INSIGHT: The CARES Act Could Have Simply Elevated Your State Taxes. Wait. What? – Half 1

When the Coronavirus Aid, Relief, and Economic Security Act (P.L. 116-136) (the CARES Act) became law on March 27, 2020, unbeknownst to many Americans, their state taxes may have increased.

The CARES Act is a historic piece of legislation providing an estimated $2.2 trillion of stimulus to the American economy in response to the viral pandemic that has devastated workers and industries throughout the country and literally around the world. Included in the mix of loans, grants, and government agency appropriations were a number of direct changes to the federal income tax law, some of which temporarily modified provisions of the Tax Cuts and Jobs Act (P.L. 115-97) (TCJA) that were enacted less than three years ago. The direct tax stimulus measures in the CARES Act include restoring a net operating loss (NOL) carryback and expanding it to five years, temporarily lifting the 80% net income offset limitations with respect to NOLs and modifying the business interest expense limitations under Internal Revenue Code Section 163(j), among others.

The CARES Act also provides indirect modifications to the IRC through enactment of special tax rules that will apply to those taxpayers who participated in the variety of loan programs, employee retention tax credits, and the deferral of the payment of employment taxes.

In the frenetic week in mid-March when Congress rapidly enacted these provisions, the state tax impacts of these changes likely were not at the front of mind of federal policymakers responding to an unprecedented crisis of global proportions. Nevertheless, many of the CARES Act provisions will have state tax impacts, and unless the state legislatures respond, some of the benefits accruing from these CARES Act provisions may result in a reduction in state tax deductions, which could increase their state income tax liabilities.

There are at least 50 different ways to address these changes. Subtle nuances in how the state tax laws conform to the federal income tax base will require careful analysis state by state, and, in some cases, the result within the state will differ depending upon whether the taxpayer is a corporation, an individual, or a pass-through entity. A one-size-fits-all approach won’t work, and each state (and their tax-type law) will have to be addressed separately.

This will be the first of two articles that will provide a few examples of the areas where state conformity to (or decoupling from) the CARES Act will have a state income tax impact.

This first article will address the indirect provisions (i.e., those that don’t expressly reference the IRC), and the next will address the direct provisions (i.e., those that expressly refer to a provision of the IRC.)

General discussion on state/IRC conformity

So, why is this happening? Every state income tax law (both corporate and individual) is in some way, shape, or form tied to the IRC. Of course, this is mostly for the convenience of not only taxpayers but also state taxing authorities. As taxpayers prepare their annual returns, the enormous amount of financial information they gather for federal income tax purposes can then be carried over and used to generate the tax base in every state. Most states tie to either federal adjusted gross income (AGI), as set out in IRC Section 62, or federal taxable income (FTI), as described in IRC Section 63, such that not only are the federal items of income, gain, and loss used but also the federal tax deductions, accounting principles, and other similar administrative matters.

In contrast, most states do not directly tie to federal tax credits that offset the taxpayer’s computed federal income tax liability. Instead, the states may adopt state tax credits that mirror the subject matter of the federal tax credits (e.g., state research and development credits). The state tax credits may even be calculated based on the same figures used to compute the analogous federal tax credit; but, in every case, they usually have their own features that are responsive to local tax policy needs. Once the federal tax base is determined, most states that tie to federal determinations of taxable income then instruct taxpayers to add or subtract different elements of FTI or deduction to reflect state tax policy decisions that may differ from those made by Congress for federal tax law purposes.

A few states, such as California with its corporate franchise tax, approach federal conformity differently, but they get to the same result as those states whose tax base ties directly to either AGI or FTI. Instead of relying upon federal income tax determinations, their state tax laws directly incorporate specific provisions of the IRC to construct the state tax base. In these states, instead of additions and subtractions to AGI or FTI, the state tax law incorporates directly by reference and modifies individual provisions of the IRC to reflect state tax policy differences. Even though the law in these states reads this way, in many of these states, as a convenience to state taxpayers (and likely their own tax administrators), they follow the federal tax base addition and subtraction method used by other states to ultimately compute the state tax base.

Finally, but perhaps most important for this discussion, states vary as to the version of the IRC to which they conform. In that regard, the states can be divided into two broad categories: “rolling conformity” and “fixed date conformity.” In the case of rolling conformity states, the state tax law ties directly to the most current version of the IRC. In these states, the tax law immediately conforms to federal tax law changes as they occur, unless the legislature enacts measures to modify or decouple from the newly adopted federal provisions. In contrast, in a fixed date conformity state, nothing happens unless and until the state legislature affirmatively updates its conformity date.

Florida, for example, is a classic fixed date conformity state—nothing happens until the legislature updates the date of its reference to the IRC. The state’s legislature, however, has a long and continuous history of updating the conformity date to the current IRC at the beginning of each annual legislative session with any such changes usually retroactive to the preceding taxable year (including any modifications the legislature decides to make to reflect state and federal policy differences.) In the Florida income tax law (at Fla. Stat. Section 220.03(1)(n)), the IRC is defined to be that as “amended and in effect as of January 1, 2019.” Those who regularly follow Florida state tax law know that every January, at the beginning of the legislative session, an update bill is introduced and shortly thereafter adopted (although certainly not without important modifications addressed by the legislature).

Illinois, in contrast, is a classic rolling conformity state. The Illinois income tax law (at 35 ILCS Section 5/1501(a)(11)), defines the IRC as that “… in effect for the taxable year.” Under this provision, federal tax law changes are automatically incorporated into Illinois’ income tax law annually, and the legislature meets, assesses the impact of the federal tax law changes since the last time it addressed the tax laws, and then adopts a conformity bill accepting or rejecting certain of those changes from the previous conformity date, usually with retroactive effect.

As if this is not complicated enough, Massachusetts presents a particular challenge to taxpayers and their advisors because the commonwealth’s corporate excise tax law generally operates as a rolling conformity state (as set out in Mass. Gen. Laws ch. 63, Section 1 (Taxation of Corporations)), while its personal income tax law (as set out in Mass. Gen. Laws ch. 62, Section 1) operates as a fixed date conformity state (currently generally tied to the IRC as of Jan. 1, 2005, but with specific and important IRC sectional carve-outs that may be rolling conformity or fixed date conformity to a different date from the general conformity date).

With this structural background on state and IRC conformity, let’s turn to a few of the provisions of the CARES Act that may indirectly result in increased state taxes for taxpayers benefiting from some of the federal stimulus measures.

Indirect state tax costs of the CARES Act

Loan forgiveness for Paycheck Protection Program loans —excluded or not for state tax purposes (and more)?

The Paycheck Protection Program (PPP) loan was intended to encourage small business employers (generally those with fewer than 500 employees but with special rules for accommodations and food services industries) to keep their employees on the payroll through an anticipated temporary shutdown of the economy. One of the unique headline features of the program is the ability to obtain forgiveness of all or a portion of the PPP loan if the borrower used the proceeds for certain specified activities (e.g., to pay payroll costs, mortgage interest, utility expenses) under Section 1106(b) of the CARES Act.

Later guidance from the U.S. Small Business Administration and the U.S. Department of the Treasury (published at 85 Fed. Reg. 20811 on April 15, 2020) clarified that 75% of the proceeds of the PPP loan amount to be forgiven had to be used to pay eligible payroll costs. Subsequent legislation signed by President Trump on June 5, 2020 (titled the Paycheck Protection Program Flexibility Act of 2020 (P.L. 116-142)) expressly reduced this administrative percentage further to 60%.

If a PPP loan is forgiven, Section 1106(i) of the CARES Act provides that the taxpayer can exclude the forgiven amount from federal income tax:

“(i) TAXABILITY — For purposes of the [IRC], any amount which (but for this subsection) would be includible in gross income of the eligible recipient by reason of forgiveness described in [CARES Act Section 1106(b)] shall be excluded from gross income.”

Generally, income from the discharge of indebtedness (or also referred to as “cancellation of indebtedness income” and hereinafter “CODI”) is expressly included in gross income in IRC Section 61(a)(11). Its inclusion in gross income has long been recognized by judicial rulings dating back to the early years of the federal income tax laws, such as United States v. Kirby Lumber Co. To further clarify, CODI was first codified in the 1939 IRC at Section 22(b)(9), a predecessor to today’s IRC Section 108.

It’s often difficult for taxpayers unfamiliar with the tax laws to fathom that a loan that is forgiven actually results in an accretion to wealth and, therefore, is rightfully part of their gross income. Since CODI usually becomes an issue only when a taxpayer is struggling with economic survival, in response, Congress also has long provided some relief to financially distressed taxpayers through IRC Section 108 and its predecessors, which expressly exclude CODI from gross income to the extent the discharge occurs in bankruptcy or to the extent of insolvency, among other conditions.

To the extent that any such CODI is excluded, IRC Section 108 provides that the tax attributes of the taxpayer (such as NOLs, tax credits, and basis in assets) must be reduced in a specific order. This attribute reduction in effect results in a deferral of, rather than an outright exclusion from, taxable income (except to the extent that the taxpayer’s attributes are completely exhausted, and IRC Section 108 otherwise provides for recognition of such income).

The PPP loan forgiveness provision in the CARES Act is unique in that it expressly excludes any such CODI from gross income without any conditions. None of the conditions that apply under the existing CODI exclusion rule in IRC Section 108 apply and a qualifying PPP borrower isn’t even required to reduce any of its attributes. On the other hand, the conditions for forgiveness of a PPP loan require the taxpayer to use the proceeds of the loan only for specified costs and, if not, the loan is not forgiven but instead, presumably would run the existing gauntlet for CODI under the current IRC (i.e., includable in gross income but excludable to the extent of bankruptcy, insolvency, or the other conditions available under IRC Section 108 (with applicable attribute reduction)).

The unusual means by which the amount of CODI from a forgiven PPP loan is statutorily excluded from gross income presents interesting state conformity problems. First, this exclusion is not provided by an amendment to the IRC but instead by a Congressional direction in an “off code” part of the CARES Act to exclude the forgiven amount of the PPP loan from gross income “for purposes of the [IRC].” The author, having no personal experience in the codification office for the United States Code, questions where the instruction from Congress is as to whether and how this provision will (or will not be) codified in the IRC. Perhaps it will be included as a note to IRC Section 61 defining “gross income.”

This codification problem, however, is precisely the problem for state tax purposes. First to be addressed is a state statutory construction problem: is CODI from a forgiven PPP loan excluded from gross income by an “amendment to” the IRC? Second, and perhaps more importantly, is any such excluded CODI from a forgiven PPP loan part of the determination of either FTI or AGI, the critical starting point under most state tax laws for determining the state tax base?

Assuming that the state is a fixed date conformity state and it does not update its IRC conformity date, presumably, the state would have no choice but to conclude that CODI from a forgiven PPP loan is not excluded from gross income (unless otherwise excluded under a different provision of the IRC or state tax law that may have existed prior to enactment of the CARES Act). Unless the PPP loan borrower is eligible to treat it as excludable under IRC Section108 for state tax purposes (e.g., such borrower was insolvent or in bankruptcy (both rather distressing conditions)), it would appear that CODI from a forgiven PPP loan would be taxable for state tax purposes where no such federal tax liability exists. In the May edition of its Tax News publication, the California Franchise Tax Board stated that California’s tax law:

“… does not conform to some of the other changes made by the CARES Act, including those related to: … loan forgiveness related to the Paycheck Protection program … (available on the internet at (last accessed May 20, 2020)).”

Considering that California’s general IRC conformity date remains Jan. 1, 2015 (as set forth in the personal income tax law at Cal. Rev. and Tax Code Section 17024.5(a)(1)(P) (defining the IRC) and incorporated by reference into the corporate tax law through the definition of IRC in that law at Cal. Rev. and Tax Code Section 23051.5(a)(1)), it would appear that the only way to provide similar relief for California taxpayers with proceeds from a forgiven PPP loan would be through express legislative conformity.

In rolling conformity states, the analysis poses a series of different questions of first impression (at least in the author’s experience), including: is the CARES Act provision actually an amendment to the IRC that is followed by state law? Recall the discussion above that Congress did not enact the forgiven PPP loan CODI exclusion provision as an amendment to the IRC but rather as an “off code” provision that is part of the CARES Act. The answer will likely depend upon the coordination of the state statute either with the IRC or with respect to a tie-in to the federal tax base (e.g., is the state starting point gross income or AGI or FTI? (and in which case does the state law tie to the amount reported to the IRS, or does it tie to the IRC definition of the tax base?)).

A careful reading of each state’s statute will be necessary. In a state such as New Jersey where, according to N.J.S.A. Section 54:10A-4(k), the starting point for the state’s Corporation Business Tax is “prima facie” the amount of taxable income reported for federal income tax purposes, it would appear to be an easy conclusion that the state will follow the federal income tax treatment (unless the legislature chooses to decouple). On the other hand, if the New Jersey taxpayer is an individual, under N.J.S.A. Section 54A:5-1 of the state’s Gross Income Tax Law (personal income tax), there is no direct tie to the IRC or to federal definitions of gross income, AGI, or FTI. The state’s tax court provides some solace by demonstrating a clear legislative intent to not subject CODI to the gross income tax in Weintraub v. Director, Div. of Taxation. Thus, at least for New Jersey personal income tax purposes, a taxpayer seems to be on firm ground that CODI is not included in the tax base at all.

In Oregon, generally a fixed date conformity state, one would think that, as with California, CODI would not be excluded. On April 21, 2020, the state’s Legislative Counsel in a response to a state representative’s question, however, issued a taxpayer favorable opinion that based on its constitutional tie to federal determinations of FTI, the state would follow the federal income tax treatment and not include excluded CODI from a PPP loan in Oregon taxable income despite the state’s IRC fixed date conformity. The Legislative Counsel, in the same letter, also concluded that CODI from a forgiven PPP loan would not be subject to Oregon’s new Corporate Activity Tax because the amounts “… would not be considered commercial activity.” It remains to be seen whether the Oregon Department of Revenue will follow the Legislative Counsel’s advice and even if it does, whether an Oregon court, if pressed, will agree.

In Massachusetts, whether CODI from a PPP loan is taxable will depend upon whether the taxpayer is a corporation or an individual. Neither the commonwealth’s corporate excise tax nor the personal income statutes directly address the issue, but, considering that the corporate tax statutes operate as a “rolling” conformity law while the personal income tax statutes operate as fixed date conformity laws, corporations likely could exclude CODI from a forgiven PPP loan from state taxation while individuals cannot. Of course, there does not appear to be any logical tax policy reason for the differential treatment of individuals and corporations in the state, but until it is addressed by the commonwealth’s legislature, it does appear to be the mechanical conclusion to the treatment of such income under these different tax laws that ought to be addressed by the legislature.

One other interesting state question for CODI from a forgiven PPP loan is whether the costs, including payroll costs, used to compute the amount of loan forgiveness are excludable. Much has been written by others about the federal income tax issues related to this. The IRS, in recently issued Notice 2020-32, concluded that if such CODI is excludable from gross income, any of the deductions relating to that excluded income would no longer be deductible under IRC Section 265. IRC Section 265(a)(1) generally provides that no deduction is allowed for an otherwise allowable deduction allocable to “exempt” income. The IRS notice has come under attack from various quarters but currently remains the law.

From a state perspective, even if the state’s tax law does not allow for the exclusion of CODI from a forgiven PPP loan, its tax law may not currently provide a mechanism for allowing the affected taxpayer to continue to add back the deduction for the expenses, including payroll costs related to the PPP loan disallowed by IRC Section 265. If so, the state effectively benefits from a “double dip”: not only does the taxpayer have to include CODI from the forgiven PPP loan in state taxable income, but also it likely has no mechanism to allow that taxpayer to claim the associated deductions disallowed for federal income tax purposes for state tax purposes.

Obviously, state tax policy leaders may want to look at the fairness of this to PPP borrowers who are small business owners facing unparalleled economic distress and who, by virtue of the program, generally had to use the funds primarily to keep monies flowing to workers who otherwise would have been unemployed during the government-ordered shutdown of the economy.

Employee Retention Credit—state disallowance of “qualified wages”

With fewer qualification restrictions (e.g., no limit on the number of eligible employees, no other size limitations, no loan forgiveness restrictions), far more taxpayers are likely to qualify for and claim the Employee Retention Credit (ERC) provided under CARES Act Section 2301 rather than any other tax stimulus in the CARES Act, including the PPP loan program. Under CARES Act Section 2301(b)(1), the ERC provides a refundable credit for 50% of “qualified wages” against the employer’s portion of the 6.2% federal Social Security tax for up to $10,000 per employee. Qualified wages generally mean wages paid to employees who are generally not providing services due to full or partial shutdown of an employer by a governmental order. The ERC has its own level of complexity related to which employers qualify and how qualified wages are determined, but from a state perspective, an interesting if seemingly innocuous provision in the CARES Act creates the potential of an adverse state tax cost with no corresponding state offset. Section 2301(e) of the CARES Act provides that:

(e) CERTAIN RULES TO APPLY — For purposes of [CARES Act Section 2301], rules similar to the rules of [IRC] Sections 51(i)(1) and 280C(a) … shall apply.

So those few cryptic words require a little “code work.” The reference to IRC Section 51 (i)(1) above relates to the related-party rules under the Work Opportunity Tax Credit. They basically direct that a beneficiary can’t claim an ERC for amounts paid to related parties, such as their spouse or children, among other issues of relatedness. That provision should create little direct state controversy.

The reference to IRC Section 280C(a), however, is something completely different and far more troubling. That provision, like IRC Section 265 discussed above with respect to CODI from forgiven PPP loans, disallows tax deductions for “wages or salaries” that are used to compute certain enumerated tax credits, such as the Indian employment credit in IRC Section 45S(a) and the Work Opportunity Tax Credit under IRC Section 51(a), among others. Both the Joint Committee on Taxation (JCT) (in its report JCX-12-20 dated April 23, 2020,, describing the provisions of the CARES Act) and the IRS (in a series of FAQs designed to assist taxpayers in understanding the ERC, notably FAQ 85, have issued their views that the effect of this provision is to disallow the deduction for wages or salaries used to compute the ERC from gross income.

The rationale of the provision, of course, is to prevent the classic “double dip” (i.e., using the same item to compute both a tax credit and then taking a deduction for the same exempt income to likewise reduce taxable income.) The oddity, of course, is that the ERC is a credit against not the federal income tax but rather the federal employment tax, a completely different tax with a completely different tax base (i.e., salaries and wages as opposed to taxable income). The federal employment tax has limited “deductions” that differ completely from the determination of the taxable base.

In fact, the author believes this particular statutory snippet was likely pulled off the shelf by the drafters of the CARES Act during its hurried drafting from prior employer retention credits that were provided to victims of earlier natural disasters without any consideration that maybe a credit against an employment tax should be treated a differently. He also believes that this marks the first time the deduction limitations of IRC Section 280C(a) have been applied outside of a federal income tax credit. In fact, even the JCT acknowledges this history in its report in its footnote 118 citing to a number of prior employee retention credits, all of which were creditable against federal income tax. Since the employer is not obtaining the credit to offset FTI but rather its employment tax liability, it really isn’t within the realm of a clear double dip in the sense of using the same expense twice to compute the same tax, but that would be a great subject for a different article.

From a state tax perspective, mechanically, the IRC Section 280C(a) disallowance of a deduction for the wages and salaries used to compute the ERC will carry over into the state tax base and, similar to the IRC Section 265 discussion above, results in a conforming state in essence obtaining yet another double dip at the expense of victims of one of the worst economic disasters in our collective experience (i.e., no state tax benefit for the taxpayer and increased state taxable income due to the mechanical disallowance of an otherwise allowable deduction from the state tax base due to conformity to the federal tax base).

Unless state legislatures act to decouple from this provision of the CARES Act (or the state tax law already is decoupled), mechanically, not only will victims of the economic Covid-19 crisis not receive a state tax benefit similar to the ERC, but those claiming the ERC also will not be allowed the deduction for the wages and salaries used to compute the federal employment tax credit.

Legislators in at least one state, New Jersey, have already introduced a bill (A3960, that, if enacted, would provide a benefit similar to the ERC. In that regard, providing such a state tax benefit helps to offset the pain of a denied federal deduction. In the New Jersey bill, however, benefits are restricted to employers of not more than 10 people.


In the next article, I’ll address the state issues relating to the direct tie-in to various provisions of the CARES Act. In the meantime, state taxpayers and practitioners should carefully assess the conformity problems to the new CARES Act benefits, and state tax policymakers ought to address the equities of the application of the state tax laws as modified by these provisions to taxpayers who are struggling to survive in this challenging pandemic environment.

This column doesn’t necessarily reflect the opinion of The Bureau of National Affairs Inc. or its owners.

Author Information

Steven Wlodychak is a principal with Ernst & Young LLP and is the EY State and Local Tax Policy Leader in Washington, DC. The views expressed are those of the author and do not necessarily represent the views of Ernst & Young LLP or those of the member firms of the global EY organization.