n-20-32.pdf

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Notice 2020-32
PURPOSE
This notice provides guidance regarding the deductibility for Federal income tax
purposes of certain otherwise deductible expenses incurred in a taxpayer’s trade or
business when the taxpayer receives a loan (covered loan) pursuant to the Paycheck
Protection Program under section 7(a)(36) of the Small Business Act (15 U.S.C.
636(a)(36)). Specifically, this notice clarifies that no deduction is allowed under the
Internal Revenue Code (Code) for an expense that is otherwise deductible if the
payment of the expense results in forgiveness of a covered loan pursuant to section
1106(b) of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), Public
Law 116-136, 134 Stat. 281, 286-93 (March 27, 2020) and the income associated with
the forgiveness is excluded from gross income for purposes of the Code pursuant to
section 1106(i) of the CARES Act.
BACKGROUND
I. Paycheck Protection Program
The Paycheck Protection Program was established by section 1102 of the CARES
Act. Under the Paycheck Protection Program, a recipient of a covered loan may use
the proceeds to pay (1) payroll costs, (2) certain employee benefits relating to
healthcare, (3) interest on mortgage obligations, (4) rent, (5) utilities, and (6) interest on
any other existing debt obligations. See section 7(a)(36)(F) of the Small Business Act
(describing allowable uses of a covered loan). See also Q&A 2.r. in Part III of the

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interim final rule, Business Loan Program Temporary Changes; Paycheck Protection
Program, Docket No. SBA-2020-0015, 85 Fed. Reg. 20811, 20814 (April 15, 2020).
Under section 1106(b) of the Cares Act, a recipient of a covered loan can receive
forgiveness of indebtedness on the loan (covered loan forgiveness) in an amount equal
to the sum of payments made for the following expenses during the 8-week “covered
period” beginning on the covered loan’s origination date (each, an eligible section 1106
expense): (1) payroll costs, (2) any payment of interest on any covered mortgage
obligation, (3) any payment on any covered rent obligation, and (4) any covered utility
payment. See section 1106(a) (defining the terms “covered period”, “covered mortgage
obligation,” “covered rent obligation,” “covered utility payment,” and “payroll costs”), (b)
(regarding eligibility for covered loan forgiveness), and (g) (regarding covered loan
forgiveness decisions). However, section 1106(d) of the CARES Act provides that the
amount of the covered loan forgiveness is reduced if, during the covered period, (1) the
average number of full-time equivalent employees of the recipient is reduced as
compared to the number of full-time employees in a specified base period, or (2) the
salary or wages of certain employees is reduced by more than 25 percent as compared
to the last full quarter before the covered period. In addition, pursuant to an interim final
rule issued by the Small Business Administration, no more than 25 percent of the
amount forgiven can be attributable to non-payroll costs. See Q&A 2.o. in Part III of the
interim final rule, Business Loan Program Temporary Changes; Paycheck Protection
Program, Docket No. SBA-2020-0015, 85 Fed. Reg. 20811, 20813-20814 (April 15,
2020).

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Section 1106(i) of the CARES Act addresses certain Federal income tax
consequences resulting from covered loan forgiveness. Specifically, that subsection
provides that, for purposes of the Code, any amount that (but for that subsection) would
be includible in gross income of the recipient by reason of forgiveness described in
section 1106(b) “shall be excluded from gross income.” Thus, section 1106(i) of the
CARES Act operates to exclude from the gross income of a recipient any category of
income that may arise from covered loan forgiveness, regardless of whether such
income would be (1) properly characterized as income from the discharge of
indebtedness under section 61(a)(11) of the Code, or (2) otherwise includible in gross
income under section 61 of the Code.
II. Deductibility of Eligible Section 1106 Expenses
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.
III. Summary of Relevant Law
Section 161 of the Code provides that, in computing taxable income under section
63 of the Code, there shall be allowed as deductions the items specified in part VI,
subchapter B, chapter 1 of the Code (for example, sections 162 and 163). However,
section 161 of the Code provides that the allowance of these deductions is subject to

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the exceptions provided in part IX, subchapter B, chapter 1 of the Code. These
exceptions include section 265 of the Code. See also section 261.
In general, section 162 of the Code provides for a deduction for all ordinary and
necessary expenses paid or incurred during the taxable year in carrying on any trade or
business. Covered rent obligations, covered utility payments, and payroll costs
consisting of wages and benefits paid to employees comprise typical trade or business
expenses for which a deduction under section 162 of the Code generally is appropriate.
Section 163(a) of the Code provides a deduction for certain interest paid or accrued
during the taxable year on indebtedness, including interest paid or incurred on a
mortgage obligation of a trade or business.
However, section 265(a)(1) of the Code and §1.265-1 of the Income Tax Regulations
provide that n
o deduction is allowed to a taxpayer for any amount otherwise allowable
as a deduction to such taxpayer that 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 subtitle A of the Code. See
generally section 265(a)(1); §1.265-1. 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.
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

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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.

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NON-DEDUCTIBILITY OF PAYMENTS TO THE EXTENT INCOME RESULTING
FROM LOAN FORGIVENESS IS EXCLUDED UNDER SECTION 1106(i) OF THE
CARES ACT
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.
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

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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.
CONTACT INFORMATION
The principal authors of this notice are Sarah Daya and Patrick Clinton of the Office
of Associate Chief Counsel (Income Tax & Accounting). For further information
regarding the application of sections 161, 162, 163, and 261 please contact Ms. Daya at
(202) 317-4891 (not a toll-free call); for further information regarding the application of
section 265, please contact Mr. Clinton at (202) 317-7005 (not a toll-free call).