Deducting Expenses Paid With Paycheck Protection Loans

There was a case in 1931 that is influencing a public controversy today.

Let’s talk about it.

The taxpayer (Slayton) was in the business of buying, holding and selling tax-exempt bonds. He would at times borrow money to buy or to carry tax-exempt bonds he already owned.

Slayton had tax-exempt interest income coming in. That amount was approximately $65 thousand.

Slayton was also paying interest. That amount was approximately $78 thousand.

COMMENT: On first read it does not appear that dear old Slayton was the Warren Buffett of his day.

Time came to file his tax return. He omitted the $65 grand in interest received because … well, it was tax-exempt.

He deducted the $78 grand that he was paying to carry those tax-exempt securities.

The IRS said no dice.

Off to Court they went.

Slayton was hot. He made several arguments:

(1)  The government was discriminating against owners of tax-exempt securities and – in effect – nullifying their exemption from taxation.

(2)  The government was discriminating against dealers in tax-exempt bonds that had to borrow money to carry an inventory of such bonds.

(3)  The government was discriminating in favor of dealers of tax-exempt bonds who did not have to borrow to carry an inventory of such bonds.

I admit: he had a point.

The government had a point too.

(1)  The income remained tax-exempt. The issue at hand was not the interest income; rather it was the interest expense.

(2)  Slayton borrowed money for the express purpose of carrying tax-exempt securities. This was not an instance where someone owned an insubstantial amount of tax-exempts within a larger portfolio or where a business owning tax-exempts borrowed money to meet normal business needs.

The link between the bonds and the loans to buy them was too strong in this case. The Court disallowed the interest expense. Since then, tax practitioners refer to the Slayton issue as the “double-dip.”  The dip even has its own Code section:

        § 265 Expenses and interest relating to tax-exempt income.

(a)  General rule.

No deduction shall be allowed for-

(1)  Expenses.

Any amount otherwise allowable as a deduction which 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 this subtitle, or any amount otherwise allowable under section 212 (relating to expenses for production of income) which is allocable to interest (whether or not any amount of such interest is received or accrued) wholly exempt from the taxes imposed by this subtitle.

Over the years the dip has evolved to include income other than tax-exempt interest, but the core concept remains: one cannot deduct expenses with too strong a tie to nontaxable income.

Let’s fast forward almost 90 years and IRS Notice 2020-32.

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.

I admit, it is not friendly reading.

The CARES Act is a reference to the Paycheck Protection loans. These are SBA loans created in response to COVID-19 to help businesses pay salaries and rent. If the business uses the monies for their intended purpose, the government will forgive the loan.

Generally speaking, forgiveness of a loan results in taxable income, with exceptions for extreme cases such as bankruptcy. The tax reasoning is that one is “wealthier” than before, and the government can tax that accession to wealth as income.

However, the CARES Act specifically stated that forgiveness of a Paycheck Protection loan would not result in taxable income.

So we have:

(1)  A loan that should be taxable – but isn’t - when it is forgiven.

(2)  A loan whose proceeds are used to pay salaries and rent, which are routine deductible expenses.

This sets up the question:

Are the salaries, rent and other qualified expenses paid with a Paycheck Protection loan deductible?

You see how we got to this question, with Section 265, Slayton and subsequent cases that expanded on the double dip.

The IRS said No.

This answer makes sense from a tax perspective.

This answer does not make sense from a political perspective, with Senators Wyden and Grassley and Representative Neal writing to Secretary Mnuchin that this result was not the intent of Congress.

I believe them.

I have a suggestion.

Change the tax law.