The U.S. Small Business Administration’s Paycheck protection program (PPP) is providing an important lifeline to help keep millions of small businesses open and their workers employed during the Pandid-19 pandemic.
Many borrowers will have these loans forgiven; eligibility for forgiveness requires the use of the loan for qualifying purposes (such as payroll costs, mortgage interest payments, rent and utilities) within a specified period of time.
Typically, a forgiven loan qualifies as revenue. However, Congress decided to exempt PPP loans forgiven from federal income tax. Many states, however, continue on the path of taxing them, treating forgiven loans as taxable income, denying the deduction of expenses paid on forgiven loans, or both.
The map and table below show the states’ tax treatment for forgiven PPP loans.
Why do states have such different practices when it comes to taxing PPP loans? It all has to do with how states comply with the federal tax code.
All states use the Internal Revenue Code (IRC) as a starting point for their own tax code, but each state has the authority to make its own adjustments. States that use rotational compliance automatically adopt federal tax changes as they occur, which is the simplest approach and provides the greatest certainty to taxpayers. States that use a static compliance link with the federal tax code on a given date and must proactively adopt legislation to accept more recent changes.
It is common for states to comply with certain parts of the federal tax code, but separate themselves from others. States that use rotational compliance sometimes adopt legislation to separate themselves from certain federal changes after they occur.
Most states that use static compliance update their compliance dates routinely, but sometimes indecision on whether or not to accept new federal tax changes results in states that remain in compliance with an outdated version of the IRC for many years. When static compliance states Does update their compliance dates, sometimes detach themselves from specific changes in a ad hoc base.
Even beyond the issue of compliance dates, there is a great deal of uncertainty surrounding the state tax treatment of forgiven PPP loans due to the way the federal government envisaged non-taxation of forgiven PPP loans.
When the CARES Act was enacted on March 27, 2020, the intention of Congress was that PPP loans forgiven should be exempt from tax at the federal level, which is a departure from usual practice. Normally, when the federal debt is forgiven for several reasons, the amount forgiven is considered taxable revenue by the federal government and the states that follow this treatment. Under normal circumstances, this is a reasonable practice.
However, Congress specifically designed PPP loans as a tax-free emergency lifeline for small businesses struggling to remain open in the midst of the pandemic, so the CARES Act excluded PPP loans from taxable income (although not changing IRC directly). Congress also appears to have intended that expenses paid for PPP loans be deductible – the Joint Taxation Committee considered the original provision as such – but did not include language to do so directly in the bylaws.
In the months following the enactment of the CARES Act, the Treasury Department determined that expenditures paid on PPP loans were no deductible under the law as it was then, citing section 265 of the IRC, which generally prohibits companies from deducting expenses associated with tax-free revenue.
This interpretation came as a surprise to many lawmakers, as excluding loans forgiven from taxation, but then denying the deduction, basically cancels the benefit provided by Congress. Therefore, on December 27, 2020, when the Consolidated appropriations law for 2021 was made into a law, the law was amended to specify that expenses paid on forgiven PPP loans would in fact be deductible.
As a result, most states now find themselves in one of three positions.
States that comply with a pre-CARES Act version of the IRC generally treat forgiven federal loans as taxable income and related business expenses (such as payroll, rent and utilities) as deductible.
States that comply with a post-CARES Act, but the pre-Consolidated version of the IRC Appropriations Act are generally on track to exclude forgiven PPP loans from taxable income, but deny deduction for related expenses.
States using revolving compliance or who have otherwise updated their compliance statutes to a post-Consolidated Appropriations Act of the IRC exclude forgiven PPP loans from revenue and allow related expenses to be deducted.
In some cases, however, states have adopted specific provisions on PPP loan proceeds that replace their general compliance approach.
State policymakers are now in a position to help ensure that PPP beneficiaries receive the full emergency benefit that Congress intended by refraining from taxing these federal lifelines at the state level. Denying the deduction of expenses covered by forgiven PPP loans has a very similar tax effect to treating forgiven PPP loans as taxable income: both methods of taxation increase taxable income beyond what would have been had the company not taken out a PPP loan in the past. First, put.
In many states that currently have tax-exempt PPP loans, including Arizona, Arkansas, Hawaii, Maine, Minnesota, New Hampshire and Virginia, bills have been introduced to prevent such taxation, and Wisconsin recently acted to do the same.
This situation is one where baselines matter: from a baseline of taxation on forgiven loans (or denial of deduction), compliance with federal treatment represents a loss of revenue. If, however, the baseline scenario is one in which there were no forgiven PPP loans – the ex ante status quo—Then following federal guidance is neutral in terms of revenue. This was not a revenue that states counted on or expected to be able to generate.
If policymakers want to avoid imposing taxes on the lifelines of these small businesses, they need to act quickly as fiscal deadlines are approaching.
Katherine Loughead is a senior policy analyst at the Tax Foundation, a tax policy research organization in Washington, D.C. This was first published on his blog – “Which states are taxing forgiven PPP loans?“