Here is a guest post from John Anthony Castro.  I don’t agree with everything in it, but I think there are some well-considered arguments.  It also ran on his website.  See my post on forbes.com on the same topic.- PJR

Introduction

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 canceled, 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.

Background

On March 27, 2020, Congress passed and the President signed into law the Coronavirus Aid, Relief, and Economic Security (CARES) Act. One of the many relief measures included the Paycheck Protection Program created by Section 1102 of the CARES Act. 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 gross income of the eligible recipient by reason of forgiveness… shall be excluded from gross income.”

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.

Wholly Exempt Income

Generally, a business expense directly allocable to tax-exempt income is not deductible. 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.” 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; or other amounts paid for legal fees which are allocable to income that is expressly exempt from income tax;
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;
3. expenses attributable to money received as non-taxable gifts are not deductible.
4. automobile expenses incurred in earning income exempt under Section 107 (rental value of parsonages);
5. Canadian income tax from income earned by a nonresident American citizen and not subject to federal income tax;
6. tuition expenses of a Navy veteran received as tax-exempt income;
7. state income tax paid by a municipal court judge on his salary exempt from federal income tax;
8. state income tax paid on a federally exempt cost-of-living allowance; and
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.

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.” 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.

Section 265 was not intended to apply to future contingent events in order to retroactively deny the deductibility of expenses. Such a reading contravenes the unambiguous language in the statute.

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

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.

Conclusion

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.

I doubt that an opinion letter from Mr. Castro’s firm would be money well spent and you should not shift to somebody new doing your return over a single position.  Also my understanding of PPP is that the discharge will take place in 2020. And I would not put as much of a sure thing as Mr. Castro does. -PJR