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Editorial 10 MIN READ

PPP forgiveness and the state-tax problem nobody planned for

Federal law excludes forgiven PPP from income, but state treatment depends on the conformity date printed in your state's tax code

The Editors
Staff, Incorporator.org
10 min read Updated
Contents 8 sections
  1. What section 1106(i) actually does
  2. Why states are not on the same page
  3. Where the states actually are in November 2020
  4. The second-order problem: apportionment and nexus
  5. What borrowers should do before the 2020 returns are filed
  6. A quiet argument about legislative intent
  7. The practical map as of today
  8. Sources

he federal rule on PPP loan forgiveness is settled: under section 1106(i) of the CARES Act, a forgiven Paycheck Protection Program loan is excluded from gross income. The state-tax rule is not. Whether a borrower owes state income tax on the forgiven amount depends on a single line of the state's tax code, the one that names the date its legislature picked to sync up with the Internal Revenue Code.

Most borrowers have not thought about this. By November 2020, five states have said out loud that PPP forgiveness is not taxable at the state level. Several more have said nothing, and a handful are quietly on course to tax it unless their legislatures act before returns come due in the spring.

What section 1106(i) actually does

The CARES Act was signed March 27, 2020. Section 1106 set up forgiveness for PPP loans used on payroll, rent, mortgage interest, and utilities during a covered period. Subsection (i), captioned "Taxability," reads: "For purposes of the Internal Revenue Code of 1986, any amount which (but for this subsection) would be includible in gross income of the eligible recipient by reason of forgiveness described in subsection (b) shall be excluded from gross income." That sentence is the entire federal answer.

Normally, discharge of indebtedness income is taxable under IRC section 61(a)(11). Congress carved PPP out of that rule by statute. But it did not, in section 1106(i), say anything about the deductions that the borrower took on the payroll and rent expenses the forgiven loan funded. Those expenses would ordinarily be deductible under sections 162 and 163.

On April 30, 2020, the IRS published Notice 2020-32 and closed that door. The Notice, citing section 265(a)(1) (expenses allocable to tax-exempt income) and a line of cases running through Manocchio v. Commissioner, took the position that no deduction is allowed for expenses paid with proceeds of a PPP loan that is later forgiven. The practical effect is that the borrower, while not recognizing forgiveness as income, loses an equivalent amount of deductions. For most borrowers, the net federal tax is the same as if forgiveness had been taxable in the first place. The exclusion is mostly a timing and character difference, not a real giveaway.

The AICPA and a bipartisan group of senators have been pushing since May for legislation clarifying that the deductions remain allowed, arguing this was Congress's intent in section 1106(i). Nothing has passed. As of this writing, Notice 2020-32 remains the federal guidance. There is no Revenue Ruling yet that addresses timing, though practitioners expect one.

Why states are not on the same page

Every state income tax statute imports the federal Internal Revenue Code by reference. How it imports matters.

A rolling-conformity state says, in effect, "our starting point for state taxable income is federal taxable income as defined by the Internal Revenue Code in effect today." Most states work this way. When Congress amends the Code, those states automatically inherit the amendment unless they decouple by statute. Illinois, New York, New Jersey, and roughly two-thirds of the states with an income tax use this approach for corporations, individuals, or both.

A fixed-date (or "static") conformity state says, "our starting point is the Internal Revenue Code as it existed on a specific prior date." That date is a line of text in the state code, updated only when the legislature passes a conformity bill. California picks a date, often several years behind. Minnesota pinned its conformity date at December 31, 2018, for many purposes and has not caught up to the CARES Act. Virginia, North Carolina, Florida, Georgia, and several other states also use fixed-date conformity and must actively pass legislation to pick up federal changes.

A third group, sometimes called selective-conformity states, writes their income tax almost entirely from scratch and conforms only to specific federal provisions. Alabama, Arkansas, California (for corporations), and Mississippi fall in this camp to varying degrees.

The CARES Act was enacted March 27, 2020. A rolling-conformity state's base broadens or narrows that day. A fixed-date state only picks up section 1106(i) when it amends its conformity date forward past March 27, 2020, or enacts a specific PPP carve-out. Until then, the fixed-date state's tax code, as a technical matter, does not recognize the federal exclusion at all.

Where the states actually are in November 2020

Five states have now issued formal guidance that PPP forgiveness is not subject to state income tax. Each got there a different way.

California: The Franchise Tax Board had authority under California's selective-conformity regime to treat PPP consistently with federal treatment, but the Legislature did the work directly. Assembly Bill 1577, signed by Governor Newsom on September 9, 2020, excludes forgiven PPP loan amounts from gross income for California tax purposes. The bill does, however, disallow deductions for expenses paid with forgiven PPP proceeds, tracking Notice 2020-32. So California borrowers receive the exclusion but not a state-level restoration of the deductions Treasury has denied federally.

North Carolina: Session Law 2020-58, signed June 30, 2020, updated North Carolina's conformity date to May 1, 2020, which sweeps in the CARES Act. Like California, North Carolina adds back the expenses paid with forgiven PPP funds, so state taxable income rises by the disallowed deduction amount even as the forgiveness itself is excluded. The Department of Revenue issued an important notice summarizing the position in late summer.

Virginia: A fixed-date conformity state that historically updates each winter. The Department of Taxation issued Tax Bulletin 20-6 on August 19, 2020, stating that while Virginia's conformity date remained December 31, 2019 (before CARES), the Department would administratively follow the federal exclusion of PPP forgiveness. Virginia also conforms to the federal deduction disallowance. The 2021 General Assembly is expected to formally update the conformity date.

Wisconsin: Wisconsin Act 185, enacted April 15, 2020, updates Wisconsin's conformity for tax years beginning after December 31, 2017, to include several CARES Act provisions, including the section 1106(i) exclusion. The Wisconsin Department of Revenue confirmed the treatment in guidance published over the summer.

New Jersey: New Jersey's Division of Taxation published guidance on November 5, 2020, confirming that PPP forgiveness is not subject to the New Jersey Gross Income Tax or the Corporation Business Tax. New Jersey is a rolling-conformity state for CBT purposes, so the result follows almost automatically, but the Division's guidance also addresses the expense-deduction question and sides with the borrower on the CBT side, pending further federal guidance.

The states that have been publicly silent as of November 10 include several fixed-date conformity jurisdictions whose treatment is, in the absence of legislative action, unfavorable or unclear. Minnesota, whose conformity date is still pinned at December 31, 2018, would, on a strict reading of its code, include forgiven PPP amounts in the Minnesota base. No guidance has come out of the Department of Revenue as of this writing. Florida and Georgia face similar tensions, though Georgia's annual conformity bill historically passes in the spring and is expected to address this in 2021. The result for a multistate borrower is that the state-level treatment of a single forgiven loan can vary meaningfully depending on where the borrower files.

For the background on how these conformity gaps tend to persist even when Congress thinks it has settled a question, see our earlier piece on state conformity to federal tax changes, the lag problem.

The second-order problem: apportionment and nexus

For a multistate business, the state-tax question is not just "is PPP forgiveness taxable in state X," it is "how much of that forgiveness, if any, is apportioned to state X."

Most state corporate income taxes use a sales-factor or three-factor apportionment formula to divide a multistate corporation's income among the states where it does business. The CARES Act did not alter these formulas. A fixed-date state that does not exclude the forgiveness will, in principle, assign a portion of that forgiveness to itself based on the borrower's apportionment factors in that state. The state apportioning the gain may or may not be the state where the borrower spent the proceeds on rent and payroll.

The scenario that creates real friction: a Minnesota-domiciled business that also operates in Wisconsin and California, each of which has confirmed the federal exclusion. Minnesota, on a strict reading of its pre-CARES conformity, would tax the Minnesota-apportioned share of the forgiveness unless the Legislature acts. The borrower's accounting will look as if Minnesota is charging a tax on a federally excluded item, because Minnesota is.

Pass-through entities face a parallel version of the issue at the individual-owner level. An S-corporation shareholder or LLC member takes the forgiveness, or its add-back, on a K-1, and the state treatment depends on the state of residence as well as the state sourcing rules for the pass-through's income.

What borrowers should do before the 2020 returns are filed

The first step is to determine whether the borrower's lender has in fact forgiven any portion of the loan by year-end. The SBA did not begin processing forgiveness applications until August 10, 2020, and the agency has been working through a backlog. Many borrowers will receive formal forgiveness decisions in 2021 or later, which pushes the income-recognition and deduction-disallowance questions into different tax years depending on one's accounting method and interpretation of Notice 2020-32.

The IRS has not yet issued formal guidance on the timing question, specifically whether a borrower who has not yet received a forgiveness decision must nonetheless disallow the deductions in the 2020 return if forgiveness is "reasonably expected." Practitioners are divided. The more conservative view is that, since the borrower spent the proceeds intending forgiveness and has submitted or will submit an application for that amount, section 265(a)(1) applies in 2020. The more aggressive view is that no disallowance is required until the forgiveness is granted. Borrowers in fixed-date conformity states whose legislatures have not yet caught up with CARES should consider this question carefully, because it compounds with the state-level uncertainty.

For small businesses that have been tracking their pandemic compliance obligations, this sits alongside the shifting landscape of state filing-fee waivers and deadline extensions during COVID, which continues to evolve on a state-by-state basis through the fall.

A quiet argument about legislative intent

Most of the state-level guidance issued to date has implicitly agreed with Treasury on the deduction-disallowance side, even as states are willing to exclude the forgiveness from income. California's AB 1577, North Carolina's S.L. 2020-58, and Virginia's Tax Bulletin 20-6 all say: yes, the forgiveness is excluded, but the expenses paid with it are not deductible. New Jersey's November 5 guidance is narrower on this point and leaves open the possibility that expenses funded with forgiven PPP proceeds may still be deductible for New Jersey CBT purposes, pending federal clarification.

The economic substance of the states' position is the same as the federal position under Notice 2020-32, which is that the borrower ends up roughly where it would have been if the forgiveness had been taxable. What is different is that a state has chosen to add this disallowance through its own statute or administrative notice rather than by silently conforming. That matters for lobbying purposes: legislators who believed, as they passed CARES, that PPP forgiveness would be functionally tax-free may yet restore the federal deductions, and a number of the states that have acted have done so in a way that can be quickly reversed if Washington moves.

The Senate Finance Committee and the House Ways and Means Committee have each circulated draft bills that would clarify the deduction question in favor of borrowers. None has yet been scheduled for a floor vote. A borrower preparing its 2020 return has no assurance that any such bill will pass before the filing deadline.

The practical map as of today

A borrower should ask three questions before assuming its state treatment. Is my state a rolling-conformity state? If yes, the federal exclusion flows through automatically and the state question collapses to the deduction-disallowance question. Is my state a fixed-date conformity state? If yes, has the Legislature or the Department of Revenue spoken on PPP? If not, the default position under a strict reading is that the forgiveness is state-taxable, and the borrower should either plan around that or wait for guidance. Does my state have its own independent computation of income, like California for corporations? If yes, check for a statute or notice naming PPP directly.

The map will keep changing through the winter. Several states historically update their conformity dates in the first weeks of their legislative sessions. A borrower whose fiscal year ends December 31 and whose state has not acted by March 2021 may find itself extending the return to wait for certainty.

Sources

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