently published an article reaching the same conclusion as our firm: see here.

Updated (11/21/2020)

The IRS issued Revenue Ruling 2020-27. In this revenue ruling, it is evident the IRS realized their reliance on Section 265 was fundamentally and fatally flawed, so now they’re switching their argument to the tax benefit rule to call loan forgiveness a de facto “recovery.” What Treasury fails to understand is that it is the tax benefit rule itself that is the logic behind Section 108's characterization of discharge of indebtedness being treated as taxable income, which Congress specifically blocked by enacting 15 U.S.C. 9005(i).

The U.S. Supreme Court has mandated that the IRS cannot interpret statutes in a manner that is inconsistent with the plain meaning of the terms in the statute. U.S. v. Home Concrete & Supply, LLC, 132 S. Ct. 1836 (2012).

Loan forgiveness is neither a “recovery” nor a “reimbursement” of an expense in any sense of the plain meaning of the term. Such an interpretation violates the plain meaning of those terms, which violates the U.S. Supreme Court’s holding in Home Concrete.

Furthermore, to argue it applies to loan forgiveness would violate Treasury’s own limited interpretation of the term “recovery” as defined in Treas. Reg. 1.111-1(a)(2). Treasury’s own regulations limit the definition of a “recovery” to “section 111 items” that Treasury itself limited to “bad debts, prior taxes, delinquency amounts, and all other items subject to the rule of exclusion.”

Furthermore, if the IRS argues that subjective intent to pursue forgiveness would foreclose deductibility, that intent would be evident by simply utilizing PPP funds exclusively for forgiveness-eligible expenses, such as payroll, which would apply to nearly all recipients. That argument will never hold up before a federal judge.

The IRS then attempts to apply the logic in Hillsboro National Bank v. Commissioner. 460 U.S. 370 (1983).

In that case, the Supreme Court held that the “tax benefit rule will cancel out an earlier deduction only when careful examination shows that the later event is. . . fundamentally inconsistent with the premise on which the deduction was initially based.”

There is no factual "premise" for deducting payroll expenses with loan proceeds that a taxpayer is liable for at the time the expense was incurred. It's a loan, and the proceeds were used for payroll. Future events and subjective intent to pursue forgiveness in the same year or later year are wholly irrelevant. Any conclusion to the contrary would require a new and novel argument the Commissioner has never made in a court of law. That's not to say their interpretation is without merit; it simply has never been tested in court.

Treasury is attempting to legislate by regulation. Congress intended to support payroll with no adverse tax effects. Congress did not expect the IRS to come up with a new and novel argument to strip the full effect of the economic support from companies in the U.S. Congress made their intent abundantly clear and determined no clarifying legislation was required given the position of law firms already mounting a legal case against the IRS's novel application of Section 265 to attempt to deny deductions.

The United States Court of Appeals for the Federal Circuit has already ruled that even properly promulgated regulations are invalid as a matter of law if they exceed the unambiguously expressed intent of Congress. Dominion Res., Inc. v. U.S., 681 F.3d 1313 (Fed. Cir. 2012). The U.S. Senate Finance Committee's Chairman, Senator Chuck Grassley, and Ranking Member, Senator Ron Wyden, in a rare showing of bipartisanship, wrote letters to Treasury Secretary Steven Mnuchin pointing out that the IRS’s position runs contrary to congressional intent. Therefore, if the IRS wishes to deny the deductibility of PPP loan proceeds, they need to write their Congressional representatives to request the legislative branch to grant them that power. As the law currently exists, expenses incurred with PPP loan proceeds are fully deductible.

Update (05/07/2020)

Our firm's legal position on the full deductibility of expenses incurred with PPP loan proceeds was covered in Forbes: see here.


The Internal Revenue Service recently issued Notice 2020-32 claiming that expenses paid with a loan that is later forgiven in the future are not deductible for U.S. federal income tax purposes on the basis that the cancellation of indebtedness income would not be taxable to the taxpayer pursuant to Section 1106(i) of the CARES Act (15 U.S.C. 9005(i)), which, according to the IRS, makes it “wholly exempt income” pursuant to Section 265.

No court has ever ruled, nor would it ever rule, that cancellation of debt that is claimed to be non-taxable pursuant to existing exclusions, whether that be due to insolvency or bankruptcy under Section 108 or pursuant to 15 U.S.C. 9005(i), somehow requires a taxpayer to amend prior-year returns to remove deductions attributable to the non-taxable cancellation of debt.

No court has ever ruled that a future contingent event that may or may not occur (i.e., loan forgiveness) in a future tax year can somehow retroactively treat expenses that were deductible at the time they were incurred as though they are now nondeductible expenses.

At the time the Paycheck Protection Program (herein “PPP”) loan proceeds are acquired, they are not considered “wholly exempt income.” In fact, because the loan proceeds may be only partially forgiven, it would logically be classified as “partially exempt.” Therefore, the IRS is wrong, and any expenses incurred with the proceeds are fully deductible.

If the IRS intends to require taxpayers to amend their 2020 U.S. federal income tax returns if and when the PPP loan proceeds are cancelled, they must do the same companies that have debt discharged pursuant to Section 108 in bankruptcy court. Most notably, President Trump’s companies that have, in the past, had debt discharged without having to amend prior-year returns to remove deductions attributable to the discharged debt.



On March 27, 2020, Congress passed and the President signed into law the Coronavirus Aid, Relief, and Economic Security (CARES) Act.[1] One of the many relief measures included the Paycheck Protection Program created by Section 1102 of the CARES Act.[2] In order to incentivize applications, the CARES Act also included Section 1106 detailing the availability of possible total and complete loan forgiveness including the non-taxability of any forgiven amount in Section 1106(i), which declared that “any amount which [is excluded from] gross income of the eligible recipient by reason of forgiveness… shall be excluded from gross income.”[3]

In response, the IRS issued Notice 2020-32 declaring that, to the extent a loan is forgiven, the expenses attributable to the cancelled debt are not deductible pursuant to Section 265 and other legal authorities that deny deductions for expenses for which the taxpayer receives reimbursement.[4]

Wholly Exempt Income

Generally, a business expense directly allocable to tax-exempt income is not deductible.[5] The rule prohibits deductions generally where “the use of tax-exempt income is sufficiently related to the generation of a deduction to warrant disallowance of that deduction.”[6] The court’s logic does not extend to the proper use of loan proceeds to generate valid deductions if said loan is later discharged in a tax-free manner.

Under the general disallowance, deductions have not been allowed for:

  1. legal fees allocated to defense of insurance proceeds;[7] or other amounts paid for legal fees which are allocable to income that is expressly exempt from income tax;[8]
  2. where the VA reimbursements received by the taxpayer were inherently exempt from taxation by their nature not subject to future contingencies under 38 U.S.C.A. § 3101(a), the taxpayer could not deduct the entire cost of a flight-training course;[9]
  3. expenses attributable to money received as non-taxable gifts are not deductible.[10]
  4. automobile expenses incurred in earning income exempt under Section 107 (rental value of parsonages);[11]
  5. Canadian income tax from income earned by a nonresident American citizen and not subject to federal income tax;[12]
  6. tuition expenses of a Navy veteran received as tax-exempt income;[13]
  7. state income tax paid by a municipal court judge on his salary exempt from federal income tax;[14]
  8. state income tax paid on a federally exempt cost-of-living allowance; and[15]
  9. interest paid on funds borrowed and used to purchase tax-exempt bonds, even though there was a foreseeable future need for funds. On the other hand, Section 265 does not apply if there is income recognition for alternative minimum tax purposes even when that does not result in income recognition to regular income tax purposes.[16]

However, "discharge of indebtedness" income is not a class of income wholly and inherently exempt from tax. It can be made exempt under Section 108 based on certain conditions and subject to certain future contingencies, but it is not inherently exempt from tax. As such, Section 265 cannot be held to apply.

Legislative Intent

The U.S. Tax Court has held that “the legislative purpose behind § 265 is to prevent taxpayers from reaping a double tax benefit by using deductions attributable to tax-exempt income to offset taxable income.”[17] However, Congress did not require taxpayers to develop an extrasensory psychic ability to foresee the future and determine the extent to which a loan may or may not be forgiven.[18]

Section 265 was not intended to apply to future contingent events in order to retroactively deny the deductibility of expenses; even if forgiveness occurs in the same year the expense was incurred. Such a reading contravenes the unambiguous language in the statute.[19]

Section 265’s use of the phrase “wholly" exempt cannot reasonably include loan proceeds that may only be partially exempt.[20]

And because the IRS’s interpretation of Section 265 could result in a requirement that debt discharged in bankruptcy or claimed as non-taxable by reason of insolvency pursuant to Section 108 give rise to an affirmative requirement to amend prior-year returns, which is beyond unreasonable, IRS Notice 2020-32 is invalid as a matter of law.[21]


Our firm is no stranger to confrontation with and victory over the IRS. We can either issue a formal covered Tax Opinion to shield against the imposition of penalties or prepare and submit the return ourselves.


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Bluebook Citation: Expenses Paid with a Forgiven PPP Loan are Deductible, IRS is Wrong, Int’l Tax Online Law Journal (May 7, 2020) url.

[1] PL 116-136.

[2] 15 U.S.C. § 636(a)(2)(F), (a)(36).

[3] 15 U.S.C. § 9005.

[4] Burnett v. C.I.R., 356 F.2d 755, 759-60 (5th Cir. 1966); Wolfers v. C.I.R., 69 T.C. 975 (1978); Charles Baloian Co. v. C.I.R., 68 T.C. 620 (1977); Rev. Rul. 80-348; Rev. Rul. 80-173.

[5] IRC § 265(a)(1). The prohibition on the deduction of interest expense incurred or continued in order to purchase or carry tax-exempt securities within the meaning of IRC § 265(a)(2), is designed to prevent the taxpayer from obtaining the double tax benefit which would occur if the taxpayer could both deduct interest on the borrowed money and on the securities purchased with it (which bear tax-exempt interest). See Denman v. Slayton, 282 U.S. 514 (1931); New Mexico Bancorporation & Subsidiaries v. C.I.R., 74 T.C. 1342 (1980), acq., 1983-2 C.B. 1 and acquiescence in result only recommended, AOD-1984-3 (I.R.S. AOD 1984).

[6] HR Rep No. 426, 99th Cong, 1st Sess. 135 (1985).

[7] National Engraving Co. v. C.I.R., 3 T.C. 178 (1944). See Jones v. C.I.R., 25 T.C. 4 (1955), aff'd, 231 F.2d 655 (3d Cir. 1956), involving the disallowance of a deduction for premiums paid on life insurance policies taken out on the lives of persons from whom the taxpayer had purchased contingent remainder interests in certain trust estates and which policies were made payable to the taxpayer. Where a trust purchased insurance on the grantor's life, the trust could not deduct the premiums since the insurance proceeds would be exempt from taxation. Glassner v. I.R.S., 46 A.F.T.R.2d 80-5228 (S.D. N.Y. 1980).

[8] Remkiewicz v. C.I.R., T.C. Memo. 2001-1, T.C.M. (RIA) P 2001-001, 81 T.C.M. (CCH) 945 (2001), holding legal fees incurred pursuing tax payer's civil rights claim, recovery from which was tax exempt income, were not deductible, despite fact that taxpayer's current employment depended on his success in resolution of the discrimination claim; Metzger v. C.I.R., 88 T.C. 834, 44 Fair Empl. Prac. Cas. (BNA) 1505, Tax Ct. Rep. (CCH) 43832, 1987 WL 49302 (1987), judgment aff'd, 845 F.2d 1013, 46 Fair Empl. Prac. Cas. (BNA) 1456 (3d Cir. 1988) and (disapproved of on other grounds by, Sparrow v. C.I.R., 949 F.2d 434, 57 Fair Empl. Prac. Cas. (BNA) 592, 57 Empl. Prac. Dec. (CCH) P 41108, 91-2 U.S. Tax Cas. (CCH) P 50567, 69 A.F.T.R.2d 92-325 (D.C. Cir. 1991)).

[9] Manocchio v. Commissioner of Internal Revenue, 78 T.C. 989, Tax Ct. Rep. (CCH) 39097, 1982 WL 11107 (1982), decision aff'd, 710 F.2d 1400, 83-2 U.S. Tax Cas. (CCH) P 9478, 52 A.F.T.R.2d 83-5566 (9th Cir. 1983); retroactively applying Rev. Rul. 80-173, 1980-2 C.B. 60. Cf. Baker v. U.S., 748 F.2d 1465, 85-1 U.S. Tax Cas. (CCH) P 9101, 55 A.F.T.R.2d 85-509 (11th Cir. 1984), acquiescence recommended, AOD-1995-5, 1995 WL 508731 (I.R.S. AOD 1995) and acq., 1995-2 C.B.1, which found retroactive application of Rev. Rul. 80-173 to be an abuse of discretion. See also Allen v. C.I.R., T.C. Memo. 1986-55, T.C.M. (P-H) P 86055, 51 T.C.M. (CCH) 427, 1986 WL 21448 (1986).

[10] See GCM 39813 (1990).

[11] Deason v. C. I. R., 41 T.C. 465, 1964 WL 1270 (T.C. 1964), acq., 1964-2 C.B. 3. See also Rev. Rul. 83-3 1983-1 C.B. 72, modified Ann. 83-100, 1983-22 I.R.B. 26.

[12] Heffelfinger v. C. I. R., 5 T.C. 985, 1945 WL 89 (T.C. 1945).

[13] The exclusion is pursuant to the Servicemen's Readjustment Act of 1944. See Banks v. C.I.R., 17 T.C. 1386 (1952); Christian v. U.S., 201 F. Supp. 155 (E.D. La. 1962); Rev. Rul. 63-43.

[14] Keith v. Commissioner, T.C.M. (P-H) P 42630, 1 T.C.M. (CCH) 184, 1942 WL 9542 (T.C. 1942).

[15] Lapin v. U.S., 655 F. Supp. 1344 (D. Haw. 1987). In a case of first impression, the court held that IRC § 265 contains no substantive changes from IRC (1939), § 24(a)(5), which precluded taxpayers from taking deductions for state income taxes on exempt income.

[16] Inapplicability of Section 265, 1 Mertens Law of Fed. Income Tax’n § 2A:126

[17] Induni v. C.I.R., 98 T.C. 618, 621 (1992), aff'd, 990 F.2d 53 (2d Cir. 1993); also see IRS CCA 200246003 (Nov. 15, 2002)

[18] Dominion Res., Inc. v. U.S., 681 F.3d 1313 (Fed. Cir. 2012) (regulations cannot exceed the unambiguously expressed intent of Congress); also see Nat’l Westminster Bank, PLC v. U.S., 512 F.3d 1347 (Fed. Cir. 2008) (regulations cannot be inconsistent with the purpose and intent.).

[19] Norman v. U.S., 942 F.3d 1111 (Fed. Cir. 2019); also see Intermountain v. C.I.R., 134 T.C. 211 (2010).

[20] U.S. v. Home Concrete & Supply, LLC, 132 S. Ct. 1836 (2012) (the IRS’s interpretation of statutory language cannot conflict with plain meaning of the term in the statute).

[21] SIH Partners v. C.I.R., 923 F.3d 296 (3d Cir. 2019).

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