While the treatment of Paycheck Protection Program (PPP) expenses has been resolved for federal income tax purposes, what do taxpayers need to do to address these expenses for state and local income taxes, especially in light of calculating their estimated state tax payments?

CARES Act: PPP Loan Forgiveness and IRS Treatment of Otherwise Deductible Expenses

As part of the CARES Act, Congress specified that forgiven PPP loans used for allowable expenses would be excluded from a recipient’s gross income. In the absence of a specific provision regarding the deductibility of these allowable expenses, the IRS issued Notice 2020-32, taking the position that expenses paid with forgiven PPP loans are not deductible. Notwithstanding criticism that the nondeductibility of such expense is in direct conflict with the Congressional intent behind the program, the IRS doubled down on its position in Revenue Ruling 2020-27, ruling that taxpayers in receipt of a PPP loan may not deduct certain otherwise deductible expenses paid for with such loan if the taxpayer expects the loan to be forgiven before the end of the taxable year. As noted below, this ruling has recently been abrogated by law.

COVID-related Tax Relief Act

On December 27, 2020, the President signed into law the COVID-related Tax Relief Act as part of the massive 5,000+ page year-end Omnibus Appropriations and Stimulus package. Among other things, the COVID-related Tax Relief Act clarified the tax treatment of deductible expenses paid from PPP loan funds. Nullifying the administrative guidance from the IRS, Congress clarified that “no deduction shall be denied” for otherwise deductible expenses paid for with forgiven PPP loan amounts. So, expenses paid with a forgiven PPP loan may be deducted from a business’ taxes.

With the federal tax treatment of otherwise deductible expenses paid for with PPP loans now clarified before the end of the year, the next question is: will states follow suit?

State Adoption of Federal PPP Loan Tax Treatment

Even in the wake of the clarifying federal statutory language, it cannot be assumed that states will conform to federal tax treatment concerning the deductibility of expenses made with forgiven PPP loans. In the absence of specific CARES Act and COVID-related Tax Relief Act guidance from states – whether by formal legislation or informal administrative guidance – existing state law governs.

Most state taxing regimes are based, to different extents, on the Internal Revenue Code of 1986, as amended (Code), but conformity to the Code in its entirety is not automatic. The type of conformity regime a state employs will inform whether a state conforms its tax regime to adopt the recently enacted federal provisions. States are roughly split evenly between rolling conformity and static conformity, with a handful taking a selective approach.

It can be anticipated that states with rolling conformity will adopt the federal changes contained in the CARES Act and the COVID-related Tax Relief Act (e.g., New York, Illinois), though each state’s treatment should be confirmed.

In contrast, states having a policy of static conformity specify conformity to the Code as of a specific date, such as January 1, 2016 (e.g., Florida, Indiana, Ohio, Kentucky, Texas). 

Still other states take a selective approach, wherein a state adopts certain federal provisions as of a specified dates (e.g., California, Pennsylvania). These states must explicitly adopt the recently enacted federal provisions into their state tax regimes in order for expenses paid with forgiven PPP loans to be deductible at the state level. 

What do you do with state tax estimates?

In calculating estimated state and local tax payments, a conservative approach would involve basing these payments on a state’s existing law and administrative guidance, and assuming that the state will adopt the IRS’s position in Revenue Ruling 2020-27. Based on recent Congressional action however, other taxpayers may reasonably adopt a more aggressive approach. For example, in light of the recent federal statutory clarification, some taxpayers may opt to calculate their state tax estimates based on the premise that such PPP loan forgiveness related expenses are deductible -----assuming that the state has adopted or will adopt the treatment provided for in the COVID-related Tax Relief Act.

Query – would a taxpayer need an opinion to support their position?

Given the complexities and lack of certainty in state conformity to the federal PPP loan forgiveness and expense deduction provisions, taxpayers should carefully consider how to treat expenses related to PPP loan forgiveness.