The US Small Business Administration’s Paycheck Protection Program (PPP) provides a vital lifeline to keep millions of small businesses open and keep their employees busy during the COVID-19 pandemic. Many borrowers are given these loans; Eligibility for forgiveness requires the loan to be used for qualified purposes (such as wages and salaries, mortgage interest payments, rent, and utilities) within a specified time period. Usually, a loan made is considered income. However, Congress chose to exempt PPP loans issued from federal income tax. However, many states remain on track to tax them by either treating issued loans as taxable income, refusing to deduct expenses paid for the use of issued loans, or both. The map and table below show the states’ tax treatment of PPP loans granted.
|Status||Excluded from taxable income||Allows cost deduction|
|South Dakota||No individual or corporate tax|
|Wyoming||No individual or corporate tax|
|District of Columbia||✔||✔|
Notes: * Nevada, Texas, and Washington do not have individual income tax or corporation tax, but rather a GRT. Ohio charges an individual income tax and a BRT. Texas and Nevada treat PPP loan issued as gross taxable income, while Ohio and Washington do not. In any of these states, there is no business expense allowance that is compatible with gross income taxation.
** Massachusetts excludes issued PPP loans from taxable income under its corporate income tax that uses rolling compliance, but not under its individual income tax that uses static compliance before the CARES Act.
Sources: Tax Foundation; state tax laws, forms and instructions; Bloomberg BNA.
Why do states have such different taxation practices on PPP loans? It all has to do with how states adhere to federal tax laws.
All states use the Internal Revenue Code (IRC) as a starting point for their own tax code, but each state has the power to make its own adjustments. States that apply ongoing compliance automatically adopt federal tax changes as they occur. This is the simplest approach and offers taxpayers the greatest security. States using static compliance tie federal tax laws at a point in time and must proactively pass laws to accept recent changes.
It is common for states to adhere to certain pieces of federal tax law but decouple themselves from others. States that apply rolling compliance sometimes pass laws to decouple certain federal changes after they occur. Most states using static compliance routinely update their compliance data, but sometimes indecision about whether or not to accept new federal tax changes results in states following an outdated version of the IRC for many years. When static compliance states update their compliance data, they sometimes become uncoupled from certain changes on an ad hoc basis. Beyond the question of compliance dates, there was great uncertainty about the state tax treatment of PPP loans granted due to the way in which the federal government provided for the non-taxation of PPP loans granted.
When the CARES bill was passed on March 27, 2020, Congress wanted issued PPP loans to be tax-free at the federal level, a departure from normal practice. When federal debt is waived for various reasons, the waived amount is usually considered taxable income by the federal government and states that follow that treatment. This is reasonable practice under normal circumstances. However, Congress designed PPP lending specifically as a tax-free lifeline for small businesses struggling to stay open during the pandemic. Therefore, the CARES Act excluded PPP loans from taxable income (but not by directly changing the IRC). Congress also appears to have intended that expenses paid for the use of PPP loans be deductible – the Joint Tax Committee assessed the original provision as such – but did not directly incorporate the language for it into the law. In the months following the entry into force of the CARES Act, the Treasury Department ruled that expenses paid in PPP loans were not deductible under the law of the time, referring to Section 265 of the IRC, which generally prohibits businesses from having tax-related costs deduct -free income. This interpretation took many lawmakers by surprise, since the exclusion of loans from taxation and subsequent denial of deduction, however, essentially nullifies the benefit granted by Congress. Therefore, on December 27, 2020, when the Consolidated Funds Act for 2021 came into force, the law was amended so that the costs paid for the use of PPP loans granted are actually deductible.
As a result, most states are now finding that they are in one of three positions. States compliant with a Pre-CARES Act version of the IRC generally treat federal loan granted as taxable income and related business expenses (such as payroll, rent, and utilities) as deductible. States that comply with a Post-CARES Act but a version of the IRC of the Pre-Consolidated Appropriations Act are generally on track to exclude issued PPP loans from taxable income but refuse to deduct related expenses. States that use ongoing compliance or have otherwise updated their compliance statutes to a version of the IRC under the Consolidated Appropriations Act exclude both income-related PPP loans and related expenses from being deducted. In some cases, however, states have specific regulations on PPP loan income that replace their general compliance approach.
State policymakers are now in a position to help ensure that PPP recipients receive full emergency congress by foregoing state-level taxation of these federal lifelines. Refusing to deduct expenses covered by issued PPP loans has a tax effect very similar to treating issued PPP loans as taxable income: both tax methods increase taxable income beyond what it would have been if the company hadn’t taken out a PPP loan in the first case. Many states that currently have PPP loans for tax purposes, including Arizona, Arkansas, Hawaii, Maine, Minnesota, New Hampshire, and Virginia, have bills in place to prevent such taxation, and Wisconsin recently did the same. In this situation, baselines play a role: based on the baseline of taxation on loans granted (or denial of deduction), compliance with federal treatment means a loss of revenue. However, if the base scenario is one in which there were no PPP loans issued – the status quo ex ante – following federal guidelines is revenue neutral. This was not income that the states were expecting or that they could probably generate.
However, if policymakers want to avoid levying taxes on these small business lifelines, they need to act quickly as tax deadlines are rapidly approaching.
February 26th: Georgia passed House Bill 265, which, among other things, updates the state’s IRC compliance regarding the treatment of PPP loans granted.
February 25th: In West Virginia, HB 2358 and HB 2359 were incorporated into law on February 24, 2021. The state’s compliance date has been updated to reflect changes in federal corporate and individual income tax in 2020, removing PPP loans granted from taxable income.
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