Are PPP Mortgage Bills Deductible? It’s Difficult.


Taxpayers throughout the country are asking their accountants whether they will be able to deduct expenses that were paid with PPP loans. The IRS has taken the position that any expense paid that facilitates forgiveness of a PPP loan will not be deductible.

Hopefully the bipartisan COVID-19 bill will pass because the language thereof would solve this problem by allowing the PPP funds received to be tax free, and permitting the borrower to deduct all reasonable and necessary business expenses paid with the loan proceeds. Assuming, however, that the bipartisan bill does not pass, the IRS’s position with respect to this may not be as strong as what many tax advisers thought to be the case.

A WARNING TO READERS: Please do not conclude that this article tells you that you can deduct your PPP expenses. The IRS’s position is a strong one, and tax advisers and their clients will need to think carefully about whether there is enough support to take the deductions, and whether there is enough “substantial authority” to therefore require prominent disclosure on the return that these expenses were taken as further discussed below.

The IRS issued Revenue Notice 2020-32 in May taking their stance and subsequently doubled down on that stance by issuing Revenue Ruling 2020-27 in November. One key case relied upon by the IRS in the Ruling is the 1982 tax court case Manocchio v. Commissioner of Internal Revenue Service (hereinafter, “Manocchio”).

This case has been cited in many subsequent cases and in IRS Notice 2020-32. A closer look at the case, however, begs the question of whether the holding is correct.

John Manocchio was a pilot and former Air Force veteran who attended flight training courses to enhance his career. He was reimbursed from the Veterans’ Administration (“VA”) for 90% of the expenses under a Federal program designed to help veterans continue their education.

Because the expenses were reimbursed, the question before the Tax Court was whether (a) the expenses were deductible after reimbursement or whether (b) the expenses were “allocable to” the VA’s non-taxable reimbursement and thus not deductible under IRC §265.

The Tax Court noted that the committee reports Congress released after establishing the 90% Reimbursement Program failed to “address the possibility of a double tax benefit arising under the circumstances which present themselves here. . . [I]t is unrealistic to assume that Congress even considered, let alone approved, the deduction of specifically reimbursed educational expenses while the reimbursement itself remains sheltered by the umbrella exemption provided in 38 U.S.C. § 3101(a).”

38 U.S.C. § 3101(a) was enacted in 1970 and provided educational expense reimbursement rights for veterans. The statute contained the following language with respect to the tax-free nature of reimbursement when received by veterans:

  • (a) Payments of benefits due or to become due under any law administered by the Veterans’ Administration shall not be assignable except to the extent specifically authorized by law, and such payments made to, or on account of, a beneficiary shall be exempt from taxation, shall be exempt from the claim of creditors, and shall not be liable to attachment, levy, or seizure by or under any legal or equitable process whatever, either before or after receipt by the beneficiary. The preceding sentence shall not apply to claims of the United States arising under such laws nor shall the exemption therein contained as to taxation extend to any property purchased in part or wholly out of such payments. The provisions of this section shall not be construed to prohibit the assignment of insurance otherwise authorized under chapter 19 of this title, or of servicemen’s indemnity.
  • Emphasis added.

Congress, though in fewer words, clearly addressed tax treatment in the CARES Act by stating the following under § 1106(i):

  • (i) TAXABILITY.—For purposes of the Internal Revenue Code of 1986, any amount which (but for this subsection) would be includible in gross income of the eligible recipient by reason of forgiveness described in subsection (b) shall be excluded from gross income.

The following quote from the Manocchio case shows that the Tax Court may have decided for the taxpayer if the intention of Congress had been to create a double tax benefit.

  • In short, there is nothing in the legislative history of the relevant veterans’ provisions to suggest that Congress intended for a veteran to have both an exemption and a tax deduction where his reimbursed flight-training expenses otherwise qualify as deductible business-related education. On the other hand, the legislative purpose behind section 265 is abundantly clear: Congress sought to prevent taxpayers from reaping a double tax benefit by using expenses attributable to tax-exempt income to offset other sources of taxable income. This is precisely what petitioner is attempting to do here, and in our judgment, the application of section 265(1) to disallow the reimbursed portion of the flight-training expense deduction is both reasonable and equitable.

Manocchio argued that I.R.C. § 265 and Section 24(a)(5) of the Revenue Act of 1934 (the predecessor to § 265), show “that the purpose of the statute is to disallow deductions allocable ‘to the production” of exempt income.’”

On May 5th, 2020, Senators Grassley, Neal, and Wyden wrote a letter to Treasury Secretary Steve Mnuchin, including language that confirms the Congressional intent to allow businesses to benefit from both deductions and PPP loan forgiveness exemption:

  • Providing assistance to small businesses, only to disallow their business deductions as provided in Notice 2020-32, reverses the benefit that Congress specifically granted by exempting PPP loan forgiveness from income… Section 1106(i) was specifically included in the CARES Act to exclude from income loan forgiveness, which would otherwise be taxable, to provide a tax benefit to small businesses that received the PPP loan. Had we intended to provide neutral tax treatment for loan forgiveness, Section 1106(i) would not have been necessary.

This differs from the Tax Court’s decision in Manocchio, which concluded that Congress did not consider or discuss the double deductibility of expenses paid for with funds from the government. The Court also found that § 3101(a) was intended to prevent the deduction of monies received from the tax-exempt source.

This position is well-described in a 2007 New York Law School Faculty Scholarship article entitled Deductibility of Treble Damages Paid for Breach of National Health Service Corps Scholarship Contracts: The Misuse of I.R.C. 265(a)(1) in Stroud v. United States and of the Origin of the Claim Test in Keane v. Commissioner by Richard C.E. Beck.

This article comes to the conclusion that I.R.C. § 265 does not apply to prevent the deduction of expenses that are paid from tax-free or tax-exempt funds, but rather § 265 was enacted to prevent the deductibility of expenses incurred for the purpose of producing tax-exempt income.

When Section 24(a)(5) of the Revenue Act of 1934 was enacted Congress explicitly denied the deduction for expenses incurred for the purpose of producing exempt interest, while not eliminating the deductibility of certain expenses that were paid with tax-exempt income.

House Version

The House version of the law would have disallowed the deduction of amounts spent by state employees from tax-exempt salaries and amounts spent by landlords from rent received from state school tenants. The Senate version of the bill was intended to limit this impact.

Professor Beck explains the history of 265(a)(1) and quotes the House and Senate committee reports as follows:

  • B. History of l.R.C. § 265(a)(l)
  • The original predecessor of current l.R.C. § 265(a)(l) was enacted as section 24(a)(5) in the Revenue Act of 193446 in order to disallow deductions for the production of tax-exempt income. Such deductions would, in effect, shelter unrelated taxable income and provide an unwarranted double tax benefit. The specific situations Congress had before it when it enacted (former) section 24(a)(5) were: (1) expenses incurred for the purpose of producing exempt interest on state securities; (2) exempt salaries received by state employees; and (3) exempt income from leases of state school lands.47 The House version would have disallowed all such expenses.

It is clear from the italicized words in the legislative history below that the statutory language “allocable to,” later to cause great confusion, should be read as interchangeable with “paid or incurred for the production of’ tax-exempt income. The House Report states:

  • Section 24(a)(5). Disallowance of deductions attributable to tax-exempt income: This paragraph has been added to the bill to eliminate as deductions from gross income expenses allocable to the production of income wholly exempt from the income tax. Under the present law interest on State securities, salaries received by State employees, and income from leases of State school lands are exempt from Federal income tax, but expenses incurred in the production of such income are allowable as deductions from gross income.

Senate Version

The Senate version adds the express provision that such deductions are disallowed even if the tax exempt income fails to materialize, and also limits the provision to tax-exempt income other than interest, which was then dealt with in a separate provision. The Senate Report states:

  • The House bill disallows amounts otherwise allowable as deductions which are allocable to one or more classes of tax-exempt income even though the income fails to materialize or is received in an amount less than the expenditures made or incurred. For instance, under the present law, salaries received by State employees, income from leases of State school lands, and the interest on State and some classes of Federal securities are exempt from the income tax. It is contended that under the existing law all expenses incurred in the production of such income are allowable as deductions. The House bill specifically disallows expenses of this character. While your committee is in general accord with the House provision, it is not believed that this disallowance should be made to apply to expenditures incurred in earning tax-exempt interest. To do so might seriously interfere with the sale of Federal and State securities ….
  • I.RC. § 265(a)(l) prohibits otherwise allowable deductions for expenses which are allocable to classes of income (other than interest) which are wholly exempt from tax. Until Stroud, the provision had been applied-albeit in a haphazard manner-in essentially two different types of situations. The first is that which was originally contemplated by Congress when the provision was enacted: disallowance of direct costs of earning tax-exempt income. Here would belong, for example, disallowance of deductions for legal fees in suits to acquire tax-exempt inheritances, damages for personal injuries, or for state and foreign income taxes imposed on items exempt from federal income tax. If the expenses are incurred to earn a mixture of taxable and tax-exempt income, they will be denied a deduction in the same proportion that the tax-exempt income bears to total income.
  • The second situation, and one of more recent provenance, is the result of the IRS’s efforts to extend the prohibition to disallow expenses for deductible items for which the taxpayer has arguably been paid reimbursement with tax-free grants in one form or another. GCM 34,50651 ably recounts the history and purpose of I.RC. § 265(a)(l), and concludes that Congress’s intent requires that the provision be applied in only two situations: first, in the original situation in which the expense is incurred for the purpose of earning tax-exempt income; and second, where the taxpayer receives tax-exempt income which is earmarked for a particular purpose, and the taxpayer incurs expenses in carrying out that purpose.52 The GCM was only half right: the second application is erroneous, and is the root of the problem in Stroud.

The Manocchio decision was appealed to the Ninth Circuit Court of Appeals, which found that a “taxpayer cannot deduct the expenses in question because they were reimbursed” by concluding that I.R.C. § 162(a) does not allow the deduction of expenses that will clearly be reimbursed. The Court cited a long string of cases going back to 1932 to support this conclusion.

Footnote 2 of the Ninth Circuit’s opinion specifically indicates that “[b]ecause we rest our decision on the definition of an expense under I.R.C. § 162(a), we need not reach the Tax Court’s construction of I.R.C. §265(1).” This could be taken as an indication that the Tax Court’s decision on § 265(1) was inaccurate. It also indicates that even if it had been accurate, the intent of Congress under the PPP was clearly to put the loan proceeds into the economy so that they could be used to pay for employee wages and benefits and expenses for interest, rental, and utilities.

Professor Beck’s article found that, with Footnote 2, “the Ninth Circuit rejected the Tax Court’s reliance on I.R.C. § 265(a)(1) in Manocchio, and if the Ninth Circuit was correct, all authority for basing the conclusion in GCM 39,336 on I.R.C. § 265(a)(1) vanishes.”

Professor Beck concluded as follows:

  • [t]he erroneous ‘reimbursement’ application of I.R.C. § 265(a)(l) did no harm in Manocchio and Induni – largely because I.RC. § 265(a)(l) was not really applied at all . . . The most significant danger is that the IRS seems increasingly aggressive and unreasonable in its interpretations of law, and the courts seem uncritically deferential to the government. If the IRS is outgunned by big business, as is often asserted, it seems equally true that the IRS in turn outguns relatively defenseless taxpayers with whom the mainstream business tax bar is largely unconcerned.

Professor Beck was just suggesting what many taxpayers and tax professionals are already thinking: the law in this area needs cleaned up.

In Milkovich, Lisa Milkovich and Dang Nguyen (the “Appellants”) purchased a property, giving the lender a recourse mortgage. The two filed a joint Chapter 7 bankruptcy petition a number of years later. The property was abandoned during the course of the Chapter 7 proceedings, with the proceeds from a foreclosure sale first going to pay the lender for accrued unpaid interest, and then being applied towards principal. The Appellants attempted to deduct the interest payment. The District Court dismissed the complaint for failure to state a claim and arguments were heard by the 9th Circuit Court of Appeals on November 3rd, 2020.

A Reply Brief of the Appellant filed in Milkovich v. U.S. states that neither the taxpayer nor the IRS was able to find any case or authority linking the exemption allowed under IRC § 265(a)(1) to the deferral of income under § 108. The brief also indicated that the Appellants argued that § 108 of the Internal Revenue Code, which excludes the forgiveness of debt in income when a taxpayer is insolvent or meets other qualifications, does not exclude income, but instead defers it.

Section 4 of this brief discusses whether money spent from the tax-free sale of a primary residence would be deductible because the sales proceeds were excluded from income under I.R.C. § 121, and reads as follows:

  • Section 121 of the Tax Code illustrates why there is a need for the classes-of-income-wholly-exempt wording in § 265(a)(1). Section 121 excludes from income the gain on the sale of a personal residence. The exclusion amount is $250,000 or $500,000 for qualifying spouses who file a joint return. I.R.C. § 121(b)(1), (2). If the classes-of-income-wholly-exempt wording were not present in § 265(a)(1), any sale of an individual’s personal residence for a gain of less than $250,000 would generate tax-exempt income and the interest deductions taken on the house would not be deductible. And, if the gain were over $250,000, the deduction would be allowable to some extent. All of this would be an accounting nightmare. Because of the classes-of-income-wholly-exempt wording, there is no accounting nightmare (and the wrath of the real estate industry is avoided). Because the gain on the sale of a house may be taxable, the gain on sale is not wholly exempt, and I.R.C. § 265 does not disallow qualified-residence-interest deductions.
  • Section 265(a)(1) purposefully refers to classes of income that are wholly exempt. The test is not whether a particular taxpayer deferred income or reported gain. Cf., Responsive Brief p.33 (“taxpayers have not alleged that they had any such tax attributes”). Even if the test were applied on a taxpayer-by-taxpayer basis, here, the discharge of indebtedness income that the United States says was excluded from income was not “wholly exempt.” That “discharged debt” was ultimately included in amount realized on the sale of the personal residence. Tufts; Simonsen v. Comm’r, 150 T.C. No. 8 (2018) ( “Simonsen”); and Treas. Reg. § 1.1001-2(a)(1) (collectively “Tufts et. al.”); and see ER 12 (Milkovich/Nguyen included the nonrecourse debt in amount realized on sale).
  • It is true that the Opening Brief cited no cases dealing with the application of I.R.C. § 265 to I.R.C. § 108. Responsive Brief p.33. This is because Milkovich/Nguyen could not find any such cases. Apparently, neither could the United States as it did not cite any such cases either.

Though there is support for the above-stated positions from well-respected tax and estate planning experts, it is important for both taxpayers and tax preparers to understand the potential penalties they may face when filing returns that take positions contrary to the IRS’ position.

IRC § 6701 is one of a number of statutes that provides for “[p]enalties for aiding and abetting understatement of a tax liability,” and states in part:

  • (a) Imposition of penalty
  • Any person—
  • (1) who aids or assists in, procures, or advises with respect to, the preparation or presentation of any portion of a return, affidavit, claim, or other document,
  • (2) who knows (or has reason to believe) that such portion will be used in connection with any material matter arising under the internal revenue laws, and
  • (3) who knows that such portion (if so used) would result in an understatement of the liability for tax of another person,
  • shall pay a penalty with respect to each such document in the amount determined under subsection (b).

If there is “substantial authority” for a position taken on a tax return then the above penalties will not apply. A substantial authority has been found to be a one-third chance or higher. If a taxpayer’s position on a tax return raises to the substantial authority level there is no obligation to disclose that there might be up to a 66 and two-thirds percent chance of the position not being upheld in court.

When determining whether authority is “substantial,” courts will use an objective standard that “involv[es] an analysis of the law and application of the law to [the] relevant facts.” Lawinger v. Commissioner, 103 T.C. 428 (1994).

If there is a “reasonable basis” to take a position on a tax return, but it does not rise to the level of a substantial authority, the taxpayer will not be subject to the above penalties, but must disclose the position taken on a Form 8275 Disclosure Statement in order to explain the position to the IRS. If a taxpayer has to prove a position that goes against a Revenue Ruling, they will likely do so using a reasonable basis standard.

In United States v. Kapp, the 9th Circuit Court of Appeals found that the appellant lacked substantial authority for claiming that mariners were “entitled to claim the full [meals and incidental expense] rate” while working on ships and barges, despite the fact that the mariners incurred no meal expenses.

The Court ruled that,

  • a well-formed analysis by a person knowledgeable in tax law would have led to the conclusion that Kapp’s position had less than a one in three chance of being sustained on the merits . . . his position was unreasonable and not supported by substantial authority. United States v. Kapp, 564 F. 3d 1103, 1112 (2009).

Many experts feel that it is probable that PPP loan forgiveness should not be subject to Federal income tax, and that the deductibility for the expenses paid to facilitate such forgiveness should not be limited.

This confusion, coupled with the ongoing pandemic, will likely create one of the busiest tax times for the IRS and tax preparers.

Unfortunately, Congress has yet to pass any legislation that would clear the path for tax-free forgiveness and deductibility of expenses. Hopefully the above-referenced bill will pass soon, as many taxpayers in the near future will face the tough question of whether to claim both a deduction and an expense.