This year business owners and self-employed taxpayers may have reason to remember that Uncle Sam is not the only tax collector around. The way state authorities across the country choose to handle the Paycheck Protection Program could have a significant impact on your total tax bill.
Congress created the Paycheck Protection Program to provide support to American businesses suffering the headwinds of the COVID-19 pandemic. In March 2020, the Coronavirus Aid, Relief and Economic Security Act – usually shortened to the CARES Act – established a variety of relief measures, including the PPP. The program has done a lot of good, but states are struggling to keep up with fast-changing tax rules and guidance for the many new economic recovery initiatives, the PPP among the rest. This has left some taxpayers dealing with unusual uncertainty.
Since Congress meant the Paycheck Protection Program to help struggling businesses, lawmakers specified that PPP loans would be fully forgiven under particular circumstances. In general, as long as employers retained employees at salary levels comparable to those before the pandemic, and used the PPP loans to cover payroll and certain other business expenses, they would not need to pay back the loans. The forgiven loans also would not be subject to federal income tax. If lawmakers had not specified this special treatment, the canceled debt would have been treated as taxable income.
This provision proved unexpectedly complicated when the Treasury Department and the Internal Revenue Service argued that Congress didn’t mean the forgiven loans to be completely tax-free. The IRS at first announced that it would disallow any normally deductible business expenses that businesses paid with forgiven loan proceeds. This stance avoided what the Treasury described as “double dipping.” Under these rules, the forgiven loan would not be subject to income tax, but borrowers could not deduct the payroll and other business expenses they used the loan to cover. Business owners who lost deductions would in turn recognize a higher net profit, which would lead to a higher tax bill. This would reduce the benefit of the PPP, essentially making the forgiven loan taxable.
As Palisades Hudson President Larry Elkin observed as far back as May, however, attempts to narrow the PPP’s benefits sprang more from fiscal panic than a good-faith reading of the CARES Act. Congress stepped in late last year to pass further legislation clarifying that it meant what it said in the first place. Forgiven loans are not subject to income tax, and business owners are entitled to deduct their ordinary and necessary business expenses even if they paid those expenses using funds from a forgiven PPP loan.
Because of this additional legislation, taxpayers and tax preparers now know that the rules are clear. Forgiven PPP loans are not income for tax purposes and they don’t affect deductions. Many business owners breathed sighs of relief. Unfortunately, some of them have relaxed too soon.
Many observers expected state legislatures to follow Congress’s lead in exempting forgiven PPP loans from income tax. The reality has been more complicated. Some states have signaled that they plan to diverge from federal guidance and tax the forgiven loans. Others have followed the original IRS position in disallowing deductions for expenses paid from forgiven loan proceeds. These positions have alarmed business owners who, assuming the forgiven loans would be tax-free, did not set aside funds to pay state tax collectors.
States connect their individual tax regimes to the federal rules in a variety of ways. Twenty-one states, as well as the District of Columbia, have adopted a “rolling conformity” approach, in which their income tax laws mirror the Internal Revenue Code as soon as it changes. State lawmakers must specifically carve out exceptions via legislation. Nineteen states have a “static” or “fixed-date conformity” approach. In these, a state’s tax regime conforms to the federal code on a particular date, but not thereafter. Such states can choose to change their conformity date, but the update will not happen automatically. And a few states uncouple their tax laws from the federal regime more fully and decide on a case-by-case basis whether to mirror federal tax provisions.
Frustratingly for taxpayers, some states that typically conform to the federal approach have carved out or suggest they may carve out exceptions for the treatment of forgiven PPP loans. And even states like Florida that do not tax personal income still must determine how they will treat businesses where income does not pass directly through to the owner. Taxpayers cannot be sure how any particular state will approach PPP loans until the state makes its position clear – a process that is still underway in many states, even as taxpayers and professionals begin to prepare 2020 tax returns.
At this writing, 16 states have issued guidance confirming that forgiven PPP loans will not be subject to state income tax. Only two have confirmed that they will conform to the federal stance on allowing business owners to deduct business expenses covered by forgiven PPP loans. Three states have said with certainty that they will not conform to the income tax forgiveness provision; Massachusetts will tax forgiven loans for individuals but not for corporations. Four states have said they will not allow deductions funded with forgiven PPP loans. While some of these positions could change, taxpayers can at least start to plan for states that have issued clear guidance.
For many taxpayers, though, this question remains unresolved. State legislatures have had limited time in session since Congress clarified its position in December. Certain fixed-date conformity states may address the issue of forgiven PPP loans later in 2021. Other legislatures could make changes that will force updates to existing guidance. Some jurisdictions that do not allow business owners to deduct expenses paid with forgiven loan funds based on earlier IRS guidance may also update the rules before the 2020 tax filing deadline. Changes could swing the other way, too, skewing more restrictive in states worried about budget shortfalls.
While the rules for every single state are beyond the scope of this article, here are a few examples. New York indicated early on that it would follow the federal government’s income tax treatment of PPP loan forgiveness, excluding forgiven loans from gross income for personal and corporate income tax purposes. It also issued guidance that said it would follow the federal government’s decision to allow business deductions for expenses paid from a forgiven PPP loan. New York is among the best-case scenarios for states that levy income tax. As a tax professional, I rarely classify New York as a “best case” scenario when it comes to anything dealing with taxes. This time, though, at least the state’s tax authorities have issued clear guidance that matches the favorable federal position, keeping things straightforward for business owners.
California is a static conformity state, and its tax code mirrors the federal tax code as of 2015. Lawmakers there did pass legislation specifying that forgiven PPP loans are not subject to income tax. Unfortunately for taxpayers, the same law provided that business expenses paid with forgiven PPP loan funds are not deductible, mirroring the earlier IRS position that Congress has since refuted. Since lawmakers passed this law outright, rather than to reflect an updated conformity date, this decision will not change by itself. California lawmakers must act if they wish to match the federal rules on deductibility.
My home state of Georgia is also a static conformity state. Its conformity date is after the CARES Act but before the clarification passed in December. Georgia’s state tax return for 2020 includes a line item to add back any deductible business expenses that the taxpayer paid from a forgiven PPP loan and deducted for federal tax purposes. That said, as of this writing Georgia’s legislature is considering a bill that would update the rules for 2020 to allow for the deductibility of business expenses paid from a forgiven PPP loan. This is a clear example of circumstances where a taxpayer with a PPP loan for 2020 should wait to file until the state acts and provides clear guidance. It’s unusual for tax laws passed in a current year to change the rules for the prior year – especially since, as of early February, taxpayers are already starting to file 2020 tax returns. But 2020 was unusual in all sorts of ways.
Wisconsin has demonstrated yet another way that fixed-date conformity can play out. The state omits forgiven PPP loans from gross income, but does not allow for the deductibility of the business expenses paid with those funds. But these rules only apply if the loan was issued in the first round of the program. Under Wisconsin tax law, “second round” PPP loan proceeds are subject to income tax if borrowers secure forgiveness. In this case, taxpayers can deduct the business expenses paid, since the forgiven loan itself is taxable income.
Let’s consider an example. Assume a business in Wisconsin received a $100,000 PPP loan. The business had total revenue of $600,000 and total business expenses of $400,000. For simplicity, say the business used all $100,000 to cover a portion of its staff’s salaries and rent, and thus qualified for and received full loan forgiveness. For federal tax purposes, the $100,000 in forgiven loan proceeds is not included as income. The business can also deduct the $100,000 it paid in salaries and rent. For federal tax purposes, it therefore has $200,000 of taxable net business profit ($600,000 less $400,000).
Under Wisconsin state law, if the business received a first-round PPP loan, the forgiven $100,000 will not be income for state income tax purposes, either. However, the business cannot deduct the $100,000 of expenses it paid using the forgiven PPP loan. The business’s net profit for state income tax purposes is therefore $300,000 ($100,000 higher than its net profit for federal purposes). If the business holds a second-round PPP loan instead, the mechanics are different but the outcome is similar. The business will owe tax on the forgiven PPP loan, but it can deduct the expenses. In this case, the business must report $700,000 of gross income to the state; after accounting for the fully allowed $400,000 of expenses, it would have $300,000 of net profit.
The state or states where you owe income tax may take a variety of approaches to forgiven PPP loans. Taxpayers who received a PPP loan and secured or expect forgiveness for any part of it should bear a few points in mind.
- Don’t assume conformity. Even states with rolling conformity have announced a variety of approaches to handling PPP loans. It is critical to be sure you research the guidance your state has – or has not yet – issued in this particular instance. Even with guidance in place, stay alert for potential changes still to come.
- Wait if necessary. If your state has not issued formal guidance, or if it seems likely the rules could change, there is a strong case for extending your return. If you file by March 15 or April 15 and the state changes the rules later, you will need to file an amended return. (Bear in mind that an extension to file is not an extension to pay, so you will need to estimate your tax liability by the usual deadline.) No one knows what the future will hold, but if there is a strong chance of the rules changing in your state, you can save yourself some aggravation by waiting for clear guidance.
- Tax authorities are not infallible. The original IRS position on disallowing deductions for expenses paid with forgiven loan proceeds was controversial. Some states’ positions may not be airtight, either. In certain cases taxpayers in states that follow the Internal Revenue Code could be able to defend their position to deduct expenses paid with forgiven PPP loans, even if the state tax authority holds to the original IRS line. Whether this is possible or advisable depends on the state. Taxpayers should consult a professional before deciding to pursue this course, as well as documenting their position thoroughly.
- Consult a professional. In fact, most taxpayers who have forgiven PPP loans would do well to work with a tax professional for tax year 2020. The rules for PPP loans, and many other types of COVID-19 relief, remain a moving target, especially on the state level. Your adviser can help you keep track of any changes that might benefit you and your business.
Take extra care with your state taxes for 2020, and as you plan for 2021. Note that you may need to make additions or subtractions when comparing your state return to your federal return. The rules may continue to change, even in states that have issued some guidance, so be patient and make sure you understand any new information as it arrives. Though federal lawmakers made their intentions clear, state tax authorities are still in the process of having their say. For business owners and individual taxpayers alike, COVID-19 relief measures present a complicated addition to this tax season.