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The Tax Lawyer

The Tax Lawyer Fall 2021

Section 265 Disallowance and the PPP Expense Nightmare

Amandeep Grewal


  • Congress created a massive loan forgiveness program to help the public deal with the economic devastation related to the coronavirus pandemic.
  • Taxpayers soon realized that they might enjoy a double benefit. They would get their loans forgiven, tax-free, and also get deductions when they spent their loaned funds.
  • The Treasury and IRS stepped in and attacked the double benefit. Congress responded and confirmed that taxpayers could, in fact, get double benefits.
  • Congress resolved the controversy over PPP loans but the double benefit issue remains highly active and consequential in other contexts. This Article explains what's wrong with the IRS disallowance of double benefits.
Section 265 Disallowance and the PPP Expense Nightmare
Natalia Gdovskaia via Getty Images

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Through the CARES Act, Congress established a generous Paycheck Protection Program (PPP). Under that program, recipients would get loans that could easily qualify for tax-free forgiveness. As an added bonus, taxpayers would enjoy tax deductions when they spent the amounts they borrowed.

Or so it seemed. After the CARES Act passed, the Service promptly issued a notice denying deductions for PPP expenses. Secretary Treasury Steven Mnuchin personally reviewed the matter and announced that the Service’s position followed from “Tax 101.” Congress eventually stepped in and offered a narrow statutory clarification: PPP expenses would be deductible.

Unfortunately, Congress did not go far enough. The Service, with the blessing of some courts, has long used an aggressive interpretation of section 265(a) to deny deductions allegedly allocable to tax-exempt income.

This Article explains the conceptual problems with the Service’s approach and argues that it should be abandoned. The Article also explains why Congress should remedy the Service’s error, and it explores alternative anti-abuse rules.

I. Introduction

Taxpayers love tax benefits. They love double tax benefits even more.

But Congress and the Service have long maintained a different attitude. Though the Code does not expressly deny all double tax benefits, various sections contain specific prohibitions on them. Through published guidance, the Service has often reinforced those prohibitions.

One prohibition on double tax benefits, codified in section 265(a)(1), relates to deductible expenses. Under that section, a taxpayer generally cannot deduct expenses allocable to tax-exempt income. In these circumstances, if a taxpayer could enjoy both a deduction and an exclusion, a significant tax windfall could arise.

Section 265(a)(1) seems relatively straightforward, but it has given rise to several interpretive disputes. Those disputes escalated in the 1970s and 1980s when the Service, after substantial internal disagreement, changed its approach to the statute. Under the Service’s revised approach, the statute could apply when expenses were paid from tax-exempt income (a “source-of-funds approach”) and not only when expenses were related to the production of tax-exempt income (a “production-of-income approach”). By reading section 265(a)(1) to cover both sets of circumstances, the Service adopted an “expansive approach” to the statute.

This shift from a production-of-income approach to an expansive approach caused significant trouble for different classes of taxpayers. But the consequences became extraordinary under the recently enacted CARES Act. That massive stimulus legislation established, among other things, the Paycheck Protection Program (PPP). The PPP authorizes $800 billion of government-backed loans that taxpayers may use for various specified expenses. Ordinarily, taxpayers would enjoy a deduction under section 162 in the taxable year they paid or incurred those expenses. But the PPP program also created a second benefit. Upon showing that borrowed funds were used for specified expenses, taxpayers would qualify for loan forgiveness. In a departure from the normal rules, Congress indicated that that loan forgiveness would not give rise to gross income. Thus, taxpayers could seemingly enjoy deductions for amounts paid with borrowed funds and have their loan forgiveness exempted from tax.

This potential double benefit prompted scrutiny from the Service. In Notice 2020-32, the agency, relying heavily on section 265(a)(1), announced that taxpayers could enjoy the loan forgiveness exclusion but could not enjoy deductions for PPP expenses. Treasury Secretary Steven Mnuchin personally reviewed the matter and similarly decided that the denial of expenses flowed from “Tax 101.”

These pronouncements ignited a storm of controversy. Many taxpayers, scholars, business groups, and legislators raised concerns about the Service’s conclusion. Some, however, maintained that the denial of deductions for PPP expenses reflected well-established tax principles. Through subsequent coronavirus relief legislation, Congress eventually affirmed that the PPP program would establish double tax benefits. Taxpayers can both enjoy section 162 deductions for amounts paid with PPP loans and exclude income that would otherwise arise on their cancellation.

Yet that congressional action has not ended the controversy over section 265(a)(1). The legislature failed to address the fundamental question over whether section 265(a)(1) embraces the expansive approach advanced by the Service. Congress merely offered a “clarification” specific to the PPP program. Thus, the tax law still reflects substantial uncertainty over section 265(a)(1).

Part II illustrates how the uncertainty came about and how the Service shifted from a production-of-income approach to an expansive approach. Part III then argues that section 265(a)(1) does not embrace the expansive approach. When the statute speaks of expenses allocable to tax-exempt income, it properly refers only to tax-exempt income that may be produced, directly or indirectly, by those expenses. Part IV illustrates how the Service’s improper adoption of the expansive approach sowed confusion over PPP expenses under the CARES Act. Part IV also encourages Congress to reaffirm the production-of-income approach and argues that the expansive approach violates sound tax policy principles.

II. Judicial and Administrative Approaches to Section 265(a)(1)

This Part describes how interpretive approaches to section 265(a)(1) have shifted. Part II.A describes the statute’s history. Part II.B illustrates how the Service initially applied a production-of-income approach to the statute. Part II.C shows how the Service, through a somewhat convoluted path, decided that section 265(a)(1) embraces an expansive approach. Part II.C also distinguishes the expansive approach from the reimbursement theory sometimes applied by courts.

A. Legislative History

For the first two decades of the modern income tax, the Code did not expressly deny deductions allocable to tax-exempt income. But the government improvised in the absence of an express rule. In 1915, the Treasury Department issued a synopsis of various rulings, including one that applied to a taxpayer who received tax-exempt state employment income. According to the Treasury’s synopsis, “[e]xpenses incurred in earning income which is not subject to tax under the income tax law do not constitute allowable deductions in computing net income from other sources which are taxable under the law.”

The 1915 synopsis does not explain its reasoning or cite statutory provisions. But one can probably infer that concerns over taxpayer windfalls motivated the Treasury. Suppose a taxpayer incurred $100 of expenses through her state employment and also received $100 of tax-exempt income through that employment. From an economic perspective, her employment did not change her position. A hundred dollars went out the door, and the same amount came in. Yet if she could deduct her expenses while excluding the related income, she would end up with a $100 deduction. That deduction could then be used to offset income unrelated to her state employment. The Treasury ruling denies that windfall.

However, the Treasury’s action did not fully discourage taxpayers from deducting expenses related to their tax-exempt state employment income. The taxpayers in Marquissee v. Commissioner were state court stenographers who received tax-exempt income for that work and taxable income for other stenographic work. The taxpayers had hired typists to assist them with their stenographic duties and claimed deductions for the amounts paid to them. But the Service challenged those deductions. The Service believed that the expenses for typists, which were at least partially allocable to tax-exempt state employment income, were not deductible.

The Tax Court held for the Service. No statute expressly denied deductions for amounts allocable to the earning of tax-exempt income, but the court believed that that denial was implicit in the provision that granted deductions. Under that provision (currently found in section 162), the allowance for “ordinary and necessary expenses of any trade or business” would not reach expenses related to activities which produced no taxable income.

On appeal, the Third Circuit affirmed. The court expressed some surprise that “neither party ha[d] been able to find and cite decisions, authoritative or persuasive, in support of his position.” But the court believed that the statute which exempted state employment income compelled a holding for the Service. Otherwise, taxpayers could use expenses allocable to state employment income to offset unrelated income, creating a “paradox of an exemption” for income that should be taxed.

The Third Circuit reached its decision unanimously. Only Judge Love, at the Tax Court level, would have found for the taxpayer. To hold for the Service, Judge Love believed, “something must be read into the statute that cannot, legitimately, be imputed to the words used therein.” It may very well have been inappropriate, as a policy matter, for the taxpayers to enjoy deductions related to tax-exempt income. But, to Judge Love, “judicial tribunals should decide cases according to the prescribed law.” If a “statute blazes the road, the courts must follow that road.”

Whether taxpayers could deduct expenses allocable to tax-exempt income eventually drew congressional attention. Deductibility questions had arisen in contexts beyond state employment income, and Congress proposed a broad fix through what would become section 265(a)(1). During confidential hearings before the Senate Finance Committee, the Assistant to the Secretary of the Treasury expressed concern that oil companies could use deductions related to their tax-exempt income to offset other income. An official from the Joint Committee on Taxation further explained that the Supreme Court prevented Congress from taxing those oil companies on the income they derived from leases on state-owned land. The draft legislation would thus create a broad, general disallowance rule for deductions related to tax-exempt income.

But Middleton Beaman, the legislative counsel for the House of Representatives, objected to a broad disallowance rule. He believed that with a broad rule “the zealous ‘watch dogs of the Treasury’” would try to allocate every claimed deduction to some item of tax-exempt income and thereby disallow it. He acknowledged that there was “undoubtedly an evil here that ought to be corrected,” but that evil could not be “remedied without doing injustice to somebody else.” Given the dangers associated with overzealous tax collectors, Beaman believed that Congress might need to consider “letting the good man go on happily, and the evil man pursue his evil way.” This drew skepticism from one Senator:

Senator KING. You are not a good theologian, because your view is contrary to the doctrine which so many moralists accept, that for every evil there is a virtuous antidote. You do not believe that?

Mr. BEAMAN. Not in the case of the income tax.

Ultimately, Beaman lost this theological debate. Through the Revenue Act of 1934, Congress enacted a broad disallowance rule for deductions related to tax-exempt income, now codified in section 265(a)(1). The next two Parts explain competing interpretations of that statute.

B. The Production-of-Income Approach

Under section 265(a)(1), a taxpayer cannot enjoy any deduction “allocable to one or more classes of income . . . wholly exempt from” the income tax. As the statute’s legislative history reveals, policymakers were concerned that taxpayers might enjoy deductions allocable to the earning of tax-exempt income. At various times, the Service has followed this straightforward production-of-income approach. To apply the production-of-income approach, the Service demonstrates the factual connection between a payment and the class of income to which it relates. If that class of income is wholly exempt from tax, the taxpayer cannot enjoy deductions allocable to that income.

The production-of-income approach can apply in many simple situations. For example, if a taxpayer incurs legal expenses to recover a damages award excluded by section 104(a)(2), no section 212 deduction would be allowed for those expenses. Because the legal expenses directly relate to producing tax-exempt income, section 265(a)(1) would deny the otherwise available deduction. Similarly, if an employee’s income enjoys a complete tax exemption, then section 265(a)(1) would deny any employee business deductions otherwise available under section 162. In each of these scenarios, the denied expenses relate to the production of tax-exempt income.

Two short revenue rulings illustrate how the Service once focused only on whether expenses produced tax-exempt income and did not examine whether expenses were paid from tax-exempt income. In Revenue Ruling 62-212, the Service concluded that a minister of the gospel could enjoy deductions for mortgage interest and property taxes paid on his personal residence. That ruling applied even though section 107 excluded his housing assistance payments. In Revenue Ruling 62-213, the Service reached a similar conclusion about a veteran’s educational expense deductions. Those deductions would be available even though the veteran had received tax-exempt payments from the Veterans Administration.

Those two revenue rulings offer little analysis and may have been deliberately ambiguous. However, each implicitly rejects the expansive approach to section 265(a)(1). Had that approach applied, Revenue Ruling 62-212 would have denied the taxpayer’s interest and tax deductions if they were paid from his tax-exempt housing allowance. Revenue Ruling 62-213 would have denied the taxpayer’s educational expense deductions to the extent they were paid from his tax-exempt Veterans Administration payments. But neither revenue ruling mentioned those potential limitations. Instead, each ruling adopted a production-of-income approach. The next Part shows how the Service and some courts have gradually moved toward an expansive approach.

C. The Expansive Approach

In Revenue Ruling 83-3, the Service reversed the holdings described in Revenue Rulings 62-212 and 62-213. In doing so, the Service emphasized that “[t]he purpose of section 265 of the Code is to prevent a double tax benefit.” The Service also relied on United States v. Skelly Oil Co. That case, the Service concluded, established that “the Internal Revenue Code should not be interpreted to allow the practical equivalence of double deductions absent clear declaration of intent by Congress.”

Applying those principles, the Service reached two key conclusions. First, it concluded that section 265(a)(1) could properly apply “to otherwise deductible expenses incurred for the purpose of earning or otherwise producing tax-exempt income.” Second, it concluded that section 265(a)(1) could apply “where tax exempt income is earmarked for a specific purpose and deductions are incurred in carrying out that purpose.” In those circumstances, it would be “proper to conclude that some or all of the deductions are allocable to the tax-exempt income.”

The first conclusion in Revenue Ruling 83-3 reiterates the production-of-income approach. The second conclusion lays the foundation for the expansive approach, though it does not adopt the broadest version of that approach. The second conclusion could be read consistently with a reimbursement theory. Under a reimbursement theory, a taxpayer may not deduct an expense when another party funds that expense.

When a reimbursement theory applies, section 265(a)(1) and the expansive approach probably have no meaningful role to play. Deductions will be denied as a threshold matter under section 162. That statute and similar deduction-granting provisions contemplate that a taxpayer has “paid or incurred” an amount. If a third party provides earmarked funds to a taxpayer and a taxpayer expends those funds consistently with that earmark, she likely has not paid or incurred any amount. The funder, instead, has done so.

However, Manocchio v. Commissioner, on which Revenue Ruling 83-3 relied, shows how a court might prefer the expansive approach over a reimbursement theory. Manocchio involved a taxpayer who tried to deduct flight school expenses under section 162. The taxpayer received an educational assistance allowance from the Veterans Administration, through which 90% of his flight school expenses would be reimbursed. The Service, relying on section 265(a)(1), claimed that 90% of the taxpayer’s claimed section 162 deduction should be disallowed.

The Tax Court could have easily applied a reimbursement theory to deny the taxpayer’s deduction, but it instead embraced the expansive approach to section 265(a)(1). The court rejected the taxpayer’s claim that the statute applied “only to expenses incurred in the production of exempt income,” and thus could not be “construed to apply to expenses which were merely paid out of exempt income.” According to the court, the legislative history may have shown that section 265(a)(1) principally targeted “expenses incurred in connection with an ongoing trade or business or investment activity, the conduct of which generates exempt income.” But the court would not “infer from these examples [in the committee reports] that Congress intended to limit the application of the statute to such situations.”

The court further emphasized that had Congress wanted to follow the production-of-income approach, “it could have easily done so by using more precise definitional language.” Thus, section 265(a)(1) could “embrace the reimbursement situation where, but for the expense, there would simply be no exempt income.” Although the court believed the reimbursement theory it adopted in a prior case was correct, it nonetheless decided to rely on section 265(a)(1). That statute provided “a more direct and appropriate rationale for disallowing” the taxpayer’s flight-training expense deductions.

Beyond that language, the Tax Court did not explain why it shifted from a reimbursement theory to one based on section 265(a)(1). The court’s expansive approach to the statute concerned Judge Fay. He wrote separately and disagreed with any implication that section 265(a)(1) “applies to expenses paid out of exempt income as well as to expenses incurred in the production of exempt income.” But only one other judge joined his concurrence.

The Tax Court’s opinion in Manocchio established the expansive approach to section 265(a)(1), but it made no ultimate difference to the taxpayer involved. On appeal, the Ninth Circuit stated that it “need not reach the Tax Court’s construction” of section 265(a)(1). It affirmed Manocchio under a reimbursement theory.

Lapin v. United States more neatly shows how the expansive approach differs from a reimbursement theory. The taxpayer in Lapin was a federal employee who received a supplemental cost-of-living allowance. Federal law did not tax that allowance, but the taxpayer’s state of residence (Hawaii) did. The taxpayer thus claimed a section 164 deduction for the taxes he paid to Hawaii on his cost-of-living allowance. The government challenged that deduction, believing that section 265(a)(1) disallowed deductions for state income taxes imposed on federally tax-exempt income.

If the production-of-income approach had applied, the taxpayer should easily have won. Section 164 provides a deduction for state and local taxes to alleviate the hardships associated with double taxation. The deduction does not arise because state income tax payments facilitate the production of income. Thus, state income tax payments ordinarily cannot be allocated to any income, whether taxable or tax exempt, and section 265(a)(1) cannot apply.

But the court applied the expansive approach to section 265(a)(1) and denied the taxpayer’s claimed deductions. With little analysis, the court, following prior authorities, flatly announced that “the Hawaii income taxes plaintiff paid on [the cost-of-living allowance] are directly allocable to” that allowance “and not to any other class of income.” The court did nothing further to support its determination.

Lapin shows that under the expansive approach, section 265(a)(1) may apply outside the income-production context. Additionally, it shows that the expansive approach extends beyond reimbursement situations. A cost-of-living allowance might, in a loose sense, help a taxpayer offset higher local tax liabilities. But the cost-of-living allowance did not directly reimburse the Lapin taxpayer, and the court did not apply a reimbursement theory.

The Service may apply the expansive approach even to programs designed to help the needy. Under the Section 8 home-ownership program, the U.S. Department of Housing and Urban Development provides financial assistance in two ways. Section 8 assistance may, if funding allows, provide one-time direct grants to low-income persons, such that they can meet down-payment requirements. Alternatively, Section 8 assistance can come through recurring monthly payments. Federal law exempts all Section 8 assistance from taxation.

When a HUD official asked the Service whether Section 8 assistance could cause a homeowner to lose deductions for mortgage interest or property taxes on his personal residence (together, “residence-related expenses”), the Service answered affirmatively. The Service emphasized that case law blessed the “long term policy of expansive application of § 265(a)(1) to housing stipends, scholarships, etc.” Thus, though section 265(a)(1) “most commonly applied to prevent the deduction of expenses incurred in the course of earning tax-exempt income,” the statute could also “prohibit deduction of expenses paid by taxpayers that were allocable to tax-free allowances.” Given that framework, section 265(a)(1) “would probably be viewed as prohibiting” a Section 8 recipient from deducting her residence-related expenses.

The Service’s guidance nicely illustrates how far the expansive approach might go. The Service did not claim that Section 8 assistance payments were earmarked for residence-related expenses. The Service did not even exclude potential Section 8 down-payment grants from its advice. Those grants are plainly designed to help a needy person meet a down-payment requirement, not pay residence-related expenses. This shows that the expansive approach can apply far beyond reimbursement situations.

Nonetheless, the expansive approach remains difficult to define precisely. Service officials and the Tax Court have referred to disallowing expenses “paid out” of exempt income, and this Article follows that phrasing. Yet that language should not be applied without any limits. For example, few would seriously suggest that taxpayers can never enjoy deductions whenever they use tax-exempt gifts to pay otherwise deductible expenses. Instead, the expansive approach likely contemplates some relationship between the tax-exempt income and the later expense.

For present purposes, we need not specify that exact relationship. To understand the issues here, one need only recognize that the relationships reached by the expansive approach, whatever they might be, extend beyond reimbursement arrangements. Cases like Lapin confirm that understanding. The Service and some courts might apply section 265(a)(1) even when tax-exempt funds are not earmarked for specific expenses. The next Part explains why that approach should be abandoned.

III. The Expansive Approach Should Be Abandoned

Whether section 265(a)(1) adopts the production-of-income approach or the expansive approach reflects an admittedly nuanced question of statutory interpretation. However, the Service’s own tortuous implementation of the statute explains almost all the interpretive difficulty that has arisen. Had the Service, from the start, respected section 265(a)(1)’s language and the Code’s structure, numerous vexing questions (and even statutory amendments) could have been avoided. Going forward, the Service and courts should abandon the expansive approach. The statutory scheme, section 265(a)’s text, the availability of congressional alternatives, and the shift in statutory interpretation methods each support the production-of-income approach.

A. Statutory Scheme

The expansive approach creates tensions within the Code’s overall statutory scheme. Under an income tax system, net gains rather than gross receipts form the tax base. Thus, Congress generally allows taxpayers to deduct expenses when those expenses relate to some type of income-producing activity. But the expansive approach, through its subsidiary adoption of the source-of-funds approach, undermines the assumptions upon which deductions are granted.

To appreciate this point, consider the grounds on which two key Code provisions, sections 162 and 212, authorize deductions. Section 162 generally allows deductions related to “carrying on any trade or business.” The quoted phrase contemplates activities through which the taxpayer actively seeks profits. Section 212 similarly applies when a taxpayer seeks profits but when her activities might not otherwise rise to the level of a trade or business. Under section 212, deductions will be allowed for expenses related to “the production or collection of income” or for expenses related to income-producing property.

The relevant regulations further illustrate how sections 162 and 212 apply. Under Regulation section 1.162-1(a), a deductible expense must be “directly connected or pertaining” to the taxpayer’s trade or business. Under Regulation section 1.212-1(d), expenses must bear a “reasonable and proximate relation” to profit-oriented activities. It is not enough that expenses come from business or investment profits.

The expansive approach disturbs these assumptions. Under that approach, an otherwise deductible expense may be denied if the Service deems it “allocable” to tax-exempt income unrelated to the profit-oriented activities contemplated by sections 162 or 212. This leads to contradictions. Section 162 or section 212 would authorize deductions because of their relationship to income generated by profit-oriented activities, but section 265(a)(1) would then deny those deductions because of their deemed relationship to different income. If Congress wanted the relationship between expenses and income to be determined one way under the deduction-granting provisions and another way under section 265(a)(1), it (presumably) would have made clear that deeply counterintuitive approach.

In Manocchio, the Tax Court responded to this structural problem in a creative yet unconvincing way. The court conceded that if the Veterans Administration program did not reach the taxpayer’s flight school expenses, those expenses would be allocable to his taxable employment income. But the court concluded that the Veterans Administration program transformed “the underlying relationship between the deduction and the employment income, leaving the deduction ‘directly allocable’” under Regulation section 1.265-(c) to tax-exempt income.

The Tax Court’s approach departs from the proper framework for section 162 analysis. Under the statute’s implementing regulation, the taxpayer in Manocchio would need to show that his flight school expenses were “directly connected or pertaining” to his employment as a pilot. Any such connection would sensibly depend on things like whether the flight school program enhanced the taxpayer’s piloting skills and therefore improved his income potential. Regulations under section 265(a)(1) should not affect that analysis.

Ultimately, the Tax Court’s approach in Manocchio is backward. If section 265(a)(1) can override the factual analysis called for by the deduction-granting provisions, then absurd results will follow. A taxpayer who purchased a $20,000 luxury vacation solely because he earned $20,000 of business profits could argue that his vacation expense was, under Regulation section 1.265-1(c), “directly allocable” to those profits. Thus, taking the expansive approach to its logical extreme, the taxpayer’s vacation expenses would give rise to a section 162 deduction. But that backward analysis would be faulty. Section 162(a), not section 265(a)(1), establishes the framework for analyzing whether an expense relates to business activities. And under that framework, a vacation expense would not be deductible. The expansive approach to section 265(a)(1) travels in the wrong analytical direction.

B. Section 265’s Text

When we move from the overall statutory structure to section 265’s text, we see that the expansive approach creates further anomalies. Though section 265(a)(1) generally denies deductions allocable to tax-exempt income, the statute will not typically apply to deductions allocable to tax-exempt interest income. The policy behind the interest income exception makes sense under a production-of-income approach. Legislators wanted to support the market for tax-exempt government bonds, and applying section 265(a)(1) to interest generated by those bonds might make those bonds less attractive. The section 265(a)(1) general disallowance rule thus does not apply to expenses allocable to the production of tax-exempt interest.

But no coherent policy rationale could explain the interest exception if section 265(a)(1) embraces an expansive approach. If that approach applied, deductions could not be taken when they were paid from any tax-exempt income, unless they were paid out of tax-exempt interest income. For example, if a taxpayer used a tax-exempt cost-of-living allowance to pay otherwise deductible business expenses, no deduction would be allowed. But if a taxpayer used tax-exempt interest income to pay those same expenses, the deduction would be allowed.

It is hard to see why legislators would have adopted this strange approach. Why should expenses paid from tax-exempt income face section 265(a)(1)’s disallowance rule unless the expense happens to be paid from tax-exempt interest income? If Congress wanted to let taxpayers receive interest income tax free and escape the section 265(a)(1) disallowance rule, one would expect Congress to expressly say so. In this context, the expansive approach, ironically, creates double tax benefits for taxpayers. Taxpayers could receive interest income tax free and then use that interest income to generate deductible expenses.

Of course, one might respond that the production-of-income approach allows just that. An amount might be received tax free, such as through a cash gift, and then generate a deduction through the later use of the gift for business expenses. But this supposed loophole follows from a realistic approach to tax administration. Given the fungibility of money, it would be impossible to perfectly trace how a taxpayer used a cash gift. Thus, Congress has not made any serious attempt to do so. Even the expansive approach does not literally do that. That approach instead requires some (indeterminate) nexus between the receipt of tax-exempt funds and a later payment.

Aside from the interest exception, section 265(a)(1)’s text confirms the production-of-income approach in another way. Under section 265(a)(1), deductions allocable to tax-exempt income may be denied “whether or not any amount of income of that class or classes is received or accrued.” This rule makes sense under a production-of-income approach. For example, suppose a taxpayer paid $10,000 of expenses while engaged in an activity that produces tax-exempt income. However, the taxpayer’s activity fails and yields no returns. Under section 265(a)(1), the taxpayer cannot enjoy any deductions even though her activity yielded a $10,000 economic loss. This may seem unfair, but it establishes symmetry. After all, if the taxpayer incurred no expenses but received $10,000 from the tax-exempt activity, she would pay no taxes. Viewed in this broader context, section 265(a)(1) disallowance sensibly applies to deductions allocable to the production of tax-exempt income “whether or not any amount of income of that class or classes is received or accrued.”

But that statutory rule becomes incomprehensible under an expansive approach. Recall that, under the expansive approach, the Service will deny deductions for residence-related expenses when the taxpayer pays those expenses with tax-exempt income. Thus, if we take section 265(a)(1)’s language seriously (which, admittedly, the courts do not), the taxpayer faces an exquisitely strange possibility. She could lose a deduction for residence-related expenses paid from Section 8 financial assistance, “whether or not any amount of [Section 8 financial assistance] is received or accrued.” That makes no sense. Why would a taxpayer lose a deduction for an expense paid out of tax-exempt income that she never received? To avoid this absurdity, the Service and some courts create an equitable limit on the extent of section 265(a)(1) disallowance. But nothing in section 265(a)(1)’s text supports that limit. The Service and the courts have simply invented a nonstatutory exception to their nonstatutory expansive approach.

Section 265(a) contains only a weak suggestion that the statute adopts the expansive approach. Under section 265(a)(6), a tax-exempt military housing allowance or a section 107 parsonage allowance will not cause the taxpayer to lose any residence-related deductions. This provision seemingly assumes an expansive approach to section 265(a)(1). Why would Congress take deductions related to these tax-exempt housing allowances outside of section 265(a)(1) if it did not otherwise believe that the expansive approach applied? After all, if the statute followed a production-of-income approach, no such denial could arise. Residence-related deductions do not produce any income, whether tax exempt or not. Thus, under an expansive approach, section 265(a)(6) seems superfluous.

But Revenue Ruling 83-3 reveals why Congress adopted section 265(a)(6). That ruling applied the expansive approach to ministers who received the section 107 parsonage allowance. Its reasoning would also have adverse consequences for military members who received tax-exempt housing allowances. The clergy and the military thus successfully lobbied Congress to delay Revenue Ruling 83-3. Congress eventually went further and, through section 265(a)(6), permanently overrode the ruling.

Congress thus restrained the Service through section 265(a)(6). It did not empower the agency. Section 265(a)(6) therefore reflects an odd source of support for the expansive approach. Yet the Second Circuit relied on that statute to apply section 265(a)(1) expansively. The court believed that, had Congress wanted to reject the expansive approach to section 265(a)(1), it would have announced a broad rule rather than the limited ones under section 265(a)(6). In reaching its holding, the court did not appreciate the political context around section 265(a). That history showed that Congress had offered a narrow clarification for well-represented constituencies.

The court should have inferred nothing more. Time and again, the Supreme Court has warned that judges should not draw inferences from congressional failures to act. The Supreme Court’s warning carries especially strong force for section 265(a)(1), where the Second Circuit’s inferences contradict the statute’s language and the Code’s structure.

C. Policy Concerns and Congressional Alternatives

Potential double tax benefits under the production-of-income approach raise fair policy concerns. Luckily, Congress knows how to address those concerns. Section 139B, which offers two temporary exemption provisions for voluntary emergency responders, illustrates this. Under the first provision, volunteer emergency responders may exempt some state tax credits received for their services. Under the second provision, they may also exempt some small cash payments so received.

Either of these exemptions could create double tax benefits. For example, exempted state tax credits could generate a section 164 deduction when used to satisfy the responder’s state tax liability. Or exempted cash payments might generate benefits when applied toward a deductible expense.

But Congress addressed these possibilities. For exempt state tax credits, Congress provided that a responder could not enjoy section 164 deductions that might otherwise arise through their use. For exempt cash payments, Congress adopted a narrow approach. Congress said that a responder could not enjoy section 170 charitable contribution deductions related to his service except to the extent that the responder’s deductions exceeded his exempt cash payments. Congress did not want a responder to receive a tax-exempt small cash payment and then use that payment to generate a charitable contribution deduction. Section 139B(b)(2) prevents that result.

Congress has other tools to limit double tax benefits, aside from the ones employed in section 139B. The corporate capital contribution provisions illustrate this. Under section 118(a), a corporation recognizes no gross income when it receives a capital contribution. The corporation may enjoy this tax exemption even when the contribution comes from a non-shareholder. However, section 362(c) makes that tax exemption temporary. When the corporation receives a cash capital contribution from a non-shareholder, the corporation must reduce the basis of later-acquired property by the amount of that contribution. The benefit of the section 118(a) tax exemption will thus be offset by increased gains when the corporation sells the later-acquired property. This capital contribution regime again shows that Congress knows how to limit double tax benefits, and that the Service need not bend section 265(a)(1) beyond its text.

Congress may even use section 265(a)(1) itself as a model to forcefully deny double tax benefits. Under section 911(a), an individual may exclude a limited amount of foreign earnings from her gross income. Section 265(a)(1) would ordinarily deny deductions allocable to the production of this tax-exempt income. But Congress wanted a stronger approach. Section 911(d)(6) denies tax deductions that are “properly allocable to or chargeable against” income excluded by section 911(a). Through the second phrase (“chargeable against”), section 911(b)(6) adopts a broader deduction disallowance rule than does section 265(a)(1).

Contrasting section 911(b)(6) with section 265(a)(1) helps illustrate the infirmities with the expansive approach. Section 911(b)(6)’s breadth easily justifies, for example, the disallowance of section 164 deductions for the payment of foreign income taxes imposed on excluded foreign earnings. After all, foreign income taxes are “chargeable against” the excluded foreign earnings. Through the expansive approach, the Service acts as if a similar phrase exists in section 265(a)(1). That is, the Service will deny section 164 deductions for the payment of state income taxes imposed on federally tax-exempt income. By doing so, the Service interprets section 265(a)(1) as broadly as section 911(d)(6), despite the two statutes’ textual differences. That approach violates well-settled presumptions of statutory interpretation.

That the Service sometimes interprets section 265(a)(1) more broadly than section 911(d)(6) further illustrates the agency’s arbitrariness. Under section 265(a)(1), the Service may treat deductions for residence-related expenses as allocable to Section 8 financial assistance or other tax-exempt income. Yet under the section 911 regulations, the Service will not allocate deductions for residence-related expenses to excluded foreign earnings or any other gross income. Thus, those deductions will not be denied by section 911(d)(6).

This inconsistency becomes rather hard to reconcile. The Service uses an expansive approach to interpret “allocable to” under section 265(a)(1). But the Service effectively uses a production-of-income approach to interpret the same phrase in section 911(d)(6). We are thus left with a regime under which section 265(a)(1)’s “allocable to” language reaches deductions not reached by section 911(d)(6)’s “allocable to” language, or even by section 911(d)(6)’s “chargeable against” language. The narrow statute somehow covers more ground than the broad statute.

D. Shifts in Statutory Interpretation Methods

The expansive approach and its inconsistencies probably follow from outmoded statutory interpretation methods. In prior years, federal courts took statutory text less seriously than they do today. Federal courts were especially casual in the tax area and sometimes applied judicial doctrines without any apparent regard for statutory text.

Though debates over proper statutory interpretation approaches will probably always continue, most courts today remain reluctant to abandon statutory text. In Gitlitz v. Commissioner, the Supreme Court sharply illustrated that reluctance. Gitlitz involved an apparent Code loophole, through which an S corporation’s excluded discharge of indebtedness income increased its shareholders’ basis in their S corporation stock. The Supreme Court acknowledged that this regime created a “double windfall,” but it would not let a “policy concern” control the analysis. Instead, the taxpayer could enjoy the double benefit that “the Code’s plain text permits.”

The Service should observe shifts in statutory interpretation methods when it applies section 265(a)(1). The expansive approach relies on the agency’s arbitrary interpretations and judicially perceived policy considerations. It does not follow from text or statutory structure, nor does it establish consistency. If the Service does not itself change its position, courts should use contemporary statutory interpretation methods when they construe section 265(a)(1) and apply the production-of-income approach.

IV. Section 265(a)(1) and the CARES Act

This Part explains how the expansive approach created extraordinary controversy for the CARES Act and how that controversy confirms the Service’s erroneous approach to section 265(a)(1). Because Congress legislatively overrode Notice 2020-32, the issues in this Part might seem stale. But they are not. Congress addressed PPP loan forgiveness but did not broadly address when section 265(a)(1) will deem expenses allocable to income from the discharge of indebtedness (DOI income). Thus, the relationship between section 265(a)(1) and DOI income remains uncertain and justifies careful attention.

Part IV.A briefly explains how the Code addresses DOI income. One must appreciate that background to determine whether PPP expenses are, under section 265(a)(1), allocable to tax-exempt DOI income. Part IV.B then explains how the Service ruled that PPP expenses are, in fact, allocable to DOI income. That Part criticizes the Service’s reasoning on its own terms. Part IV.C explains that the production-of-income approach should have applied to PPP expenses, and that deductions for those expenses should not have faced disallowance under section 265(a)(1). Part IV.D argues that Congress should reaffirm the production-of-income approach. That Part rejects arguments that Congress should instead expand section 265(a)(1) to catch situations like those presented in the CARES Act.

A. DOI Income: General Principles

Section 61(a) broadly states that gross income includes all income from whatever source derived. Though attempts to exhaustively define “income” have proven elusive, the Supreme Court has established some commonly cited principles. In Commissioner v. Glenshaw Glass, the Court emphasized that income arises for “undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.”

Under these principles, taxpayers will not recognize income when they borrow funds. Any borrowed amount immediately gives rise to an offsetting obligation to repay. Though a taxpayer may subjectively feel richer when a loan disbursement appears in her bank account, she has not enjoyed one of the “undeniable accessions to wealth” contemplated by Glenshaw Glass.

On the deduction side, payments with borrowed funds will usually be treated in the same way as any other payment. Thus, for example, a section 162 deduction may arise whether a taxpayer pays her business expense with borrowed funds or with her savings. The law assumes that the taxpayer will repay her loan, and so payments made with borrowed funds are treated as bona fide expenditures.

If a taxpayer fails to repay her loans, these assumptions become disturbed. When a repayment failure occurs and the lender discharges the taxpayer’s debt, DOI income generally arises. As described further below, the discharge of the taxpayer’s debt reflects an accession to wealth under the Glenshaw Glass standard.

Taxpayers who recognize DOI income may face challenges paying the taxes imposed on that income. Section 108(a) thus establishes various exceptions to income recognition. Those exceptions principally relate to taxpayer hardships, such as bankruptcy or insolvency. However, the section 108 exclusion will not always be permanent. Under section 108(b), a taxpayer must generally reduce her existing tax attributes by the amount excluded under section 108(a). Thus, a taxpayer might exclude $100 of DOI income under section 108(a) but then reduce her available net operating losses by the same amount. In this way, the amount excluded under section 108(a) is eventually recaptured.

B. PPP Expenses Under the Expansive Approach

1. The Service Denies PPP Deductions

On March 27, 2020, President Donald Trump signed the CARES Act into law. Legislators passed that Act to help businesses deal with the devastation caused by the COVID-19 pandemic and the related economic consequences. Among other things, the CARES Act amended the Small Business Act and established the PPP program. That program, which was expanded in subsequent legislation, offers low-interest loans for various businesses. Congress generously provided that taxpayers could earn forgiveness for PPP loans to the extent they used those loans for various specified, business-related expenses.

Under the rules described in Part IV.A, a taxpayer who borrowed (for example) $25,000 through the PPP program would recognize no income when she received that loan. Additionally, she would enjoy $25,000 of tax deductions under section 162 if she used the loan to pay business expenses. That tax benefit could be short-lived, however. If the borrower secured loan forgiveness, she would ordinarily recognize $25,000 of DOI income. Thus, tax-wise, the PPP program would be neutral. Tax deductions would be later offset by an income inclusion. From an economic perspective, that makes sense. After all, when the loan, expenses, and forgiveness are considered together, the taxpayer has not suffered any out-of-pocket loss.

However, in the CARES Act, Congress departed from the section 108 framework that ordinarily governs DOI income. Under section 1106(i) of the CARES Act, Congress excluded from gross income any amount that might otherwise arise “by reason of forgiveness” of a PPP loan. Additionally, excluded amounts would not face the recapture rules described in section 108(b). Thus, the taxpayer would seemingly enjoy a windfall. To the extent that the taxpayer used the $25,000 loan toward the expenses specified in the CARES Act, she would usually enjoy tax deductions under section 162. But no DOI income would arise under section 61.

In Notice 2020-32, the Service did not challenge this exclusion of DOI income. Instead, it addressed the windfall through the expansive approach to section 265(a)(1). The Service first concluded that any DOI income excluded by the taxpayer under section 1106(i) gave rise to a “class of exempt income” under the section 265(a)(1) regulations. Then, it concluded that any of a taxpayer’s otherwise available section 162 deductions would be deemed allocable to that class of exempt income. Consequently, section 265(a)(1) would deny the taxpayer’s claimed section 162 deductions, up to the amount of the excluded DOI income. The Service alternatively invoked the reimbursement theory to deny PPP deductions.

Notice 2020-32 generated heavy criticism from legislators, scholars, and business groups. Their concerns were understandable, given the extraordinary amounts at stake. The CARES Act and subsequent legislation authorized more than $800 billion in PPP loans. Whether taxpayers could deduct PPP-related expenses was thus no small issue.

Legislators offered various proposals to reverse the Service but, in Revenue Ruling 2020-27, the agency confirmed its position. That Revenue Ruling addressed whether a taxpayer could enjoy deductions for PPP-funded expenses in a given taxable year if, at the end of that taxable year, her loan had not been forgiven. The Service concluded that, at least where the taxpayer had already applied for loan forgiveness or expected to do so, deductions would be disallowed. That conclusion was necessary because under section 265(a)(1), the PPP expenses would be “allocable to tax-exempt income in the form of the reasonably expected covered loan forgiveness.”

The ruling also discussed the tax benefit doctrine. That doctrine has spawned uncertainty in the case law, and generalizations about the doctrine remain perilous. But, as described in Revenue Ruling 2020-27, the tax benefit doctrine contemplates that if a taxpayer deducts an item and, in a later year, “an event occurs that is fundamentally inconsistent with the premise on which the previous deduction was based (for example, an unforeseen refund of deducted expenses), the taxpayer must take the deducted amount into income.” Revenue Ruling 2020-27 does not expressly describe how this principle applies to the PPP program. Instead, it cryptically suggests that because the tax benefit doctrine would not apply to the PPP program, a reimbursement theory would.

2. Conceptual Problems with the Service’s Approach

For all the reasons described in Part III, the Service should have applied the production-of-income approach to section 265(a)(1) and PPP expenses. As Part IV.C later shows, PPP expenses ordinarily produce taxable business income, not tax-exempt DOI income. However, questions would arise over Notice 2020-32 and Revenue Ruling 2020-27 even if one accepts the expansive approach.

The expansive approach contemplates that deductions may be denied when they are paid from tax-exempt funds. In the PPP context, if one could somehow ignore money fungibility issues, she would probably conclude that PPP expenses were paid from amounts borrowed through the PPP program. That is, PPP expenses would be deemed paid from PPP loans.

This straightforward assumption creates conceptual problems under section 265(a)(1). That statute applies when a deduction is allocable to tax-exempt income. But PPP loans are neither tax-exempt income nor taxable income. They are not income at all. Borrowed amounts come with an obligation to repay, so section 61(a) does not reach them. Thus, even if PPP expenses were deemed allocable to PPP loans, section 265(a)(1) would not apply.

To get around this fundamental problem, the Service allocates PPP expenses to the DOI income that may eventually arise through loan forgiveness, rather than to the PPP loan itself. Yet that approach seems odd. DOI income does not arise through any hypothetical or actual cash payment to the taxpayer. And if a taxpayer has not been deemed to have received any payment through loan forgiveness, how can that forgiveness be treated as the source of the taxpayer’s expense?

Notice 2020-32 contemplates that section 265(a)(1) applies when “tax exempt income is earmarked for a specific purpose and deductions are incurred in carrying out that purpose.” But loan forgiveness involves no earmarked income. A lender or the government cannot earmark how a debtor “spends” DOI income. The PPP program thus differs from the situation in Manocchio, where the Veterans Administration made a payment on the taxpayer’s behalf after he incurred an expense. There, one could more easily connect an expense to earmarked funds.

The Service’s alternative reliance on a reimbursement theory also stands on shaky ground. In Manocchio, the relevant statute, on its face, established a reimbursement mechanism. Thus, one could easily conclude, as the Ninth Circuit did, that the taxpayer in that case never paid any deductible expenses under section 162. That analysis might apply to the PPP program if it were recharacterized as a conditional grant program. Under that recharacterization, PPP borrowers might be deemed to have received grants to use toward only the expenses described in section 1106. To the extent PPP borrowers (now, grantees) used the PPP grants in the prescribed manner, no business expense deduction would arise. A taxpayer does not pay or incur an expense under section 162 when someone else foots the bill. But if the taxpayer used the PPP loan (grant) for expenses described outside section 1106, the taxpayer would need to return the grant. In that case, the taxpayer would suffer the economic burden associated with the expense, and a section 162 deduction would arise.

Maybe Congress should have established the PPP program in the manner described above. Or maybe a tax theorist might argue that there is no conceptual difference between a loan-and-forgiveness program and a conditional grant program. However, the CARES Act contains numerous indications that Congress established PPP loans as bona fide loans, not as disguised conditional grants. Had Notice 2020-32 or Revenue Ruling 2020-27 tried to recharacterize the CARES Act as a grant program, the Service probably would have faced even more congressional backlash than it already did.

C. PPP Expenses Under the Production-of-Income Approach

Had the Service followed the production-of-income approach, the tax treatment of the PPP program would have been relatively straightforward. Expenses paid with PPP loans would ordinarily qualify for section 162 deductibility because those expenses relate to the borrower’s business. In other words, expenses paid with PPP loans help produce taxable business income rather than tax-exempt DOI income. Section 265(a)(1) would not apply.

The principles behind DOI income support these points. Two main theories have emerged to explain why DOI income arises. Under either theory, PPP expenses would not be allocated to tax-exempt DOI income.

Under the first theory, DOI income arises to correct the mistake associated with the original exclusion of borrowed funds from gross income. The taxpayer enjoyed that exclusion only because she would repay her debt. When she fails to do so, this “mistake-correction theory” requires that she recognize the canceled debt as income.

Under the second theory, DOI income arises because, after a debt is canceled, the taxpayer has enjoyed a “freeing of assets,” which creates an accession to wealth. For example, consider a taxpayer with $10 of assets and a $10 debt obligation. If the lender cancels the taxpayer’s debt, the lender will no longer have any potential claim over the taxpayer’s assets. Thus, $10 of DOI income would arise under this freeing-of-assets theory. However, if the taxpayer were insolvent even after a debt cancellation, no income would arise. Both before and after the debt cancellation, all her assets would face creditors’ claims. No assets would have been freed up.

PPP expenses do not help produce tax-exempt DOI income whether one applies the mistake-correction theory or the freeing-of-assets theory to DOI income. Under the mistake-correction theory, DOI income arises because of limitations in how the Code addresses loans. Under the freeing-of-assets theory, DOI income arises through a somewhat peculiar focus on a taxpayer’s balance sheet. Neither theory contemplates that ordinary business expenses produce DOI income.

One might point out that DOI income would not arise “but for” the fact that the taxpayer made the expenses specified in the CARES Act. Thus, the argument might go, the expenses must be allocable to DOI income, rather than to ordinary business income. But if those expenses were so allocable, section 162 deductions probably should not arise in the first instance. Producing DOI income—if such a phrase even makes sense—does not reflect an expense incurred in “carrying on any trade or business.” Additionally, taxpayers who receive PPP loans may not know whether they will eventually earn loan forgiveness. Thus, it seems far more natural to allocate PPP-funded expenses to ordinary business income than to DOI income. The production-of-income approach does not support denying PPP-related expenses.

There are serious arguments that double tax benefits under the PPP program violate sound tax policy principles. But the Service does not implement sound tax policy in the abstract. It implements the tax policy adopted by Congress. Through section 1106(i) of the CARES Act, Congress decided, rightly or wrongly, to exclude DOI income that would otherwise arise through the forgiveness of a PPP loan. In doing so, Congress provided a windfall for taxpayers. The Service’s attempted denial of deductions through section 265(a)(1) would have negated that congressionally intended windfall.

The controversy over PPP deductions confirms that the Service should reevaluate its approach to section 265(a)(1). Notice 2020-32 and Revenue Ruling 2020-27 caused extraordinary uncertainty over almost a trillion dollars of potential tax deductions. Uncertainty and confusion do not facilitate sound tax administration, especially in times of economic or public health crises. That Congress overrode the Service only further supports the need for reevaluation.

Unfortunately, the Service’s reaction to the legislative override does not suggest that the agency will change its position. In Revenue Ruling 2021-2, the Service stated that the “conclusion” in Notice 2020-32 and the “holding” in Revenue Ruling 2020-27 no longer provided accurate statements of law. The Service therefore rendered those guidance items obsolete. But the Service did not abandon the reasoning that supported Notice 2020-32 and Revenue Ruling 2020-27. This implies that the Service will continue to apply the expansive approach to section 265(a)(1).

D. Congressional Response

Congress should amend section 265(a) and reaffirm that the production-of-income approach applies under the statute. Congress has already enacted two statutes in response to Service overreach under section 265(a)(1). And the Service shows no sign of backing away from the expansive approach. To preempt future controversies, Congress should act now.

As previously acknowledged, one can express fair concerns about double tax benefits. However, an expansive approach to section 265(a)(1) provides a poor vehicle through which to address those concerns. If Congress embraced the strongest version of the expansive approach and used section 265(a)(1) to deny all deductions paid from tax-exempt income, tax administration challenges would arise. Nonbusiness taxpayers enjoy various tax exemptions, whether through the gift provisions, the life insurance provisions, or otherwise. Asking nonbusiness taxpayers to trace the income exempted under those provisions—and forgo any deductions traceable to them—would create substantial compliance burdens.

Those burdens would likely yield minimal benefits. Nonbusiness taxpayers probably do not pay many deductible expenses with tax-exempt income. Instead, items like tax-exempt gifts or tax-exempt life insurance proceeds probably often go toward personal consumption. Additionally, the new section 67(g) limitation on miscellaneous itemized deductions makes section 265(a)(1) far less relevant to nonbusiness taxpayers than it had previously been. The new limitation eliminates many deductions for nonbusiness taxpayers. Thus, under current law, cases like Manocchio would not have been brought. Section 67(g) would have eliminated the taxpayer’s claimed section 162 deductions, and section 265(a)(1) would have had no meaningful role to play.

Congress might nonetheless consider expanding section 265(a)(1), such that the statute would deny the creation of basis in property when a taxpayer purchases property with tax-exempt income. Usually, a taxpayer’s basis in property is its cost. Thus, in theory, a taxpayer could use tax-exempt income to purchase property for $100 and then enjoy a double tax benefit through the creation of that $100 basis. For example, the taxpayer could, among other things, depreciate the $100 basis or recognize a $100 loss on the property’s abandonment. But again, for nonbusiness taxpayers, those possibilities seem inconsequential. Depreciation deductions or abandonment loss deductions usually arise only when a taxpayer uses property for business or investment purposes. Thus, nonbusiness taxpayers generally won’t enjoy depreciation or abandonment deductions, regardless of section 265(a)(1).

Even for business taxpayers, section 265(a)(1) often reflects the wrong target. That provision did not create any unwarranted double tax benefits under the CARES Act. Rather, the CARES Act itself created double benefits through the tax exemption for PPP-related loan forgiveness. Additionally, the CARES Act failed to subject PPP-related loan forgiveness to the section 108(b) recapture rules. If, upon reflection, Congress decides that the PPP program established overly generous tax benefits, Congress should think twice before it offers those benefits again.

Of course, none of this means that Congress should blithely bless double tax benefits. It means only that Congress should not expand section 265(a)(1) beyond its conceptual foundations. Nor should Congress create massive tax compliance burdens. To better address double tax benefits, Congress should revise or limit the specific provisions that grant tax exemptions.

Whether Congress adopts tax-exemption limits may vary by Code section. For example, it makes little practical sense to ask nonbusiness taxpayers to track all their tax-exempt gifts. Thus, arguably, Congress should leave undisturbed the possibility that a nonbusiness taxpayer will receive a tax-exempt cash gift and later enjoy a deduction when she uses that cash gift toward a deductible expense. Even in contexts that do not present compliance burdens, Congress might bless double tax benefits to maximize federal assistance.

In other contexts, however, Congress could take a firmer approach. For example, some existing tax-exempt housing-allowance provisions might be overly generous. If so, Congress should directly cap those allowances, rather than limit them indirectly through section 265(a)(1). This direct approach would help avoid tax administration problems. No taxpayer would need to determine whether she put her tax-exempt allowance toward deductible expenses. Instead, Congress would limit the tax exemption for everyone.

Admittedly, this rough justice approach might not satisfy tax theorists. But tying limitations to the tax exemption itself, along with reaffirming the production-of-income approach to section 265(a)(1), implements sound tax administration principles. Congress would make the limits on tax exemptions transparent. Nonbusiness taxpayers could avoid the section 265(a)(1) thicket. The controversy over the CARES Act should leave no doubt about whether unanticipated Service positions create tax compliance challenges.

For tax exemptions that benefit business taxpayers, Congress has wider tools at its disposal. As with nonbusiness taxpayers, money fungibility challenges exist. But, as the capital contribution provisions show, Congress can limit the benefits of a tax exemption without requiring that businesses trace exactly how they use tax-exempt funds. Thus, the same principle that applied to nonbusiness taxpayers should apply to business taxpayers. Whenever appropriate, legislators should directly consider their objectives when drafting a tax exemption and limit it accordingly.

V. Conclusion

The controversy over section 265(a)(1) and the CARES Act shows that Congress should squarely consider whether and how it uses the Code to implement social programs. Generally worded tax provisions can effectively address business or investment transactions. Yet, when Congress uses technical tax rules to implement social programs, general provisions like section 265(a)(1) come under pressure. Confusion inevitably ensues.

Some confusion might have been avoided had Congress established the PPP as a direct grant program rather than as a complex forgivable loan program. But even if Congress did not implicate the DOI income rules, the uncertainty over 265(a)(1) would linger in the background. Future controversies over section 265(a)(1) seem inevitable, especially given Congress’s increasing reliance on the Code’s machinery to provide social assistance.

As Congress continues to facilitate social programs through the Code, it should take a realistic approach to taxpayer compliance issues. It’s likely that many PPP recipients would have had no idea that their deductions might be denied through section 265(a)(1). And it seems almost cruel to expect Section 8 recipients to navigate section 265(a)(1) as they use much-needed assistance to meet housing costs. By reaffirming the production-of-income approach to section 265(a)(1), Congress could remove those burdens and help clarify an unpredictable area of the law.