Tax Deductions

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

by John Anthony Castro, J.D., LL.M.



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, which, according to the IRS, makes it “wholly exempt income” from tax 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 Section 1106 of the CARES Act, 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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About the Author

John Anthony Castro, J.D., LL.M., is the Managing Partner of Castro & Co., the author of International Taxation in Plain English as well as International Estate Planning in Plain English, an esteemed graduate of Georgetown University Law Center in Washington DC, an OPM Fellow at Harvard Business School, and an internationally recognized tax attorney with offices in New York, Los Angeles, Miami, Chicago, Dallas, and Washington DC.

To provide feedback on this article or suggest an idea for a future article, please contact Tiffany Michelle Hunt, J.D., LL.M., Director of Tax Planning at Castro & Co., at

Bluebook Citation: John Anthony Castro, 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).