While many states automatically update their tax laws to reflect federal changes, there are a few quirks when it comes to state income tax treatment of PPP loan forgiveness and PPP expense deductibility. Here’s what executives need to know.
A short overview of the PPP at the federal level
The PPP offered Small Business Administration (SBA) loans to businesses that could be forgiven if the proceeds were used to fund payroll and other key expenses such as mortgages, rent, and utilities. At the time of enactment in spring last year, it was made clear that businesses that applied for and were granted forgiveness on these loans wouldn’t be subject to taxes on “cancellation of debt” income that might normally apply in similar circumstances.
Within a few months, the IRS released an interpretation of the PPP rules stating that, while the forgiven amounts wouldn’t be treated as income, expenses paid with PPP proceeds would not qualify for deduction from taxable income if the loan was forgiven. Congress responded by including a provision in the CAA legislation at the end of 2020 that overruled the IRS interpretation and allows taxpayers to claim a deduction for expenses paid with proceeds from PPP loans even if the debt is forgiven. While the provision allowing deductibility of the expenses paid with PPP funds is federal law, it wasn’t incorporated into the Internal Revenue Code (IRC), and now poses a unique state tax issue for taxpayers.
CARES Act and CAA conformity
A key point of ambiguity for state treatment of PPP loan forgiveness and deductibility of expenses paid with forgiven PPP proceeds is that the federal income tax treatment resides outside of the IRC. This administrative distinction really doesn’t mean that much to the Americans who are counting on these funds to meet payroll and keep their businesses open. As we’ll see in the following explanation, it may have a significant impact on how the transactions are treated for state income tax purposes.
State conformity and PPP forgiveness
If you look at most state income tax returns, one of the first lines is usually, “Enter your federal adjusted gross income” or “federal taxable income.” The remainder of the form then consists of adding back into income those federal deductions that the state doesn’t allow and deducting state-specific expenses that aren’t allowed at the federal level.
State legislatures and departments of revenue have had little opportunity to enact laws and issue guidance in response to the PPP program before tax returns are due this year. Consequently, taxpayers are left to interpret how PPP forgiveness and related expense deductibility will be treated based on each state’s standing relationship with the IRC and federal tax law not codified in the IRC, while at the same time watching for upcoming state legislation that could create a special rule for PPP forgiveness and expense treatment. In the absence of specific legislation, the treatment likely will be determined by whether the state ties its income tax to the IRC based on a “rolling conformity” or a “static conformity” model, and the extent to which the state extends its conformity to other provisions of federal law that impact income tax.
State legislatures and departments of revenue have had little opportunity to enact laws and issue guidance in response to the PPP program before tax returns are due this year.
States that follow a rolling conformity model with the IRC have set up their laws to accept the IRC, as amended, on an ongoing basis. When it comes to the PPP, they would presumably recognize that the forgiveness of a loan doesn’t result in taxable income and the expenses paid with proceeds from a forgiven loan would be deductible, unless the state legislature enacts a law to decouple from the federal law in this area.
However, here’s where the federal income tax treatment related to PPP as provided by the CARES Act and CAA could cause issues. The CARES Act and CAA provide for nontaxable loan forgiveness and related expense deductibility without actually modifying the IRC. As a result, there is a possibility that even a rolling conformity state could argue against following the federal treatment by claiming that the provisions in question aren’t within the statutes with which the state automatically conforms.
States that follow a static conformity model with the IRC vote periodically on maintaining their conformity with the federal rules as of a certain date. Many of these legislatures haven’t had time to update their conformity date to reflect changes made last spring by the CARES Act, much less last December by the CAA. These states are far more likely to default to treat forgiven PPP balances as “cancellation of debt” income. However, if the forgiven loan proceeds are treated as income, the state is much less likely to challenge that the expenses paid with the proceeds are deductible.
As previously noted, states may incorporate other federal laws impacting income taxes, in addition to the IRC, when determining state income tax. In this instance, static IRC conformity states might conform to the federal treatment of PPP loan forgiveness and related expense deductibility regardless of the fixed date of its IRC conformity. Irrespective of whether a state currently adopts other federal laws generally, if state legislatures act to update the date of IRC conformity, they have an opportunity to specifically reference any non-IRC laws necessary to align or clarify alignment with the federal nontaxability of forgiven PPP loans and to recognize the treatment of expenses paid with forgiven debt.
PPP loan forgiveness and state apportionment
For businesses operating in multiple states, the PPP loan forgiveness could also have an impact on the sales, payroll, and property apportionment factors. Depending on a state’s definition of “gross receipts,” forgiven PPP proceeds might be classified as gross receipts for apportionment purposes, and included in the calculation of the sales apportionment factor as a result. For the payroll and property factors, considering the specific statutory definitions of those terms, taxpayers must decide whether potential nondeducibility of expenses impacts calculating the apportionment factor. What’s more, inconsistencies between states over how to treat the proceeds of forgiven PPP loans could lead to significant confusion when it comes to calculating apportionment.
Depending on a state’s definition of “gross receipts,” forgiven PPP proceeds might be classified as gross receipts for apportionment purposes, and included in the calculation of the sales apportionment factor as a result.
If proceeds from a forgiven PPP loan are used for payroll or other expenses that would otherwise qualify for a state credits, such as a research and development credit, a state’s disallowance of those expenses could possibly result in a reduction of the credit. Similar credits based on payroll could also be affected.
States to focus on CARES Act conformity
Many states will be addressing these issues in the months ahead, both at the legislative and administrative levels. The scope of the PPP is so broad and its financial impact on eligible businesses and the tax base is so significant that few states can afford to ignore these consequential federal programs.
To learn more about how actions in your state may affect the status of PPP loan forgiveness and whether your business can deduct expenses paid with PPP funds, please contact your Plante Moran advisor.