Businesses that receive debt forgiveness from the emergency loan program created by Congress could face an unwelcome surprise without more clarity from their state legislatures: tax bills on those forgiven loans.
Debt forgiveness typically counts as a taxable benefit, but Congress made loans from the $349 billion Paycheck Protection Program forgivable as long as certain conditions are met, and said the federal government wouldn’t tax the discharged debt. But unless some states update their own tax codes to allow for similar forgiveness they may end up taxing debt relief intended as economic aid.
Some states, like New York and Tennessee, have what’s called “rolling conformity” with federal tax law. That means their tax codes automatically update to changes in the federal tax code. But others update their tax codes to federal changes on a static basis, and sometimes it takes them several years to do so.
This year legislatures have truncated their sessions because of the health emergency. Some part-time legislatures may have to call an emergency session if they want to address the issue.
“States with what is known as rolling conformity are set; they will not tax the forgiveness of federal loans under the PPP unless lawmakers in those states adopt a law expressly doing so,” Jared Walczak, director of state tax policy for the Washington-based policy nonprofit the Tax Foundation, said in a recent analysis. “But with static conformity states, it all depends on if and when they update their conformity.”
Barring an update to their own laws, more than half of states, including some of the largest economies like California, may tax the emergency benefit. According to the Tax Foundation, as many as 30 states may need to update their tax law to conform with Congress’s third emergency relief package (Public Law 116-136).
The National Conference of State Legislatures didn’t respond to a request for comment.
A Democratic congressional tax policy aide, who requested anonymity to speak freely, said they weren’t immediately aware of businesses facing increased taxes from federal debt forgiveness. The aide said that the payments businesses had to spend the federal money on to qualify for forgiveness—utilities, wages, rent, and mortgage—might qualify for enough state deductions to offset an increase in state levies due if the loan is forgiven. But the staffer cautioned that deductions might not be enough to offset the tax burden in all states or for all businesses.
Tax specialists’ opinions vary as to whether the forgiven loans might incur state taxes, or the expenses would be eligible for tax deductions—a reflection of the uniqueness of the situation.
Normally, expenses like wages and utilities are deductible for taxpaying businesses and nondeductible for tax-exempt organizations. When Congress made the forgiven loans exempt in this unprecedented relief program, it didn’t say anything about deductibility.
Because the employer-borrowers receiving loans under the Paycheck Protection Program don’t bear the economic cost of the wages, utilities, and other expenses, they wouldn’t be able to deduct them to offset any increased taxes due to federal debt forgiveness, Harvey Bezozi, a certified public accountant based in Boca Raton, said.
“The intent is to provide tax free income by forgiving the loan debt,” he said in an email. If the expenses weren’t deductible, “the whole purpose of encouraging the maintenance of full employment would be lost. So, we are expecting clarity from Treasury to allow not only tax-free income, but also expense deductibility. This gives employers even more of an incentive to stay fully-staffed.”
Michael Daze, a Bloomberg Tax analyst, said state legislatures might look at the intent of the law and allow deductibility, or Congress could as well.
“Deductions are a matter of legislative grace,” Daze said. “Congress or a state legislature could always decide to limit deductions, but that would be surprising in the current situation.”
Some tax lawyers are warning states to preempt the possibility of a tax increase on small businesses that take federal aid.
Bruce Ely, a partner at Bradley Arant Boult Cummings LLP in Alabama, said he is working with an Alabama senator to determine whether the state needs to pass a bill that specifically exempts PPP loan forgiveness from the state’s version of the cancellation-of-indebtedness rules.
As it’s written, the coronavirus relief law “does not constitute an amendment to the IRC,” Ely said.
For states with rolling or automatic conformity to the IRC, like Alabama on the corporate income tax side, the language in the federal relief law may be enough to protect taxpayers from adverse state income tax consequences, Ely said.
“However, I’d want an announcement or ruling from the state DOR to confirm that,” he said.
“States that do not adopt the Internal Revenue Code on a rolling basis would need to enact legislation that provides for PPP loan forgiveness,” said Marc Finer, chair of the Tax Practice Group at Murtha Cullina, a Connecticut-based law firm.
Since a state like Massachusetts generally adopts the federal code for personal income tax purposes, PPP loan forgiveness would likely be included in the state’s personal taxable income, Ely said.
But lawmakers could specifically adopt a provision exempting the loan amount from the state’s personal income if they wanted to provide certainty, he added.
Ely raised a cautionary note. For states conforming to the IRC “as amended from time to time” or in “effect from time to time”—as Alabama’s conformity statute reads—a beneficiary of that state’s income tax revenue might challenge the state DOR’s favorable interpretation, according to Ely. Since the ruling wasn’t done legislatively and it would reduce income tax revenue flowing into the state coffers, they could dispute it as lacking statutory authority,
“Perhaps a governor or state DOR could wave their magic wand and announce that the income will be exempt from state income tax, but that could be subject to challenge down the road by, for example, a beneficiary or recipient of those revenues,” Ely said.